Last Updated: April 2026
Section 1031 of the IRS code allows real estate investors to defer capital gains taxes when selling investment property by reinvesting in a like-kind replacement property within specific time limits. This deferral can be repeated indefinitely ('1031 until you die'), with the basis stepped up at death under current law. At the federal level, 1031 exchanges are straightforward. At the state level, compliance varies — most states conform, but California, Massachusetts, and a few others have rules that can complicate 1031 strategies for investors moving between states.
A 1031 exchange (also called a 'like-kind exchange') defers capital gains taxes by rolling the proceeds from one investment property into another:
A 1031 exchange defers: long-term capital gains (0%, 15%, or 20% federal), net investment income tax (3.8% if applicable), and state income taxes (in conforming states). It does NOT eliminate: depreciation recapture (25% federal rate on accumulated depreciation is carried forward in the replacement property basis, not deferred in a standard 1031), and state clawback taxes in states like California.
You cannot touch the proceeds from the sale — they must be held by a Qualified Intermediary (QI), also called an exchange accommodator. If you constructively receive the funds before the replacement property closes, the entire exchange fails and the gain is immediately taxable. Choose a reputable QI; they are not regulated federally, and QI fraud and insolvency have resulted in significant investor losses.
California's 1031 clawback rule is the most important state-level issue for real estate investors:
California requires taxpayers who defer gain in a California 1031 exchange to file Form 3840 annually if the replacement property is located outside California. California tracks the deferred gain and asserts the right to tax it when the replacement property is eventually sold — regardless of whether the seller is a California resident at that time. This means: (1) You sell California investment property, defer a $500,000 gain into a Texas replacement property; (2) You move to Florida, never return to California; (3) You sell the Texas property years later for a gain; (4) California asserts the right to tax the original $500,000 deferred gain from the California sale as California-source income. California's position: the gain was deferred from California property and therefore retains its California source character. This is a significant trap for investors who use 1031 to move California real estate gains into other states.
California Form 3840 must be filed annually until the replacement property is sold and California tax is paid. Failure to file can result in penalties. California will calculate interest on the deferred tax from the original exchange. The only way to definitively avoid the California clawback on CA-origin 1031 gains: sell the replacement property and pay California tax, or exchange back into California property (which resets the clawback to CA-source).
| State | 1031 Conformity | Notes |
|---|---|---|
| California | Conforms (with clawback) | CA Form 3840 required for out-of-state replacement; clawback on eventual sale |
| New York | Full conformity | No clawback; NY taxes gain on NY-source property regardless |
| Florida | Full conformity | No state income tax — 1031 provides no state tax benefit to save (already $0) |
| Texas | Full conformity | No state income tax — same as Florida |
| Pennsylvania | Non-conforming | PA treats 1031 exchanges as taxable for state purposes using installment sale method |
| Massachusetts | Full conformity | Standard 1031 deferral; like federal rules |
| Washington State | Partial | No income tax; WA capital gains tax (7%) has its own 1031-like deferral provision |
The optimal 1031 strategy for departing California investors: (1) Sell the California property; (2) Use a 1031 exchange into a new investment property — but keep it in California (avoids clawback trigger); (3) Move domicile to Florida or Texas; (4) After establishing new domicile, sell the California replacement property — you will owe California non-resident tax on the California-source gain, but not Florida/Texas tax; (5) Use a final 1031 into out-of-state property, then do a deferred 1031 where you eventually sell the CA source property, paying the accumulated CA gain then. This complex but legitimate planning is commonly used by high-net-worth California real estate investors.
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US Real Estate Tax Help for Expats →No — a 1031 exchange defers California capital gains tax, it does not eliminate it. California conforms to the federal 1031 rules and defers the tax. However, if you exchange into out-of-state property, California's clawback rule (Form 3840) tracks the deferred gain and taxes it when the replacement property is eventually sold — even if you are no longer a California resident. The only way to permanently avoid California tax on deferred CA-source gains is to hold the replacement property until death (basis step-up eliminates the gain) or through charitable giving strategies.
Under current law (as of 2026), inherited property receives a stepped-up basis to fair market value at the date of death. This means 1031 exchange deferred gains 'disappear' at death — the heirs inherit the property at current FMV with no income tax due on the deferred gain accumulated during the decedent's lifetime. This is often called '1031 until you die' as a planning strategy. Note: California's clawback rule may still apply to the heirs depending on how the estate handles the inherited property — consult an estate attorney for California-origin 1031 chains.
No — primary residences are not eligible for 1031 exchange treatment (which applies only to investment property held for business or investment use). However, there is a strategy involving converting a primary residence to a rental: (1) Convert primary residence to rental property; (2) After sufficient rental use period (typically 2 years), the property qualifies as investment property; (3) Sell and use a 1031 exchange. Separately, the §121 exclusion ($250K/$500K) can apply to the gain up to the exclusion amount before or after a 1031 — a combination strategy. These combined strategies are complex and require professional guidance.