If you replace California real property with property located outside California in a Section 1031 exchange, you are required to file an annual information return on Form FTB 3840, California Like-Kind Exchanges. This form must be filed until the individual owner is deceased or the gain is fully recognized at the federal level.
What is a like-kind exchange or Section 1031 exchange?
A like-kind exchange, also known as a Section 1031 exchange, is a tax-deferral strategy in real estate transactions. A like-kind exchange allows you to swap one investment property for another while deferring capital gains taxes.
It’s named after Section 1031 of the U.S. Internal Revenue Code, which outlines the rules for these exchanges. The properties exchanged must be of “like-kind,” which for real estate means any real property held for investment or business use.
Guidelines for Section 1031 exchanges (like-kind exchanges)
- You must identify potential replacement properties within 45 days of selling your original property.
- You must close on the new property within 180 days of the sale of the original property.
- The replacement property should be of equal or greater value than the relinquished property to fully defer taxes.
- As of 2018, only real property qualifies (not personal property or intangible assets).
- The tax is deferred, not eliminated. If you eventually sell the property without another exchange, you’ll owe taxes on the original deferred amount plus any additional appreciation.
When should you file Form 3840?
You must file Form 3840 in the year that the like-kind exchange occurs, and every following year for as long as the gain or loss is deferred. It’s worth noting that you do not need to file Form 3840 to report property located in California that was acquired in a Section 1031 exchange.
You must file Form 3840 until:
- The property has been disposed of in a fully taxable transaction
- The property is transferred through inheritance (eliminating deferred California source gain or loss)
- The replacement property is donated to a nonprofit organization
The requirement to file Form 3840 ends if the non-California replacement property is exchanged in a subsequent transaction for California property.
In this case, file a final Form 3840 and attach a statement explaining that the replacement property was exchanged for a California property.
Converting out-of-state replacement rental properties to personal use
If you convert an out-of-state replacement rental property to personal use, you must still file Form 3840 because conversion to personal use is not considered a disposition in a fully taxable transaction.
Receiving replacement property as a gift
If you receive a replacement property as a gift rather than as an inheritance also has to continue to file Form 3840 until the property is otherwise disposed of.
For example, when a parent gifts a property to their child with the property’s carryover basis, we recommend that:
- The giftee attach a statement to Form 3840 explaining that the property was received as a gift.
- The gifter must file a final Form 3840 and attach a statement that explains that the property was gifted to the giftee.
Like-kind exchanges including Delaware Statutory Trusts (DST)
When you exchange a California real property for an interest in a Delaware Statutory Trust (DST), you can include the name of the DST in the description of the like-kind property received on Schedule A, Part 2, Line 9.
You must report the deferred gain on Schedule A, Part 1, Line 8, and file the return annually until the gain is recognized for federal income tax purposes. There’s no need to report each out-of-state property owned by the DST.
Advice when you neglect to file Form 3840
If you do not file a California return, you must still file form 3840 separately as a California information return. The due date is the same due date that would apply if you were required to file a California return. Form 3840 should be signed and mailed to the address included in the form instructions.
If you should have filed Form 3840 but didn’t, the FTB strongly encourages submitting the form with an amended return. If it’s filed separately, there will more likely be an inquiry from the FTB concerning the transaction.
According to the form 3840 instructions, if a taxpayer fails to file form 3840, the FTB may issue a notice of proposed assessment on the amount of income deferred. This essentially accelerates the gain recognized on the deferred exchange into the year the form was not filed.
However, the law really only allows the FTB to accelerate this gain recognition if the taxpayer fails to file Form 3840 and fails to file a California return for that year. If you file a return but fail to file Form 3840, you may not be subject to this accelerated gain recognition.