Federal 1031 Exchange Requirements

The federal rules are the foundation. You sell investment or business property, park the proceeds with a qualified intermediary (you can’t touch the money), identify replacement property within 45 days, and close within 180 days. Both properties must be “like-kind,” which for real estate is broadly defined — a retail strip mall qualifies as like-kind to an apartment complex, a vacant lot, or a single-family rental.

Since 2018, only real property qualifies per the Tax Cuts and Jobs Act changes. Personal property, equipment, and intangible assets are out. For LA real estate investors, this restriction doesn’t change much — the assets in question were almost always real property to begin with.

California Conformity and the FTB

California fully conforms to Section 1031. When you complete a qualifying exchange, the gain deferral applies to both your federal return and your California return. The Franchise Tax Board (FTB) recognizes the exchange and defers the state capital gains tax right alongside the federal tax.

But California adds a reporting requirement that many investors overlook: Form 3840. Every year that you hold the replacement property, you must file Form 3840 (California Like-Kind Exchanges) with your state return. This form tracks the deferred gain, the replacement property details, and confirms you’re still holding the property. Miss a filing and the FTB may assert that you’ve broken the exchange — or at minimum, you’ll get a letter asking questions.

This is one of those details that separates California from most other states. Very few states require annual tracking of 1031 exchanges. California does, and they pay attention to it.

Prop 19 and Property Tax Reassessment

Here’s where California 1031 exchanges get complicated in a way that’s unique to this state. Proposition 13 (1978) capped property tax increases at 2% per year, which means long-held properties have tax assessments far below market value. When a property changes hands, it gets reassessed to current market value.

A 1031 exchange is a change of ownership for property tax purposes. You sell your relinquished property and buy a replacement property, and the replacement property gets reassessed at whatever you paid for it. Your old Prop 13 base goes away.

This creates a hidden cost in California 1031 exchanges that doesn’t exist in most states. You might defer $500,000 in income tax but trigger a property tax increase of $30,000+ per year. Over a 10-year hold, that’s $300,000 in additional property taxes. Whether the income tax deferral outweighs the property tax increase depends on the specific numbers.

Proposition 19 (2020) added further changes. It allows homeowners over 55, disabled persons, and wildfire victims to transfer their Prop 13 base to a new primary residence. But it also eliminated the parent-to-child exclusion for investment properties. These rules interact with 1031 planning in complex ways, especially for family-owned investment portfolios in LA.

Los Angeles Market Specifics

The LA real estate market has its own features that affect 1031 exchange planning:

• Rent control and the RSO: Properties under the LA Rent Stabilization Ordinance have tenant protections that affect value. If you’re exchanging out of a rent-controlled building, the replacement property’s economics may look very different.
• Seismic retrofit requirements: Some older LA buildings face mandatory seismic retrofit costs. Investors sometimes 1031 out of buildings with looming retrofit obligations and into newer construction. The exchange defers the tax; the retrofit becomes someone else’s problem.
• LA city transfer tax: The City of Los Angeles charges a transfer tax on real property sales. The base rate is $4.50 per $1,000 of value, but Measure ULA (effective April 2023) added a 4% tax on sales over $5 million and 5.5% on sales over $10 million. This transfer tax applies regardless of whether the sale is part of a 1031 exchange. For a $10 million property, that’s $400,000 in city transfer tax alone.

Measure ULA has changed the math on some exchanges. Investors with high-value LA properties are factoring in a $400,000-$550,000 city tax bill on the sell side, which means the replacement property needs to be that much more attractive to justify the exchange. Some investors are holding longer, waiting for potential repeal or amendment.

Exchanging Out of California

A lot of LA investors exchange into properties in states with better cash-on-cash returns or no state income tax. Texas, Florida, Tennessee, and Nevada are popular destinations. The 1031 exchange defers both federal and California tax on the sale.

But like New York, California tracks the deferred gain. If you sell a property in LA, exchange into property in Texas, and eventually sell the Texas property outright, the FTB expects you to report and pay California tax on the gain attributable to the original LA property. Form 3840 exists partly for this purpose — it follows the deferred gain wherever it goes.

Whether the FTB actually pursues out-of-state former residents for this tax depends on the dollar amounts and how visible the transaction is. Large sales involving California-source gain are more likely to attract attention. If you’re planning to exchange out of California real estate and leave the state permanently, the tax planning should happen before the sale, not after.

Sources & References

• 26 U.S.C. § 1031 — Like-Kind Exchanges (Cornell Law)
• IRS Publication 544 — Sales and Other Dispositions of Assets
• California FTB — Form 3840: Like-Kind Exchanges
• CA Board of Equalization — Proposition 19
• CA Board of Equalization — Proposition 13 Overview