1031 Exchange Advisor for California Sellers

A taxable sale costs a California owner up to 13.3 percent, because gains are ordinary income here

California has no separate capital-gains rate. Gains are taxed through the ordinary brackets, which reach 12.3 percent, and Revenue and Taxation Code section 17043 adds 1 percent on taxable income over $1 million, so a large gain is taxed at the margin at 13.3 percent on top of federal tax, depreciation recapture and the net investment income tax. That is the figure a completed exchange defers, and it is why the first thing a proposal for a California seller shows is the state and federal cost of doing nothing. Whether an exchange defers state tax at all, and how other states compare, is answered in does a 1031 defer state capital gains tax.

Two federal alternatives do not work for the California half. The state does not conform to the opportunity zone deferral, so a gain rolled into a qualified opportunity fund is fully taxable in California in the year of sale, and it does not follow federal bonus depreciation. Those tools can still cut a federal bill; for the California bill the exchange is the route.

Form 593 at closing: certify the exchange exemption, or 3 1/3 percent of the price is withheld

Escrow withholds 3 1/3 percent of the sales price on a California real estate sale unless the seller certifies an exemption on Form 593 or the price is $100,000 or less. A deferred exchange is exempt at the time of the initial transfer, but the qualified intermediary becomes the withholding agent: it must withhold on any money or other property you receive over $1,500, and if the exchange fails to complete it must withhold 3 1/3 percent of the whole price. The exchange agreement should say who completes the form and when, because it has to be with escrow or the intermediary before closing.

We check this on the first call for every California sale, since a missed certification ties up cash you intended to reinvest until it is refunded through your state filing. The form, its deadlines and the boot rule are set out line by line in our closing guide to Form 593 in a 1031 exchange.

FTB 3840 follows the deferred gain out of the state, every year until it is recognised

If you exchange California property for property outside California, Revenue and Taxation Code section 18032 requires an information filing, Form FTB 3840, for the year of the exchange and every year after it until the California-source gain is recognised. The obligation does not end when you exchange again; a new 3840 is filed for the later exchange. If the form stops and no California filing is made, the Franchise Tax Board may estimate the deferred gain and assess tax, penalties and interest.

This matters for DST buyers in particular, because the trusts we place most California sellers into hold property in other states. The 3840 allocates the deferred California gain across the trust's properties as the sponsor reports them, and when a property is sold California taxes its share of the gain even if you have since left the state. Exchanging into another state in general is covered in exchanging into another state; the 3840 mechanics are on the California page.

Proposition 13: a California replacement is reassessed, a DST holding property elsewhere is not

Article XIII A of the state constitution caps property tax at 1 percent of assessed value and limits increases to 2 percent a year, but resets the base to market value on a change in ownership. Your sale is a change in ownership, and so is the purchase of any California replacement, which is reassessed at its price. An owner who bought in the 1980s and is paying tax on a fraction of today's value cannot carry that base into a new California building.

A DST whose properties are in other states, or a direct title security on an out-of-state property, sits outside Proposition 13 entirely, which is one reason California sellers so often exchange out. It is also where the trade-off lives: the out-of-state replacement starts the FTB 3840 obligation above. Both the traditional DST and the direct title security are illiquid investments with no public market, their distributions or rent can be interrupted by a tenant default, and the property can sell for less than it cost, so principal can be lost; the proposal states these risks beside each recommendation.

Transfer taxes come out of the proceeds before the exchange starts

Every California county charges a documentary transfer tax of $0.55 per $500 of consideration on the relinquished deed, and charter cities add their own. Los Angeles charges a base 0.45 percent plus the Measure ULA tiers on high-value sales, and San Francisco's schedule climbs to 6 percent. These are taxes on the conveyance, so an exchange does not avoid them, and they reduce what reaches the intermediary. Our guide to California city transfer taxes in a 1031 exchange lists the city schedules; a replacement outside the state avoids a California transfer tax on the purchase side.

How we work with California sellers from Irvine

We are based in Irvine, licensed in all 50 states, and we meet by phone and video, so a seller in Sacramento or San Diego gets the same first call as one in Orange County. That call asks where you are on the clock, what loan is paid off at closing, your state of residence, the income you need and who inherits; for a California property it adds the Form 593 certification and whether the replacement will be in state or out. The proposal that follows shows the state and federal cost of a taxable sale, the equity and debt figures to replace, the structures that fit and the offerings open now, and it goes to your CPA before anything is signed.

For a view of the three Southern California markets we serve most, see our Southern California page, and for the home market, Orange County. The general advisory role, and how it sits beside the intermediary, the CPA and the attorney, is on the 1031 exchange advisor page.

Questions California sellers ask