When a taxpayer does a “tax-free exchange” of California real estate for real estate in some other state, California form 3840 is required to be filed each year and when the replacement property is sold.
The “tax-free exchange” is known under the federal law as “1031 exchange” (for the IRS tax code number). It applies for exchange of “like kind” real estate-investment real estate for other investment real estate, etc.
California form 3840 is required to be filed so California can receive the income tax on the sale of the replacement property in some other state, when sold years later.
If the form 3840 is not filed, California may use estimates in determining what California tax is owed when the replacement property is sold.
For example, if Joe sold California investment real estate after 2013 for $100,000, but received replacement investment real estate of equal value instead of cash, he could report the sale but defer or postpone paying the tax on the gain under the “tax free exchange” tax rules for federal and California purposes.
Of course, there are special rules when the seller receives cash (“boot”) and replacement property (usually the “boot” is current taxable income). If the mortgage given up is different than the mortgage assumed on the replacement property, the difference affects the computation of gain.
Assume Joe received qualified Nevada real estate worth $100,000. Now if Joe sold the Nevada real estate a few years later for $100,000, his cost or tax basis was $20,000. He can defer paying federal and California income tax on the $80,000 gain in the year of sale if he purchases qualified replacement real estate in accordance with the tax free exchange rules. The replacement property has a tax cost or basis of only $20,000. If his later sale of the replacement property is for cash, the deferred gain is taxable for both federal and California tax.
California wants an income tax on the sale of the replacement property, even though it is in Nevada, not California. If the gain increases from $80,000 in the example above to say $180,000 gain, then California (and IRS) will get income tax on the larger gain.
The point is California form 3840 is supposed to be filed every year when there is a “tax free” exchange of California real estate for qualified real estate in some other state. Maybe it would be best to not elect the “tax-free exchange” rules on some sales of California real estate.
Did you hear, “Keep smiling. It makes everybody wonder what you have been up to.”
John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.