1031 exchanges in California

Why the bill is worse in California

Most states give capital gains at least some favorable treatment, or have no income tax at all. California does neither. The entire gain on your rental sale, including the portion that is depreciation recapture, is taxed as ordinary income at your marginal rate.

For 2026 that means the top brackets run to 12.3 percent, plus the 1 percent mental health services tax on taxable income above one million dollars, for a top rate of 13.3 percent. A large property sale routinely pushes an otherwise middle-income household straight into those brackets for one year.

Stack that on top of the federal side and the arithmetic gets uncomfortable quickly.

A Los Angeles example, line by line

A married couple bought a rental in 1990 for $85,000, spent $40,000 on a new roof and a kitchen over the years, and now have an offer for $900,000. They have depreciated the building fully over 27.5 years.

They paid $85,000 for the house. The tax alone is more than three and a half times what the house cost. California accounts for $109,193 of it, and none of that exists for the identical property in Nevada or Texas.

A 1031 exchange defers all $309,591. Run your own numbers →

The 3 1/3 percent withholding and Form 593

California generally requires escrow to withhold 3 1/3 percent of the total sale price and send it to the Franchise Tax Board. Note that this is the sale price, not the gain. On a $900,000 sale, that is $30,000 held back before you see a dollar.

A 1031 exchange is exempt, but the exemption is not automatic. Form 593 must be completed and delivered to escrow or your qualified intermediary before escrow closes, certifying the transaction as a like-kind exchange.

The clawback rule, explained

Here is the piece that surprises almost everyone.

Suppose you sell your Pasadena rental and exchange into an apartment building in Texas. Texas has no income tax, so it feels as though the California exposure is gone. It is not.

Under Revenue and Taxation Code Section 18032, effective for exchanges completed on or after January 1, 2014, the deferred gain that accrued on California real estate keeps its character as California-source income. When you eventually recognize that gain, whether next year or in twenty years, California taxes the portion attributable to the original California property.

This applies whether or not you still live in California. It applies whether or not you file a California return for anything else. The gain is sourced to the property, not to you.

The clawback does not apply if your replacement property is also in California. It is triggered only by exchanging out of the state.

FTB Form 3840, the filing that never ends

Because California intends to collect on that gain eventually, it needs to keep track of it. That is Form 3840.

• You file it with your California return for the year of the exchange.
• You file it every year afterward, for as long as you hold the replacement property, until the deferred gain is finally recognized.
• You file it even if you have moved out of California and have no other California filing requirement. In that case Form 3840 is filed on its own.
• If you exchange again into another out-of-state property, the obligation continues into the new property.
• The form reports the properties, the exchange dates, the deferred gain, and the adjusted basis.

Practically, this means your relationship with a California CPA does not end when the exchange closes. Put the filing on a recurring calendar reminder and make sure whoever prepares your return knows it exists, particularly if you change accountants after moving.

What happens to your Proposition 13 basis

Long-time California owners often have a property tax assessment far below market value, because Proposition 13 caps annual increases at 2 percent. On a house bought in 1990, the difference can be thousands of dollars a year.

A 1031 exchange is a change in ownership for property tax purposes. The replacement property is reassessed at current market value, and your Proposition 13 advantage on the old property does not carry over.

Two narrow exceptions exist, and neither usually helps a rental owner:

• Proposition 19 lets homeowners who are 55 or older, severely and permanently disabled, or whose home was destroyed by wildfire or disaster transfer their base year value to a replacement principal residence. It does not apply to investment property.
• Revenue and Taxation Code Section 68 allows a base year value transfer when property is taken by eminent domain or governmental action. This does apply to investment property, but only in that specific circumstance.

Budget for the higher property tax bill on the replacement. This is one of the quiet advantages of exchanging into a Delaware Statutory Trust instead: property taxes are an expense inside the trust, already reflected in the projected distributions, rather than a bill that arrives at your house twice a year.

Can you move away and avoid it?

Not for gain that accrued while the property was California real estate. That is what the clawback is for.

Changing residency can matter for other income and for gain that accrues after you leave, and people do move for tax reasons. But California scrutinizes residency changes closely, the Franchise Tax Board has an established audit program for it, and a sale shortly after a move attracts attention. If you are considering it, talk to a California tax attorney first, well before either the move or the sale.

The more reliable answer, for most people, is to defer the gain rather than to try to change where it is sourced.

Why DSTs suit California owners particularly well

Every California owner faces the same arithmetic: the state's share is large enough that deferring it changes the outcome materially. Beyond that, a few things line up specifically for people here.

• The gain is often enormous relative to the property. Decades of California appreciation on a near-zero basis produces gains that dwarf what the same building would generate elsewhere. That makes the deferral worth more.
• California rental economics have gotten harder. Statewide rent caps under AB 1482, expanded local ordinances, and long eviction timelines have made small-scale landlording more work than it was. Many owners want out of the operating business, not just out of the property.
• Yields elsewhere are better. A California rental with a 3 percent cap rate on today's value can often be exchanged into diversified out-of-state real estate with better income characteristics. The firefighter in our case study nearly doubled his income doing exactly this.
• The exchange resets depreciation. Your California property has almost certainly run out of depreciation. A new basis in the replacement means a fresh schedule that shelters much of the income you receive going forward.

The tradeoff is that exchanging out of state is exactly what triggers the clawback and the annual Form 3840 obligation. That is a compliance cost, not a tax cost, and it is manageable, but it must be planned for rather than discovered.

Your California checklist

• Engage a qualified intermediary before you close. Not before you list, not before you sign, before escrow funds. This is the only unfixable step.
• Get Form 593 to escrow before closing to prevent the 3 1/3 percent withholding.
• Pull your depreciation schedule. Form 4562 from your return. In California, land is often 40 percent or more of the value, so the building portion and the depreciation on it can be smaller than a rule of thumb suggests.
• Decide in-state or out-of-state deliberately. Staying in California avoids the clawback and Form 3840 entirely. Going out of state usually improves the economics. Both are defensible, and the choice should be made on purpose.
• Calendar the Form 3840 filing if you exchange out of state, and tell your CPA it exists. Every year, indefinitely.
• Budget for reassessment on any replacement property you own directly. Your Proposition 13 basis does not travel.
• Watch the late-year trap. A November sale means your April filing deadline arrives before day 180. File an extension.