Section 1031 in Action: Like-Kind Exchanges in the Golden State

Introduction

IRC Section 1031 of the Internal Revenue Code offers taxpayers the opportunity to delay recognizing gains or losses when swapping property for business or investment.  California generally conforms to IRC section 1031 as outlined in the California Revenue and Taxation Code sections 18031 and 24941. This means that California taxpayers can enjoy non-recognition treatment for state tax purposes, given that their like-kind exchanges meet the criteria defined in IRC Section 1031. 

California Issues

The California Franchise Tax Board (FTB) has established three key prerequisites for qualifying for non-recognition treatment under section 1031: (1) the exchange must genuinely involve swapping properties rather than conducting separate sales and reinvestments by the same taxpayer; (2) both the relinquished property and the replacement property must be of a similar kind; and (3) both the relinquished and replacement properties must be held for investment or for productive use in a trade or business, excluding properties primarily held for sale or personal use.

In like-kind exchanges, the sourcing of gain or loss on the property exchange is determined at the time of the exchange. Therefore, if the relinquished property is in California, the deferred gain from the exchange is linked to California, regardless of the taxpayer’s residence or the location of the replacement property. California asserts that this source of gain or loss remains intact until it is recognized—meaning that when the replacement property is ultimately sold in a taxable transaction, the gain deferred on the California property becomes taxable by California.

In recent years, the FTB has scrutinized the sourcing of gains to California during audits of like-kind exchanges. The FTB encountered challenges in tracking a taxpayer’s replacement property to verify whether it was later sold in a taxable transaction, which would trigger a tax liability to California for the deferred gain attributed to California property. The situation is further complicated by taxpayers engaging in multiple consecutive section 1031 transactions, making it difficult for the FTB to trace subsequent exchanges by nonresident taxpayers, which further defers the gain recognition.

Form 3840

To prevent taxpayers from evading California taxation on capital gains arising from the exchange of California real property, California mandates that taxpayers report details about the relinquished and replacement properties on Form 3840, as well as the amount and allocation of the California source deferred gain to the FTB. This form is designed to facilitate tracking of California-sourced gain deferrals from section 1031 exchanges and must be filed annually by taxpayers, even if they have no other California filing obligations for that year. This requirement currently applies exclusively to exchanges involving real property, not tangible personal property.

Conclusion 

Given the FTB’s increased scrutiny and strict interpretation of section 1031 requirements, certain exchanges that would typically be respected for federal tax purposes may come under FTB review. The FTB has emphasized that noncompliance in section 1031 exchanges, such as errors in gain calculations, improper compliance with replacement property identification rules, inclusion of post-exchange property improvement costs in taxable boot calculations, and withdrawal of cash from the proceeds of relinquished properties are all specific areas of review. Therefore, taxpayers considering like-kind exchanges should be meticulous in adhering to all section 1031 requirements.

Voss Real Estate Advisors

October 27, 2023

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