1031 Exchange Rules in Los Angeles
How a 1031 Exchange Works (the federal rules that apply everywhere)
Under IRC Section 1031, you can defer capital gains tax when you swap one piece of real property held for investment or business use for another of like kind. Since the 2017 Tax Cuts and Jobs Act, only real property qualifies — equipment, vehicles, and other personal property no longer count.
Two clocks start the day you close on the property you are selling. You have 45 days to identify the replacement property in writing, and 180 days to close on it. Both deadlines are hard. A qualified intermediary has to hold the proceeds in between, because the moment the cash touches your account the exchange is dead. If the replacement property is worth less than what you sold, or you pull cash out, that difference (“boot”) is taxable.
None of that is unique to Los Angeles. The next part is.
The California catch: Form FTB 3840 and the clawback
California conforms to the federal deferral, so a properly structured 1031 defers your California tax too. But the state added a string in 2014. If you exchange California real property for replacement property located outside California, you must file Form FTB 3840 the year of the exchange and **every year after** until you finally recognize the gain.
The form is how California preserves its right to tax the original California-source gain even after you have moved your money to Texas, Nevada, or Arizona. When you eventually sell that out-of-state replacement property in a taxable transaction, California reaches back and taxes the deferred California gain. That is the clawback. The deferral is real, but California does not forget.
What happens if you skip the 3840
The Franchise Tax Board ran a multi-year compliance sweep specifically on missing 3840s. If you do not file it, the FTB can issue a Notice of Proposed Assessment, pull the entire deferred gain back into income, and add penalties and interest on top. We have picked up Los Angeles clients who did a clean federal exchange, moved to a no-tax state, and assumed they were done — then got an FTB letter two years later. Filing the 3840 is annoying. It is far cheaper than the assessment.
Why the deferral is worth more in Los Angeles
California has no preferential capital gains rate. Long-term gains are taxed as ordinary income, which tops out at 13.3% — the highest state rate in the country — and that sits on top of the federal 20% and the 3.8% net investment income tax. For a Los Angeles fourplex that has appreciated for a decade, the combined bill on a straight sale can clear 37%. Deferring that with a 1031 is not a minor convenience; it is the difference between reinvesting your whole basis or two-thirds of it.
A Los Angeles example
Say you bought a Silver Lake duplex for $700,000 and it is now worth $1.5 million. A straight sale hands you roughly an $800,000 gain (before depreciation recapture), and California alone takes well over $100,000 of it. Exchange into a larger Phoenix apartment building instead and you defer the federal and California tax — but you file Form FTB 3840 with your California return that year and every year after. The day you sell the Phoenix building for cash, California taxes the original Los Angeles gain it has been tracking the whole time.
Mistakes we see Los Angeles investors make
Three come up constantly. Investors blow the 45-day identification window because they started shopping after closing instead of before. They take “boot” without realizing a small cash-out or a reduced mortgage triggers tax. And they stop filing the 3840 once they leave California, which is exactly when the FTB is watching. A 1031 in Los Angeles is a two-part job: nail the federal mechanics, then keep the California paperwork alive.
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Frequently Asked Questions
Does California recognize 1031 exchanges?
Yes. California conforms to IRC Section 1031, so a valid federal exchange also defers your California tax. The wrinkle is reporting. For any exchange where you give up California property and receive property outside the state, California requires Form FTB 3840 every year until the deferred gain is recognized. In-state exchanges (California for California) do not trigger the annual 3840 filing, though you still report the exchange in the year it happens.
What is Form FTB 3840 and how long do I file it?
Form FTB 3840 is California’s like-kind exchange information return. You file it the year you exchange California property for out-of-state replacement property, and then again every following year for as long as the gain stays deferred. It tells the Franchise Tax Board how much California-source gain you are carrying and on which property, so the state can tax it when you eventually cash out. The filing obligation ends only when you recognize the gain — typically when you sell the replacement property in a taxable sale.
What happens if I forget to file FTB 3840?
The Franchise Tax Board can treat the deferred gain as currently taxable and issue a Notice of Proposed Assessment for the full California-source gain, plus penalties and interest. The FTB has actively pursued non-filers, so this is not a theoretical risk. If you exchanged out of California property and have not been filing the 3840, the fix is to get current before the FTB contacts you — the penalty exposure is smaller when you come forward.
Is there a separate California capital gains tax rate on real estate?
No. California does not give capital gains a preferential rate the way the federal system does. Your real estate gain is taxed as ordinary income on your California return, with rates running up to 13.3% for the highest earners. That is why deferring through a 1031 matters so much here — you are postponing both the federal tax (up to 20% plus the 3.8% net investment income tax) and a California bill that can reach into the double digits. See our California capital gains guide for the full rate detail.
Can I 1031 a Los Angeles rental into an out-of-state property?
Yes, and many Los Angeles investors do exactly that to move equity into lower-cost, higher-yield markets. The federal exchange works normally. Just remember the California consequence: you start filing Form FTB 3840 that year and keep filing it annually, and California retains the right to tax the original Los Angeles gain when you sell the replacement property. Moving to a no-income-tax state does not erase the California gain you deferred — it only postpones it.