The California 1031 Clawback
California lets you defer the gain. It does not let you leave with it.
If you exchange California property for replacement property outside California, the state permanently tracks the California-source gain you deferred. When you eventually sell that out-of-state property in a taxable sale, California taxes that original gain — even if you moved away years earlier.
The rule is Revenue & Taxation Code Section 18032, added by AB 92 in 2013 and operative for exchanges in tax years beginning on or after January 1, 2014. It comes with an annual filing obligation, FTB Form 3840, that does not end until the deferred gain is finally recognized. It is one sharp edge of the broader 1031 Exchange Strategy playbook.
What the Clawback Actually Does
- California does not recapture tax at the moment of the exchange. Nothing is due that year.
- Instead it tags the California-source deferred gain as an attribute that follows the replacement property, indefinitely.
- A subsequent 1031 of that out-of-state property does not end the obligation. The tag follows into the next property, and the next.
- It applies whether or not you remain a California resident. California asserts the right to tax that gain as California-source income even against a nonresident.
- The corporate companion provision is R&TC Section 24953.
Correction worth making: you will see this attributed to AB 2663. It is AB 92, signed June 27, 2013. The wrong bill number circulates widely in 1031 marketing material.
The Parts People Get Wrong
It does not expire
There is no sunset and no year cap. The obligation runs until the deferred California gain is recognized in a taxable sale — which, for an investor who keeps exchanging, may be never during their lifetime.
Destination state does not defeat it
Buying in Texas or Nevada does not avoid the clawback. Those states have no income tax of their own, which affects the tax on future appreciation and operating income. It has no effect on the California gain you already deferred. Any content implying otherwise is simply wrong.
The filing is the trap, not the tax
Most people who get caught did not evade tax. They filed Form 3840 for a year or two, moved on with their lives, and stopped. Years later a Notice of Proposed Assessment arrives. See the statute of limitations section below — this is the part that surprises people.
The Sharp Edge Nobody Writes About
FTB’s position is that source is determined when gain is realized, not when it is recognized.
Worked illustration: exchange a Sacramento property with a $500,000 realized gain into Wyoming property. The Wyoming property later declines in value and produces only a $200,000 federally recognized gain on sale. Montana’s rule expressly caps state-source gain at the federally recognized gain. California’s statute contains no such cap.
Here is the honest part: this is an area where the statute is silent. FTB’s administrative position on realized-versus-recognized should be confirmed with a CPA for any specific set of facts. We flag it because it is genuinely under-discussed — not because we are certain of the outcome. If a page tells you exactly how this resolves, be skeptical.
Illustration only. Confirm with your CPA.
Deferred is not forgiven.
Form 3840: Who Files, and for How Long
- Who: anyone — resident or nonresident — who exchanges California real property for out-of-state replacement property with any California-source gain unrecognized. Individuals, estates, trusts, partnerships, LLCs, and corporations. Disregarded entities do not file; the owner files on the entity’s behalf.
- It can be filed as a standalone information return by someone with no other California filing obligation. This is the provision people who leave California miss entirely.
- Filed annually, every year, until the deferred California gain is recognized.
- When it ends: on a taxable disposition. Remove the property from the 3840, report the gain, and attach an explanatory statement.
| Filer | Due (TY2025) | Extended |
|---|---|---|
| Individuals, estates, trusts | April 15 | October 15 |
| C corporations and LLCs taxed as C corps | April 15 | — |
| S corporations and partnerships | March 16 | — |
| Exempt organizations | May 15 | — |
The full mechanics live on our FTB Form 3840 page. See also the FTB’s own 2025 Form 3840 instructions.
The Penalty Answer Most Articles Get Wrong
There is no standalone statutory penalty for failing to file Form 3840 by itself. Most content asserts one. That is not what the statute says.
The real exposure is §18032(b): fail to file the 3840 and the return, and the FTB may estimate net income and assess tax, interest, and penalties on that basis.
And the real risk is the statute of limitations. California’s normal four-year limitations period under R&TC §19057 runs from the filing of a return. No return filed means the clock never starts — exposure stays open indefinitely.
Enforcement is active. The FTB runs a dedicated Form 3840 compliance program: initial contact letter, then a follow-up with a 30-day response window, then referral to the Audit Division, then a Notice of Proposed Assessment.
California Is Not the Only One
| State | Annual filing? | Notes |
|---|---|---|
| California | Yes — Form 3840, indefinitely | R&TC §18032. Most aggressive. Active audit program. No cap in the statute. |
| Oregon | Yes — Form OR-24, indefinitely | ORS 316.738, enacted 2001 — actually older than California’s. |
| Massachusetts | No | 830 CMR 62.5A.1(3)(d). Tracks quietly and waits for the taxable sale. |
| Montana | No | Mont. Admin. r. 42.2.308. Expressly caps state-source gain at the federally recognized gain. |
Worth stating plainly: exchanging California into Oregon stacks two perpetual annual filings.
And retire a common error: “Pennsylvania doesn’t allow 1031 exchanges” has been wrong since tax year 2023. Pennsylvania conformed its personal income tax to federal §1031 via HB 1342, signed July 7, 2022.
What It Costs If You Don’t Exchange At All
Illustrative: a commercial building bought for $1,500,000, held fifteen years, sold for $3,000,000. After roughly $461,000 of depreciation, the taxable gain is about $1,961,000.
| Component | Rate | Tax |
|---|---|---|
| Federal unrecaptured §1250 | 25.0% | $115,385 |
| Federal long-term capital gains | 20.0% | $300,000 |
| Net investment income tax | 3.8% | $74,538 |
| California | 13.3% | $260,885 |
| Total | $750,808 |
Effective rate on the gain: 38.3%. On the depreciation slice specifically: 42.1%. Plus $100,000 withheld at closing under Form 593.
The correction that builds authority: California’s top marginal rate on a property sale is 13.3%, not 14.4%. The extra 1.1% commonly quoted is SDI, a payroll tax on wages — it never touches a capital gain, rent, or investment income. The 13.3% is the 12.3% top bracket plus the 1% Behavioral Health Services Tax on income over $1M (renamed from the Mental Health Services Act by Proposition 1 in March 2024; FTB’s 2026 forms use the new name).
Illustration only. Your numbers depend on basis, holding period, entity structure, and bracket. Confirm with your CPA.
Two 2025 Changes That Matter
- SB 711 moved California’s IRC conformity date from January 1, 2015 to January 1, 2025 — the first update in a decade. It adopts the federal limitation of §1031 to real property only, ending the AB 91 rule that let lower-AGI individuals still exchange personal property. Net effect for commercial clients: neutral — real property always qualified — but it moots a lot of pre-2025 published guidance.
- California still does not conform to Opportunity Zone treatment. An OZ investment defers federal tax but not California tax. For a California investor weighing 1031 versus OZ, that is decisive, and almost nobody says it out loud.
If you are exchanging out of the Sacramento region specifically, our Sacramento 1031 exchange and Placerville 1031 exchange guides cover the local market side of the decision.
Questions California Owners Ask About the Clawback
It only bites when the replacement property is outside California. An in-state exchange keeps the gain in California’s system, so there is nothing to track — no Form 3840 required.
The obligation follows. A subsequent 1031 of the out-of-state replacement does not extinguish the California-source deferred gain, and the Form 3840 filing continues. Report the new replacement property on the same form.
This is genuinely under-covered, and we will not pretend otherwise. Federal law provides a step-up in basis at death that generally eliminates the deferred federal gain. How that interacts with California’s tracked, previously-deferred source gain is not addressed clearly in published guidance. Anyone planning around this needs a California tax attorney, not a website.
Talk to a CPA before you do anything else. Because the four-year statute of limitations runs from the filing of a return, unfiled years generally stay open. There are remediation paths, but they depend on your specific facts and this is not a do-it-yourself situation.
The relevant question is where the underlying real property sits. A DST holding out-of-state property raises the same California-source tracking issue as buying that property directly. Note: DSTs are securities. We cover them educationally and refer to a licensed partner.
Not by choosing a destination state. The honest answers are narrow: keep the replacement property in California, or eventually recognize the gain and pay California on it. Anyone selling you a structure that makes California-source deferred gain disappear is describing something you should run past a tax attorney first. There is a third answer people skip, which is deciding whether the exchange is worth doing at all. Is a 1031 exchange worth it, or should you just pay the tax prices the straight sale against the exchange on the same building.
California withholds under R&TC §18662 using Form 593 — the standard rate is 3⅓% of the total sales price. A simultaneous exchange is exempt; a deferred exchange is exempt at the initial transfer. Certify on Part IV, Line 10. Boot over $1,500 is subject to withholding. And if the exchange fails, withholding applies to the full sales price, not just the boot. Run both the standard and alternative methods — on a $3,000,000 sale the standard method is $100,000 while the alternative can be far higher, and it inverts on low-gain deals.
Before you exchange out of state, map the California tail.
Fifteen minutes, no pitch. We will walk through where your replacement property sits, what California will keep tracking, and the filing you will owe for years — then hand the specifics to your CPA. Matt is not a tax or legal advisor and coordinates closely with your CPA and attorney.