Selling California, Buying Arizona
Phoenix pencils. Then two line items show up that were never in the model, and California is not finished with you either.
A Sacramento owner runs the numbers on a Maricopa County building, sees a 2.50% state income tax where California charges up to 13.30%, sees no transfer tax on the closing statement, and the deal looks obvious.
Then two line items show up that were never in the model. Arizona taxes a commercial building on a bigger share of its value than the house next door. Arizona also taxes commercial rent, in Maricopa and Pima counties both, and the well-publicized 2025 rental tax repeal does not cover you. Neither one kills a good deal. Both change the math. And California is not finished with you either: the gain you deferred keeps its California source no matter where the building sits or where you live. Here is the whole picture, with links to the deep dives.
Deferred, Not Erased
Section 1031 lets you sell investment or business real property and defer federal tax on the gain if you reinvest in like-kind real property.
- Real property only. After the Tax Cuts and Jobs Act, no equipment, no vehicles, not your house.
- 45 days to identify replacement property in writing, from the sale of the California property.
- 180 days to close, or your return due date, whichever comes first. These do not bend outside a declared disaster.
- You cannot touch the money. A Qualified Intermediary holds the proceeds.
- Any state qualifies. Arizona property is like-kind to California property. Foreign real estate is not.
California conforms to the federal deferral under R&TC §18031.5. Crossing the state line is not the problem. What California does next is. Full walkthrough on the 1031 exchange hub. (IRS FS-2008-18 | FTB Form 3840 Instructions)
The Gain Keeps Its California Source
The rule in one sentence: when you exchange California property for property outside California, the gain keeps its California source, and California taxes it when it is finally recognized, no matter where you live at that point.
- California sources real estate gain to where the dirt is. FTB Publication 1100 walks through this exact fact pattern and confirms the deferred gain stays taxable by California when recognized, even after you leave the state.
- The statutory hooks are R&TC §18032 (personal income tax) and §24953 (corporation tax).
- Residency is irrelevant. The filing applies to all taxpayers who exchange California property for out-of-state property, regardless of residence status or commercial domicile. A Nevada owner with a Roseville strip center exchanging into Tucson is in this system.
- FTB Form 3840 is annual, not one-time. You file it for the year of the exchange and each subsequent taxable year, generally until the California-sourced deferred gain or loss is recognized. That can run for decades.
- No California return still means a California filing. If you have no California filing requirement, you sign the 3840 and mail it on its own to the Franchise Tax Board, PO Box 1998, Rancho Cordova, CA 95741-1998. This is the most common miss.
- Going dark has teeth. For taxpayers who fail to file the 3840 and who also do not file an income tax return, the FTB may issue a Notice of Proposed Assessment to adjust the income for the California-sourced deferred gain and assess tax plus any applicable penalties and interest. California does not have to wait for you to sell.
- You stop with a Final FTB 3840 in the year the deferred gain or loss is recognized.
The full treatment lives on two other pages: California’s 1031 clawback rule, including how the gain is tracked and allocated, and FTB Form 3840: what it is and how to file it, including entity-by-entity rules and due dates. (FTB Publication 1100)
What actually triggers the California tax
| Event | Result |
|---|---|
| You sell the Arizona property in a taxable sale | Main event. Deferred California gain is recognized and California taxes it. |
| You take boot | Cash out or debt relief means partial recognition now. California withholding can apply on money or other property over $1,500. |
| Your exchange fails on timing | Taxable sale, and 3 1/3% of the sales price gets withheld for California. |
| Any other taxable disposition | The FTB’s language is sold or otherwise disposed of, which is broader than a sale. |
| You exchange again | No trigger. Gain stays deferred, 3840 keeps running, and you can chain exchanges indefinitely. |
One limit worth real money: California claws back the California-sourced deferred gain, the gain baked in when you sold the California property. Appreciation earned afterward on the Arizona building is Arizona-source. Confirm the split with your CPA.
Why the Credit Runs Backwards
This is the question people actually came for. You eventually sell the Arizona building. California wants tax on the old deferred gain. Arizona wants tax too. Do you pay both? No, not in full. But the mechanism is backwards from intuition. Normally your resident state credits you for tax paid to the source state. California and Arizona instead use a reverse credit: the source state gives the credit.
If you are still a California resident. California’s Schedule S lists the states for which a California resident may claim the other state tax credit, and Arizona is not on it. Arizona appears only in the nonresident section. Arizona gives you the credit instead, on AZ Form 309, which states that Arizona nonresidents filing resident returns with California, Indiana, Oregon, and Virginia qualify for the credit on the Arizona return. Because California’s rate is many times Arizona’s 2.50%, the Arizona tax is typically wiped out and you effectively pay California rates.
If you have moved to Arizona. The credit flips. Form 309 says that for an Arizona resident, nonresident returns filed with California do not qualify for the Arizona credit, and you may instead claim a credit for taxes paid to Arizona on the nonresident return filed with the listed states. California agrees: Schedule S allows the credit to California nonresidents who are residents of Arizona, Guam, Oregon, or Virginia, on Schedule S, Section D. (FTB Schedule S | Arizona Form 309)
- You are not taxed twice. The reverse credit prevents it in both directions. Credits are limited, so in practice you pay roughly the higher of the two states’ tax, not the sum.
- Moving to Arizona does not reduce the clawback. The clawback is source-based, not residence-based. Relocating changes which state issues the credit. It does not change who collects on the California-sourced gain.
- Moving does cut everything after. Future appreciation, rental income, and other gains get taxed at Arizona rates. The clawback is a fixed historical liability. Do not let it talk you out of a move, and do not expect the move to erase it.
Use 2.50% as Your Planning Number
Arizona has a flat 2.50% individual income tax rate, one rate at every income level and filing status. California runs 1.00% to 13.30% and gives capital gains no break at all: California does not have a lower rate for capital gains, and all capital gains are taxed as ordinary income. (AZDOR | FTB, Capital gains and losses)
Arizona law allows a subtraction of 25% of net long-term capital gain from assets acquired after December 31, 2011, under A.R.S. §43-1022. Applied against a 2.50% flat rate, that arithmetic produces an effective rate of about 1.875%. Read the hedge before you use that number. In a 1031 exchange your basis and holding period carry over from the relinquished property. Whether an Arizona replacement property received in 2026 for a California property you bought in 2004 counts as acquired after December 31, 2011 for this subtraction is unsettled. There is no Arizona Department of Revenue guidance on the point that this page could find, so the subtraction may or may not apply to exchanged replacement property.
Underwrite at the flat 2.50%. Treat 1.875% as a possible improvement, not a fact, and have an Arizona CPA confirm it in writing before it shows up anywhere in your model. Figures are illustrative of the rules, not a projection for your deal. Confirm with your CPA.
The Assessment Ratio Nobody Explains
For a commercial investor this is the single most important Arizona property tax fact. Arizona sorts property into legal classes, and each class has a different assessment ratio, the share of value that actually gets taxed.
| Class | Property type | Assessment ratio |
|---|---|---|
| Class 1 | Commercial and industrial | 15.5% in 2026, 15% in 2027 and after |
| Class 2 | Agricultural and vacant land | 15% |
| Class 3 | Owner-occupied primary residence | 10% |
| Class 4 | Residential rental and leased residential | 10% |
Class 1 is on a statutory step-down: 18% from 2017 through 2021, then 17.5%, 17%, 16.5%, 16%, and 15.5% in 2026, landing at 15% in 2027 and after. Classes 2 through 4 come from AZDOR classification guidance and should be reverified against current A.R.S. 42-15001 through 42-15009. Why it matters: a commercial building is taxed on roughly 15.5% of its value while the house next door is taxed on 10%. Same rate, bigger base. Coming from California, where Proposition 13 applies one base rate structure regardless of use, this is a structural difference you have to model. (Arizona Laws 2022, Ch. 171 | AZDOR, Property Classification)
- The 1% constitutional cap is residential only. Arizona’s constitution caps ad valorem taxes on a primary residence at 1% of full cash value. Commercial property gets no such ceiling.
- The homeowner rebate is Class 3 only. Arizona pays a share of primary school district tax on owner-occupied primary residences under A.R.S. 15-972. Rental residential does not qualify.
- Classification carries over from the prior owner. Buy a Class 3 property and put it into commercial or rental use, and someone has to correct the classification. It does not fix itself.
- Rates come from overlapping districts. School, fire, community college, and special districts all levy. Two parcels a mile apart can carry meaningfully different rates. Pull the parcel, not the county average.
The Tax Foundation puts Arizona’s effective property tax rate on owner-occupied housing at 0.48% against California’s 0.70%. That is a residential number. Do not underwrite a commercial deal with it. Confirm current ratios with the county assessor for your parcel.
The Trap the Repeal Did Not Fix
If you are buying a leased commercial property in Phoenix or Tucson, read this twice.
- Arizona imposes a transaction privilege tax on commercial rent. It is not a state tax. Counties and cities levy it.
- AZDOR lists five counties that require county tax on commercial leases: Coconino, Gila, Maricopa, Pima, and Pinal. Maricopa is Phoenix. Pima is Tucson.
- Cities layer their own on top under business codes 213 and 313.
- The definition is broad: real property leased for commercial purposes, land or structure, including office, retail, industrial, farm land, parking and storage, banquet halls, and meeting rooms.
Here is the trap. Arizona eliminated transaction privilege tax on residential rental effective January 1, 2025 for stays of 30 days or more under business code 045. That repeal got heavy press. Investors hear that Arizona repealed the rental tax and assume it covers them. It does not cover commercial leases. Buy a multi-tenant retail center in Chandler and this tax is live: you need a TPT license, and you need lease language that passes it through to tenants. Rates are address-specific, so run the property through the AZTaxes.gov lookup. (AZDOR, Commercial Lease | AZDOR, Residential Rental Tax Changes)
You Need an Arizona Statutory Agent
If your replacement property is residential rental, A.R.S. §33-1902 requires registration with the county assessor and updates within ten days of any change. Out-of-state owners must designate a statutory agent who lives in Arizona to accept service. Civil penalties are steep: $1,000 plus $100 per month for newly acquired property, and $150 per day in other cases, both waived if you comply within ten days of notice. California investors buying Arizona rentals remotely trip this constantly. Handle it at closing. (A.R.S. 33-1902)
One Gift, One to Verify
- No real estate transfer tax, at all. Article 9, Section 24 of the Arizona Constitution bars the state and every county, city, town, and district from imposing any new tax, fee, stamp requirement or other assessment, direct or indirect, on conveying any interest in real property, carving out only assessments that existed on December 31, 2007. Voters added it through Proposition 100 in 2008. Real money at closing, and it sits at the constitutional level rather than in a statute a legislature can flip.
- Nonresident seller withholding appears not to apply, but verify. Arizona’s withholding regime is built around wages and voluntary pension withholding, and Arizona does not appear on industry lists of states that withhold on nonresident real estate sales. This page has not found an affirmative AZDOR statement that no real estate withholding exists, so confirm with your CPA rather than assuming.
(Arizona Constitution, Art. 9, Sec. 24 | AZDOR, Withholding Tax)
The Preventable Ones
Nobody owns the annual filing
Your Qualified Intermediary closes and moves on. Your California CPA may not stay engaged after you leave. Your Arizona CPA may not know a California information return exists. Decide at closing who files the 3840 every year, and put it in writing. This is the most preventable failure in the process.
Sloppy entity structure
Partnerships, LLCs, and trusts have their own 3840 rules and due dates by entity type. Sort the entity question before the 45-day clock starts, not after.
Keep, sell, or exchange
A lot of owners land here because they hit a wall with what they own: aging asset, a tenant situation that will not resolve, a property that eats a weekend a month.
- Keep. You keep the basis, the depreciation schedule, and the headache.
- Sell outright. You write a check to California and the IRS now.
- Exchange into Arizona. Real option, with a California filing obligation that follows you.
Run all three before you commit to any of them.
Questions Owners Ask on This Route
Yes. If you exchanged California property for out-of-state property and the California-sourced gain is still deferred, you file. With no California filing requirement, you sign the form and mail it on its own to the Franchise Tax Board, PO Box 1998, Rancho Cordova, CA 95741-1998, every year until the gain is recognized, at which point you file a Final FTB 3840.
Yes. California sources real estate gain to the location of the property, and FTB Publication 1100 confirms the deferred gain keeps its California source and stays taxable by California when recognized, even after you leave.
Generally no. The two states use a reverse credit. As a California resident, you take the credit from Arizona on AZ Form 309. As an Arizona resident, you take it from California on Schedule S, Section D. Credits are limited, so you generally pay roughly the higher of the two, not the sum. Have your CPA compute it.
Beyond income tax, most likely yes. Arizona’s commercial lease transaction privilege tax is imposed at the county and city level, and Maricopa and Pima counties both impose it, with cities levying under business codes 213 and 313. The January 1, 2025 repeal of residential rental TPT does not cover commercial leases. Rates are address-specific.
No. Article 9, Section 24 of the Arizona Constitution prohibits any new tax or fee on transferring an interest in real property, other than assessments already in existence on December 31, 2007, added by voters through Proposition 100 in 2008.
Arizona sorts property into legal classes with different assessment ratios. Commercial and industrial property is Class 1, assessed at 15.5% for 2026 and 15% for 2027 and after. Residential classes are assessed at a substantially lower ratio, so the same tax rate lands on a larger base for commercial property. Confirm current ratios with the county assessor for your parcel.
Weighing a California sale against an Arizona buy?
Matt Bingaman works Greater Sacramento commercial real estate, and this is the work he does. A short conversation now is worth more than a correction later. Fifteen minutes, no pitch. Matt is not a tax or legal advisor and coordinates closely with your CPA and Qualified Intermediary.
Sources and References
Federal
California
- FTB: 2025 Form 3840 Instructions
- FTB: Publication 1100 (2024)
- FTB: 2025 Schedule S Instructions
- FTB: Capital Gains and Losses
Arizona
- Arizona Dept. of Revenue: Form 309
- Arizona Dept. of Revenue: Individual Income Tax Highlights
- Arizona Laws 2022, Chapter 171
- Arizona Dept. of Revenue: Property Classification
- Arizona Dept. of Revenue: Commercial Lease
- Arizona Dept. of Revenue: Residential Rental Tax Changes
- Arizona Revised Statutes: Section 33-1902
- Arizona Constitution: Article 9, Section 24
- Arizona Dept. of Revenue: Withholding Tax