Many real estate investors think California's 1031 exchange (also called like-kind exchange) rules mirror the federal playbook. The big surprise comes later: California tracks your deferred California-source gain even after you exchange into property in another state—and it keeps tracking until that deferred California gain is finally recognized.

Example: Sarah owns three rentals in Los Angeles. She sells one with a $300,000 California-source gain and uses Section 1031 to buy a $950,000 replacement in Texas. Five years later, she sells the Texas property. California isn’t taxing the Texas sale itself. It’s taxing the deferred $300,000 California gain that carried over in the exchange. Until that gain is recognized, Sarah must file FTB 3840 every year to report the deferred amount.

At the federal level, Section 1031 exchanges still follow the same rules: real property only, like-kind requirement, investment or business use, and strict 45/180-day timing deadlines. California generally conforms—but adds its own ongoing reporting and tracking obligations that can catch investors off guard years later.

What is a 1031 Exchange?

A 1031 exchange—also called a like-kind exchange after the language in the tax code—lets you sell one investment property and reinvest the proceeds into another without paying capital gains taxes right away. The name comes from Section 1031 of the Internal Revenue Code, which spells out the rules.

The core benefit is tax deferral. Instead of immediately owing 15%–20% federal capital gains tax plus California’s state tax of up to 13.3%, investors can roll all of that equity into the next property. This preserves more capital for growth and allows the deferred tax to continue working for you inside the new investment.

Key features of a 1031 exchange:

• Like-kind requirement: The old and new properties must be of the same general nature (e.g., residential rental for commercial, vacant land for apartments, office for warehouse).

• Investment or business use only: Personal-use property, such as a primary residence or vacation home, doesn’t qualify.

• Strict timelines: You have 45 days from the sale to identify potential replacement properties and 180 days to close.

• No “touching” the proceeds: A qualified intermediary (QI) must hold the sales proceeds and facilitate the swap.

When done correctly, a 1031 exchange can be repeated over and over, allowing investors to compound wealth across multiple properties while deferring tax liability—sometimes indefinitely, if planned alongside estate strategies.

California's Special Rules

California generally conforms to the federal framework for 1031 exchanges—but it layers on its own twists that can surprise investors years down the road.

1. Annual Out-of-State Reporting: If you exchange California property for property located in another state, California requires you to keep filing Form FTB 3840 (California Like-Kind Exchanges) every year until the deferred California-source gain is finally recognized. This is true even if you’ve moved out of California and no longer own property in the state.

Example: You sell a San Diego rental for a $300,000 gain and reinvest through a 1031 into an Arizona apartment building. Each year until you sell the Arizona property, you must file FTB 3840 to report that the $300,000 California gain remains deferred. When you eventually sell the Arizona property, California will tax that $300,000 deferred gain.

2. Personal Property Exception (Narrow): Unlike federal law, California has not fully conformed to the 2017 federal change that restricted Section 1031 exchanges to real property only. Under California rules, certain personal property exchanges are still allowed for taxpayers under specific AGI thresholds. In practice, this exception is rare and applies to limited cases (such as equipment or machinery swaps for smaller taxpayers). For most real estate investors, the federal “real property only” limitation effectively applies.

3. Residency Doesn’t End Liability: Moving out of California does not make the state lose track of deferred gain. If your original property was located in California, the gain remains a California-source obligation—even if you’ve relocated and are a nonresident when the replacement property is sold.

The California Reporting Trap

The most common mistake investors make is assuming that once they exchange out of California, the state has no further claim on their transaction. In reality, California law requires ongoing annual reporting until the deferred California-source gain is finally recognized.

That means if you sell a California property and buy a replacement property in another state, you must file Form FTB 3840 with your California tax return every year until the gain is triggered.

How it plays out:

• Year 1: You sell a Los Angeles rental and realize a $300,000 gain. Through a 1031 exchange, you buy a Nevada apartment building. On your California return, you file FTB 3840 showing that the $300,000 gain has been deferred.

• Years 2–7: You keep filing FTB 3840 annually, reporting that the $300,000 is still deferred.

• Year 8: You sell the Nevada property. At that point, California taxes the original $300,000 deferred gain—even though you don’t own any California property anymore.

Anjum Tunuli, Town’s Head of Tax, recalls a client who had moved to Oregon and assumed California was “out of the picture” once their exchange closed. “They stopped filing FTB 3840, and years later, California sent a notice with penalties and interest. The deferred gain never disappeared—it just kept following them. We had to back-file multiple years to get the account current.”

Failing to file FTB 3840 can result in penalties and interest, and California doesn’t lose track of the obligation just because you do. The form is short, but missing it can cause expensive headaches later.

Key Requirements for California 1031 Exchanges

To qualify for full tax deferral, both federal and California rules must be satisfied. Here are the essentials every investor should check off:

Property Qualification

• Both the relinquished and replacement properties must be held for investment or business use (not personal use).

• Properties must be real estate (federal law no longer allows personal property, and California’s exception is narrow and rarely used).

• Properties must be like-kind, which the IRS defines broadly:

  • Residential rental for commercial property

  • Vacant land for an apartment building

  • Office building for an industrial warehouse

  • One property for multiple properties

Critical Timelines

A 1031 exchange runs on two strict federal deadlines, which California also follows:

• 45-Day Rule: You must identify potential replacement properties in writing within 45 days of selling your original property. You can identify up to three properties, or use the 200% rule (multiple properties whose combined value does not exceed 200% of the property you sold).

• 180-Day Rule: You must close on your replacement property within 180 days of selling the original property.

• Identification must be in writing, unambiguous, and delivered to your QI or other permitted party.

2025 Wildfire Extensions: For transactions where the original 45-day or 180-day deadline falls between January 7, 2025, and October 15, 2025, the IRS has extended the deadline to October 15, 2025, for affected taxpayers. The California Franchise Tax Board conforms to these extensions. Always confirm your eligibility based on county disaster designations before relying on relief.

Anjum Tunuli warns that the 45-day window is often tighter than clients expect. “I’ve seen investors wait until the last week to identify properties, only to discover that two of their picks fell out of contract. With so little time left, they had no viable options. The exchange failed—not because of the money, but because of the calendar.”

Value Requirements

To fully defer gain in a 1031 exchange, two conditions must be met:

1. Equal or greater value: The replacement property must be equal to or greater in value than the property you sold.

2. Equal or greater debt: You must also take on at least as much debt as you paid off, or contribute additional cash to make up the difference.

If you receive cash, a reduction in mortgage debt, or any other non-like-kind property (collectively called “boot”), the boot portion is taxable immediately.

Example: You sell a property for $1 million with a $400,000 mortgage. If your replacement property is worth $1 million but carries only a $200,000 mortgage, the $200,000 reduction in debt is treated as boot and taxed—even if you didn’t pocket any cash.

Anjum Tunuli often cautions clients about this hidden trap: “One investor thought they had a clean exchange because the purchase price matched up. But they reduced the debt load on the new property without adding cash. That $150,000 shortfall was taxable boot, and it caught them by surprise.”

Technical note: Boot is recognized before other gain categories, so even a small shortfall in debt or value can create immediate tax liability.

Basis Carryover & Future Tax Impact

A 1031 exchange defers tax, but it doesn’t erase it. The gain from the relinquished property carries over into the basis of the replacement property. That lower basis reduces future depreciation and sets up a bigger taxable gain when the replacement property is eventually sold.

Example:

• You sell a California rental for $1 million with a $300,000 gain.

• You exchange into a $1.2 million property.

• Instead of getting a fresh $1.2 million basis, your new property’s basis is $900,000 ($1.2 million purchase price minus $300,000 deferred gain).

• When you later sell the replacement property, California will tax the deferred $300,000 gain, plus any additional appreciation.

Key point: The deferral keeps more money working for you in the meantime, but the tax liability hasn’t disappeared—it’s just waiting down the line. Some investors continue exchanging until death, when current federal law provides a step-up in basis for heirs (though California conformity may vary in the future).

Depreciation recapture and unrecaptured Section 1250 gain are deferred in a qualifying exchange and generally recognized only to the extent of boot.

Anjum Tunuli says that “too many clients think of a 1031 as tax-free. It’s not—it’s tax-deferred. The trick is building an exit plan. Sometimes that’s exchanging until step-up at death, sometimes it’s planning for a strategic sale when cash is needed.”

Common California 1031 Exchange Mistakes

Even experienced investors trip up on California’s unique rules. Here are the pitfalls to avoid:

1. Timing Miscalculations: Missing the 45-day identification or 180-day closing deadline disqualifies the entire exchange. Extensions are rare and generally limited to federally declared disasters.

Anjum Tunuli points out: “Investors sometimes assume a lender delay or a buyer backing out gives them extra time. It doesn’t. Unless you qualify for disaster relief, those deadlines are absolute.”

2. Forgetting Annual Reporting: Failing to file FTB 3840 when exchanging out of California doesn’t erase the state’s claim—it creates penalties and interest. California will enforce the tax when the replacement property is sold, whether or not you’ve been filing.

3. Overlooking Boot: Receiving cash, paying off less debt, or accepting non-like-kind property can all generate taxable boot. The most common trap is “silent boot,” where debt isn’t fully replaced.

4. Misusing Personal Property: Vacation homes, primary residences, or properties held for quick resale don’t qualify. California may scrutinize intent—especially if a property has mixed personal and rental use.

5. Assuming Residency Ends Liability: Moving out of California doesn’t eliminate the obligation to report deferred California-source gain. The gain follows the property history, not the taxpayer’s zip code.

6. Skipping a Qualified Intermediary: Trying to route funds through escrow, or worse, taking possession yourself, will blow the exchange. The IRS requires a qualified intermediary (QI) to hold proceeds and facilitate the swap. Using an unqualified party—like your attorney, CPA, or broker—can also disqualify the transaction under IRS rules.

Types of 1031 Exchanges in California

There’s more than one way to structure a 1031 exchange. The right approach depends on your timing, financing, and the type of property you’re moving into.

Simultaneous Exchange: Both properties close on the same day. This was the original form of 1031, but it is rare today because it requires perfect coordination between buyers and sellers.

Delayed Exchange (Most Common): You sell the original property, then have 45 days to identify replacements and 180 days to close. A qualified intermediary (QI) holds the proceeds in escrow until the replacement purchase is complete. This structure is by far the most common for California investors.

Reverse Exchange: You buy the replacement property first, then sell your original property within 180 days. This can help in hot markets where good properties move quickly. Reverse exchanges require more capital upfront and often involve an “exchange accommodation titleholder” (EAT) to temporarily hold title.

Build-to-Suit (or Improvement) Exchange: You use exchange proceeds to improve or build on the replacement property. This allows customization, but strict rules apply: the improvements must be completed and the property received by you within the 180-day exchange window.

Anjum Tunuli says: “I tell clients not to force a delayed exchange if their replacement deal isn’t lining up. A reverse or build-to-suit can save the exchange, but both require careful structuring and more moving parts. The earlier you involve your QI and advisors, the better.”

Working with Qualified Intermediaries

A 1031 exchange only works if you never take possession of the sales proceeds. That’s where a qualified intermediary (QI) comes in. The QI holds the funds in escrow, prepares the exchange documents, and ensures the transaction meets the IRS rules.

Why it matters:

• If you touch the money—even for a day—the IRS considers it taxable income.

• Never use your attorney, accountant, real estate agent, or anyone who has worked for you in the past two years as your QI—IRS rules prohibit it.

• Using the wrong person can disqualify the exchange and trigger immediate taxation.

Qualities to look for in a QI:

• Experience handling California exchanges (especially with FTB 3840 reporting).

• Strong financial backing and errors & omissions insurance.

• Transparent fee structure and secure handling of escrowed funds.

• Solid references from other investors.

Anjum Tunuli notes that “most people assume their escrow company can handle the exchange. That’s a costly mistake. Always ask about insurance coverage and whether client funds are held in segregated accounts. I’ve seen exchanges collapse—and investors lose money—because the QI wasn’t properly set up.”

California State Tax Considerations

California’s high tax rates make 1031 exchanges especially powerful. While federal long-term capital gains top out at 20%, California taxes all capital gains as ordinary income, with rates reaching 13.3% for high earners. Add the 3.8% Net Investment Income Tax (NIIT), and some investors face a combined hit of over 37%.

Example: Federal vs. California Tax Without an Exchange

• Gain on sale of rental property: $500,000

• Federal long-term capital gains tax (20%): $100,000

• California tax (13.3%): $66,500

• Net Investment Income Tax (3.8%): $19,000

• Total tax bill: $185,500 (37.1%)

By using a 1031 exchange, that entire tax bill is deferred, leaving the full $500,000 available to reinvest into the next property.

Why this matters:

• The larger the gain, the more dramatic the benefit of deferral.

• California-source gains remain taxable no matter where you move or reinvest—making compliance (via Form FTB 3840) critical.

• For long-term investors, deferring multiple exchanges can compound into hundreds of thousands of dollars in additional purchasing power.

According to Anjum Tunuli, “when clients see the numbers side by side, the value of a 1031 exchange in California is undeniable. The key is remembering that the state will eventually want its share—you’re deferring, not escaping, the tax.”

When 1031 Exchanges Make Sense

A 1031 exchange isn’t always the right move—but in the right circumstances, it can be a game-changer for California investors.

Situations where a 1031 exchange often makes sense:

• Upgrading to stronger assets: Trading a single-family rental for a multi-unit property, or moving from older buildings into newer, more profitable ones.

• Relocating investments: Shifting from California to other markets with better cash flow or appreciation potential (while remembering California still tracks the deferred gain).

• Diversifying or consolidating holdings: Selling multiple smaller properties to buy one larger one, or breaking up a large holding into several smaller properties.

• Deferring significant tax liability: When the potential tax bill is large, deferral keeps more money working inside your investment portfolio.

Situations where a 1031 exchange may not be worth it:

• You need access to cash for other investments or personal use.

• Property values in your target market are falling, making reinvestment less attractive.

• You can’t find a suitable replacement property within the 45/180-day deadlines.

• The complexity and costs of the exchange outweigh the tax benefit.

Professional Guidance for Complex Situations

Many business owners handling real estate investments need specialized tax guidance that goes beyond the basics. California’s unique reporting rules, strict timelines, and debt replacement requirements can trip up even experienced investors.

That’s where Town’s real estate tax experts come in. Unlike some CPAs who only show up at tax time, Town provides year-round guidance for timing major real estate decisions, structuring exchanges to maximize benefits, and staying compliant with California’s ongoing reporting requirements.

When to bring in professional help:

• Structuring reverse or build-to-suit exchanges with multiple moving parts.

• Handling exchanges that cross state lines, especially when California-source gain is involved.

• Coordinating debt replacement to avoid hidden “silent boot.”

• Integrating a 1031 exchange with broader tax planning, such as estate strategies or entity structuring.

With the right professional support, investors can not only avoid costly mistakes but also unlock strategies that compound long-term wealth—like pairing exchanges with cost segregation studies or building an exit plan that defers taxes across generations.

Planning Your Next Steps

If you're considering a 1031 exchange in California, think of the process in three phases: before, during, and after the transaction.

Before You Sell

• Line up potential replacement properties early (don’t wait until day 40).

• Interview and select a qualified intermediary (QI).

• Model the tax impact to confirm the exchange makes financial sense.

• Understand California’s ongoing reporting requirements if you’re exchanging out of state.

During the Exchange

• Stick closely to the 45-day identification and 180-day closing deadlines.

• Work with your QI, tax advisor, and escrow team to ensure proceeds are handled correctly.

• Keep records of identification notices and exchange agreements.

After the Exchange

• File Form FTB 3840 annually if you replaced California property with out-of-state property.

• Track your adjusted basis in the new property to plan for future depreciation and eventual gain recognition.

• Revisit your long-term plan: will you keep rolling exchanges forward, or eventually recognize the gain?

Anjum Tunuli cautions that “exchanges don’t end when escrow closes. The paper trail—especially with California reporting—can last for years. I tell clients to treat their FTB 3840 filings like an annual reminder that the deferred gain is still on the books.”

Tax Strategy Beyond 1031 Exchanges

A 1031 exchange is a powerful tool, but it shouldn’t be your only tax strategy. Smart investors layer additional approaches on top of exchanges to maximize long-term benefits.

Strategies to consider:

• Cost segregation studies – Accelerate depreciation on replacement properties to create larger current deductions.

• Entity structuring – Use LLCs, corporations, or other entities to protect assets and optimize tax treatment.

• Depreciation planning – Track basis carefully to balance short-term deductions with long-term tax impact.

• Estate and succession planning – For some investors, exchanging until death can unlock a federal step-up in basis for heirs (though California conformity may shift in the future).

Town’s real estate tax experts work with investors to integrate these strategies with overall business and wealth goals—rather than treating a 1031 as a stand-alone move.

Key Takeaways

• California follows federal 1031 rules but adds its own twist: annual reporting of out-of-state exchanges on Form FTB 3840 until the deferred gain is recognized.

• Strict 45-day and 180-day deadlines govern exchanges, with limited disaster extensions.

• To fully defer gain, you must replace both the value and the debt of the relinquished property.

• Deferred gain carries into the basis of the replacement property, reducing depreciation and setting up a bigger taxable gain later.

• Qualified intermediaries (QIs) are mandatory—never use your attorney, CPA, or broker as a stand-in.

• With California’s high tax rates, exchanges can save six figures in immediate taxes, but the gain is deferred, not erased.

Disclaimer: This content is for educational purposes only and does not constitute personalized tax advice. Tax laws are complex and subject to change. Individual circumstances can vary significantly, and strategies that work for one taxpayer may not be suitable for another.