FTB Form 3840, Exchange Trap That Can Follow You Out of State

For real estate investors, a Section 1031 exchange may be a way to delay federal and California tax on exchanges of like-kind property. However, there is an important reporting requirement in California that can stay with an investor even after they have left the state.

If you are a taxpayer who sells one property that is like-kind in California and then moves to another state, you may need to keep that tax trail in California for taxpayers who need to exchange California property and then are no longer a resident of the state. Look for an expert (like a tax lawyer in Santa Monica) for necessary guidance and help.

What Is Form 3840?

Generally, California requires taxpayers to account for deferred gain if they sell or otherwise dispose of California real property for property outside of California. The information on the exchange and subsequent disposition of the replacement property will be reported on Form 3840.

The form provides the California Franchise Tax Board (FTB) with information on deferred California-source gain. Just because you’ve moved to another state doesn’t mean you’ve gotten rid of that deferred CA tax responsibility.

The 1031 Trap Has Evolved Over Time

Imagine the investor sells their rental property in California and exchanges it for a replacement rental property in another state. The gains may be deferred under federal regulations.

California, however, must keep reporting the deferred gain from the California property.

The trouble starts when the investor moves to other states, like Texas or Nevada, and decides that California is irrelevant.

The investor can cease filing California returns – or not file a Form 3840 when needed. The California gain may be exposed and result in queries regarding the original exchange when a replacement property is sold many years later.

Tool: How to Track the Gain – California Continues Tracking the Gain

The California rules will allow California to retain its interest in gains from California real property. The basic idea behind Form 3840 is to provide a paper trail between the California property and the replacement property and the deferred gain.

That will require taxpayers to keep records that demonstrate:

• Original property’s purchase price and adjusted basis
• The sale price and exchange charges
• Amount of gain deferred
• Replacement property’s details
• California-source deferred gain
• Subsequent sales or exchanges

What Will Happen If You Don’t File?

Missing Form 3840 doesn’t necessarily mean California immediately assesses all deferred gain. But it can lead to a compliance chasm.

The FTB may request documents relating to the original exchange, replacement property, and/or change of residency, as well as any additional transactions, if the FTB later determines there is a California connection.

If a taxpayer does not have the records after years, it will be much more difficult to be examined. Get in touch with experts (a reliable San Francisco tax attorney) if you need some urgent help.

The Most Common Errors Students Make Are Listed Here

1. Can’t get away from California obligations: California does not lose its interest in previously deferred California-source gain upon becoming a nonresident.
2. Don’t forget about annual reporting: Form 3840 could have continuing reporting implications, and taxpayers should check their California filing requirements annually.
3. Lost exchange records: A 1031 transaction can have a long duration.
4. Interpretation of federal and California rules as the same: California has its own conformity and reporting requirements; these should be reviewed separately.

Tips for 1031 Investors

1. Maintain the entire 1031 exchange file for as long as the exchange is in effect or for the required record-keeping period.
2. Separately track the deferred California gain from federal calculations.
3. When preparing a California return, check out Form 3840 requirements.
4. Let your tax advisor know of your move.
5. When selling replacement property, see if any California gain has been deferred.
6. Do not assume that California reporting is not required for an out-of-state replacement property.

California doesn’t “forget” about future gain under a 1031 exchange, but it does defer tax. FTB Form 3840 is provided to maintain the state’s paper trail. Investors who move should keep monitoring their California reporting requirements – but don’t presume that moving ends the reporting of the first transaction.