Like-Kind Exchanges for Out-of-State Property
July 10, 2023
You may have read our blog on Building Wealth Utilizing 1031 Exchange, where we discuss the options available to investors when they have a like-kind exchange of property in California. But if you are considering purchasing an investment property in another state, you will need to understand how it will impact your taxes.
California residents are required to file Form 3840 when the like-kind exchange of business or investment property occurs outside of California. This form is required annually beginning the year the like-kind exchange occurred until the gain or loss on the deferred tax is paid or until the property is transferred through inheritance or replacement property is donated to a nonprofit organization.
Who Needs to File?
- Multiple owners: For investment property with multiple owners, each owner will need to complete Form 3840 and report their portion share in gain in the year of the sale and every year they own the investment property.
- Pass-through entity: For property owned by a PTE, the entity must complete Form 3840 each year until the property is liquidated or passed to the owners. If this occurs, the owners will now be responsible for filing the form.
- Single member LLC: When the investment property is owned by a single member LLC., the individual is required to fill out the form with his or her tax return.
- Death: If the owner of the investment property dies and the price of the inherited assets on the date of death exceeds the original purchase price, your CPA can file a final Form 3840 stating death as the reason for the final filing. However, if the property is co-owned, the surviving investor must continue to file Form 3840 for the portion they owned before the inheritance.
- Divorce: In the case of divorce, the spouse that receives the property must file Form 3840. If both spouses continue to own the property jointly, they must file the form for their portion.
- Property exchanged: If you complete another like-kind exchange, you must identify the replacement property if that property is disposed of in any subsequent exchange for a property outside of California until the gain is fully recognized.
- Converting Investment Property: You are still required to file Form 3840 if you convert an out-of-state rental property for personal use.
What are the consequences of not filing?
Failure to file the annual Form 3840 may result in the California Franchise Tax Board estimating the deferred income and assessing the tax and related penalties and interest. This acceleration of tax occurs even though the taxpayer has not disposed of the replacement property and continues to defer tax for federal tax purposes.
Given that like-kind exchanges are one of the top audit areas, it is essential to work with your CPA closely through the year to understand the impact out-of-state investment property will have on your annual taxes. Contact our team today to discuss your individual situation.