When you do a 1031 exchange from California to another state, the IRS and the Franchise Tax Board both let you defer the capital gains tax at the time of the swap, but California does something the federal government doesn’t: it keeps a permanent claim on the gain that built up while the property sat in California. That claim, known as the clawback, follows the money through every later exchange and comes due the day you finally sell without rolling into another qualifying property, even if you’ve long since moved out of state.
How California’s Clawback Works
Under Revenue and Taxation Code Sections 18031 and 18662, California treats the appreciation that occurred while your capital was invested in California real estate as California-sourced income forever.1California Legislative Information. California Revenue and Taxation Code RTC 18662 Exchanging into out-of-state property doesn’t wash the gain clean. It just defers it, exactly the way the federal deferral works, with one critical difference: the state keeps tracking you.
Say you sell a California rental with $400,000 of built-up gain and exchange into an apartment building in Arizona. The federal government defers the $400,000. California defers it too. If you later sell the Arizona building in a taxable transaction, California comes back for its share of that original $400,000, regardless of where you live when the sale closes.
The obligation survives further exchanges. Trade the Arizona property for one in Florida, then the Florida property for one in Tennessee, and California is still tracking the original California-sourced gain through each swap. The only thing that ends the clawback is a final taxable sale where you recognize the gain and pay the California tax.
What California Will Charge You
California taxes capital gains at ordinary income rates, with no preferential long-term capital gains rate. The rate on the deferred gain depends on your total taxable income in the year you finally recognize it, running from 1 percent to 13.3 percent.2Franchise Tax Board. Capital Gains and Losses
On a $400,000 deferred gain, a taxpayer in the top bracket owes California more than $53,000. That bill can arrive many years after the original California sale, and it arrives whether or not you’ve maintained any other tie to the state.
Annual Reporting While You Hold the Replacement Property
Every year that you hold an out-of-state replacement property with California-sourced deferred gain, you must file Form FTB 3840 with the Franchise Tax Board. The form is how California keeps the clawback alive on its books until a taxable event triggers it.3Franchise Tax Board. Reporting Like-Kind Exchanges
FTB 3840 requires the legal description and physical location of both the original California property and the current replacement property, the dates the exchange was initiated and completed, and the exact amount of California-sourced deferred gain. That gain figure is built from your original cost basis, accumulated depreciation, and the final sale price of the California property, so keep the closing statements from both transactions along with the exchange agreement from your qualified intermediary.
If you still file a California return, attach FTB 3840 to it. If you’ve moved out of state and have no other California filing requirement, file FTB 3840 on its own as a standalone information return. The deadline for individuals matches the California return due date: April 15, with an extended due date of October 15.4Franchise Tax Board. 2025 Instructions for Form FTB 3840 California Like-Kind Exchanges
On the federal side, you report the exchange on IRS Form 8824, which covers the gain calculations, any boot received, and the basis of the replacement property.5Internal Revenue Service. About Form 8824, Like-Kind Exchanges Make sure the deferred gain figures on Form 8824 and FTB 3840 match. Discrepancies between the two are a common audit trigger.
The filing obligation applies to exchanges from 2014 onward and continues every year until the California-sourced gain is fully recognized on a California return.3Franchise Tax Board. Reporting Like-Kind Exchanges
What Happens If You Stop Filing
Skipping the annual FTB 3840 is not treated as a minor paperwork problem. Under Revenue and Taxation Code Section 18032, if you stop filing the information return and also fail to file a California return when the replacement property is eventually sold, the FTB can estimate your income from whatever data it has and propose an assessment for the full amount of deferred gain, plus interest and penalties.6California Legislative Information. California Revenue and Taxation Code RTC 18032
In practice, the FTB reconstructs the gain from property records, intermediary filings, and the original exchange documentation, then sends a notice of proposed assessment built on worst-case assumptions. Contesting that assessment after the fact is substantially more expensive than filing the annual form would have been.
Withholding at the California Sale
California imposes a 3⅓ percent withholding on real estate sales, calculated on the total sales price. On a $900,000 property, that’s roughly $30,000. A properly structured 1031 exchange is exempt from this withholding at the time of the initial transfer. You certify the exemption on Form 593, which your escrow company or qualified intermediary submits to the Franchise Tax Board.7Franchise Tax Board. 2026 Instructions for Form 593 Real Estate Withholding Statement
Two situations override the exemption. If you receive boot exceeding $1,500 at closing, the intermediary must withhold 3⅓ percent on the full sales price. And if the exchange later fails because you miss the 45-day or 180-day deadline, the intermediary must withhold 3⅓ percent before releasing the funds to you.7Franchise Tax Board. 2026 Instructions for Form 593 Real Estate Withholding Statement No withholding is required at all when the sales price is $100,000 or less.
Federal Rules the Exchange Still Has to Satisfy
The California clawback only matters if the underlying 1031 exchange actually works federally. If the federal exchange collapses, the California sale becomes a taxable event right then, and the FTB collects at closing through withholding rather than years later through the clawback.
The replacement property has to be real property held for business or investment. It can be a different type of real estate, so an apartment building in California can be exchanged for farmland in Texas or a warehouse in Nevada. Property held primarily for sale, such as homes you flip, is excluded.8Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment Personal residences don’t qualify.
Two deadlines start the day the California property closes, and missing either kills the exchange with no extensions. You must identify potential replacement properties in writing within 45 days, delivered to a party involved in the exchange such as your qualified intermediary.9Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 You must receive the replacement property within 180 days of the sale, or by the due date of your tax return for that year including extensions, whichever comes first.8Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
That second deadline hides a trap. Sell in late January and your 180 days run into late July, but your tax return is due April 15. Without a filing extension, the exchange deadline is cut short to April 15. Filing a tax extension pushes the return due date to October 15 and restores the full window.
You cannot touch the sale proceeds. A qualified intermediary holds the funds in a segregated account from the moment the California property closes until the replacement property is purchased. Taking control of the money, even briefly, collapses the deferral.10Franchise Tax Board. Qualified Intermediary Accommodator Your agent, attorney, accountant, or employee cannot serve as the intermediary, nor can anyone who has acted in those capacities for you within the previous two years. Banks and title companies commonly provide the service.
If you don’t reinvest every dollar, the leftover is “boot” and it’s taxable. Boot comes in two forms. Cash boot is the difference when the replacement property costs less than what the California property sold for and the intermediary returns the shortfall to you. Mortgage boot is debt relief: if you had a $500,000 mortgage on the California property and take on only a $350,000 mortgage on the replacement, the IRS treats the $150,000 difference as money received.8Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment Cash boot and mortgage boot stack to produce your total recognized gain, and any depreciation claimed on the California property can be recaptured at the federal level at a 25-percent rate to the extent boot triggers recognized gain. The cleanest way to avoid boot is to buy a replacement property of equal or greater value and take on equal or greater debt.