The Hidden Tax Trap: California’s Claw-Back on Out-of-State 1031 Exchanges

A 1031 Exchange allows real estate investors to defer capital gains taxes by reinvesting proceeds from the sale of an investment property into a like-kind replacement property. However, California has a unique tax rule known as the Claw-Back Provision, which can still subject investors to state taxes even if they exchange out of California into another state. Understanding this provision is essential for investors who wish to avoid unexpected tax liabilities.

What Is the California Claw-Back Provision?

The California Claw-Back Provision applies to taxpayers who conduct a 1031 Exchange involving California property and later acquire a replacement property in another state. While federal taxes remain deferred under Section 1031, California requires investors to track and potentially pay state taxes on the deferred gain when they eventually sell the out-of-state replacement property in a taxable transaction.

This means that even though an investor successfully defers California state taxes by completing a 1031 Exchange, those taxes are not forgiven—they are simply postponed until the investor fully exits the exchange process.

How Does the Claw-Back Provision Work?

1. 1031 Exchange Out of California

   • An investor sells a property in California and acquires a like-kind replacement property in another state using a 1031 Exchange.

   • The capital gains tax at the state level is deferred, but California continues to track the deferred gain.

2. Holding the Out-of-State Property

   • The investor continues to defer taxes as long as they follow the 1031 Exchange rules and do not sell the replacement property in a taxable sale.

   • California requires investors to file an annual FTB Form 3840 (California Like-Kind Exchange Information Return) to report the deferred gains and keep track of out-of-state replacement properties.

3. Selling the Out-of-State Property

   • When the investor eventually sells the out-of-state replacement property in a taxable transaction (without another 1031 Exchange), California claws back the previously deferred state taxes, requiring the investor to pay California capital gains tax on the original sale.

4. Continuous Deferral

   • The only way to avoid California’s claw-back is to continue executing 1031 Exchanges indefinitely or return to investing in California properties.

Who Is Affected by the Claw-Back Rule?

• California Residents: Must report and pay state taxes on the deferred gain when selling an out-of-state replacement property in a taxable event.

• Non-Residents Who Exchanged California Property: Even if a taxpayer moves out of California, they remain subject to the claw-back provision for any deferred gains from prior exchanges of California properties.

Strategies to Minimize Claw-Back Tax Exposure

1. Continue 1031 Exchanges

   • Investors can keep deferring capital gains taxes, including California’s claw-back, by continuing to reinvest through 1031 Exchanges.

2. Invest Back into California

   • If an investor exchanges into another California property, they avoid triggering the claw-back provision.

3. Monitor State Tax Laws

   • Some investors explore estate planning strategies to pass on properties to heirs with a step-up in basis, potentially reducing taxable gains.

The California Claw-Back Provision ensures that the state can still collect capital gains taxes on deferred gains when an investor ultimately sells an out-of-state replacement property in a taxable transaction. While 1031 Exchanges offer powerful tax-deferral benefits, investors must be aware of the long-term implications of exchanging out of California. Proper planning with tax professionals and continued exchanges can help mitigate potential claw-back liabilities and maximize investment benefits.