State Tax Rules for 1031 Exchanges

The Good News: All States Now Conform

Prior to 2023, Pennsylvania was the only state that refused to recognize the federal 1031 exchange deferral for personal income tax purposes. A resident selling a Pennsylvania rental property and completing a valid federal exchange would still owe Pennsylvania income tax immediately. That changed when Pennsylvania Act 53 of 2022 (signed July 8, 2022) conformed Pennsylvania's personal income tax to federal IRC § 1031 treatment, effective for tax years beginning on or after January 1, 2023.¹

Today, every state with a personal income tax recognizes the 1031 deferral on an exchange that qualifies under federal rules. You complete the exchange on schedule, file IRS Form 8824, carry over your basis, and the state follows suit. The state income tax clock stops — as long as you stay inside the rules.

The complications arise from three separate phenomena that are easily confused with non-conformance but are actually distinct:

Clawback States: The Gain Travels With You

A clawback provision means that when you deferred a gain on a property located in State X and later sell the replacement property in a taxable transaction in State Y, State X retains the right to collect income tax on the portion of the gain that accrued while the original property was in that state. The federal deferral does not extinguish the state's claim — it simply suspends it.

California: The Most Aggressive Enforcement

California's approach is the most rigorous of any clawback state and deserves detailed attention because it affects a large share of the country's highest-value investment real estate transactions.

Under California Revenue and Taxation Code §§ 18032 and 24953, any taxpayer who completes a 1031 exchange in which the relinquished property was located in California but the replacement property is located outside California must:²

• File FTB Form 3840 with their California income tax return for the year of the exchange and for every subsequent year until the deferred gain is recognized in a taxable transaction.
• Report the deferred gain amount, the replacement property's location, and any subsequent exchanges involving the same gain chain.
• Pay California income tax on the deferred gain in the year the replacement property is sold in a taxable transaction — regardless of where the seller then lives or where the replacement property is located.

The Franchise Tax Board cross-references federal Form 8824 filings (which every 1031 exchanger must file with the IRS) against California returns to identify exchanges where a California property was sold but no Form 3840 appears. Missing annual filings trigger automated notices and can restart the statute of limitations for assessment.

California's income tax rates for capital gains are particularly important here because California treats all capital gains — including long-term capital gains and §1250 depreciation recapture — as ordinary income. There is no preferential long-term rate at the state level. The top California income tax rate is 13.3% on income above approximately $1 million (single or MFJ). For investors with substantial other income, the effective California rate on a large deferred gain can approach 13.3% on the full amount.

Oregon

Oregon follows a similar structure to California: when a taxpayer sells Oregon property in a 1031 exchange and acquires out-of-state replacement property, Oregon requires an annual informational filing with the Oregon Department of Revenue to track the deferred gain. The filing requirement continues until the gain is recognized. Oregon's capital gains are taxed as ordinary income at a flat 5% rate for tax years beginning on or after January 1, 2025 (previously up to 9.9%).³

Montana, Massachusetts, and Idaho

These three states impose clawback but do not require annual filings. The practical difference: if you exchange out of Montana into Idaho and later sell the Idaho property taxably, Montana will attempt to collect its deferred tax — but there is no annual tracking form that keeps the clock running or triggers automated audit. This does not mean the obligation disappears. Montana, Massachusetts, and Idaho retain their statutory right to tax the gain that accrued in their state, and that right is enforceable when the replacement property's taxable sale is reported.

Nonresident Withholding: A Cash Flow Issue, Not a Tax Issue

Withholding at closing for nonresident sellers is a separate concept from clawback. Most states with income taxes require the buyer (or escrow/title company) to withhold a portion of the gross sale price or the estimated gain when a nonresident seller closes. The purpose is to ensure the state collects any taxes owed by an out-of-state seller who might not file a state return.

When the exchange qualifies under federal and state rules, the withholding is fully refundable — you file a nonresident state return, show the exchange qualifies, and get the withheld amount back. But the refund can take weeks to months to process, and the withheld amount can be substantial.

No-Income-Tax States: Clean Exit on State Tax

Nine states impose no personal income tax at all, which means a 1031 exchange into replacement property in one of these states defers federal capital gains tax and also eliminates state capital gains tax entirely for as long as you hold the replacement property:

Texas, Florida, Nevada, Washington, Wyoming, South Dakota, Alaska, Tennessee, New Hampshire — no personal income tax on capital gains.

Important exception for Washington: while Washington has no income tax, it does impose a Real Estate Excise Tax (REET) of 1.28%–3.0% on the sale price at every transfer of title, including on replacement property acquired in a 1031 exchange. The REET is triggered by the deed transfer itself, not by any gain. When you eventually sell a Washington replacement property in a taxable transaction, the REET applies in addition to federal capital gains tax. Budget for it in the replacement property analysis.

For investors who own highly appreciated California property and are approaching retirement — or who are eligible to hold property until death and receive a step-up in basis under IRC § 1014 — exchanging into a Texas or Florida replacement property and then dying holding that property results in zero federal capital gains tax (step-up eliminates the deferred gain) and zero state income tax at either stage. This is one of the most powerful combined-state/federal estate planning strategies available to real estate investors, and it is the primary reason the step-up at death strategy is so frequently discussed in the context of California exchanges.

Cross-State Exchange Scenarios: What the Numbers Look Like

The state tax analysis changes materially depending on where the relinquished and replacement properties sit. Three common patterns:

Scenario 1: California property → Texas replacement

State tax deferred by exchange: California income tax on the full gain (up to 13.3%) — deferred but not eliminated. Form 3840 required annually. If replacement property is sold taxably in Texas: California bills the deferred tax on the original California gain. Step-up at death eliminates both federal and California deferred tax if held until death. Result: state tax deferral works, but the California liability follows you unless you hold until death or route through a charitable strategy.

Scenario 2: Texas property → California replacement

State tax on the Texas sale: zero (no Texas income tax). California state tax situation going forward depends on when and how the California replacement property is sold. If you later exchange out of California again, Form 3840 will apply. If you sell taxably in California, California taxes the California gain (the gain accrued since you acquired the replacement property). The pre-acquisition gain (the Texas gain you deferred federally) does not create a California liability — California has no claim on gain that accrued on Texas property. Result: you pick up a California tax footprint on the California replacement property's future appreciation.

Scenario 3: California property → California replacement

State tax: deferred entirely at the California level, no Form 3840 needed (replacement property is still in California). The clawback provision only activates when the replacement property leaves California. If you continue exchanging within California until death, the California deferred tax is also eliminated by the step-up at death. Result: cleanest state tax outcome other than an out-of-California exchange with a death-hold strategy.

Planning Strategies When State Taxes Are a Factor

State tax exposure in a 1031 exchange changes the pre-decision analysis in a few important ways:

• File Form 3840 every year without fail. If you exchange out of California, missing even one annual filing restarts the statute of limitations and can lead to penalty and interest assessments that compound the underlying tax liability. Build this into your annual tax calendar.
• Model the state tax as a separate layer in the exchange-vs-taxable-sale comparison. The federal tax deferred by the exchange often gets the headline — but for a California seller at a 13.3% marginal state rate, the state-level deferred tax can equal 30–40% of the total tax at stake. That component belongs in the model before the decision is made.
• DST-to-UPREIT conversions may trigger clawback in some states. When a DST contributing to a UPREIT makes a § 721 contribution and DST investors receive operating partnership units, that transaction may be treated as a taxable recognition event by clawback states on the originally deferred California or Oregon gain. This is an active planning issue for DST investors who entered through a California 1031 and are considering the UPREIT conversion path.
• Step-up at death strategy is more powerful for clawback-state investors. Holding California or Oregon property (or a replacement acquired via exchange from those states) until death eliminates the entire deferred gain under IRC § 1014, including the state-level component. For older investors who are not dependent on the sale proceeds for liquidity, this is often the highest-value outcome. See the depreciation recapture and basis guide for how the step-up calculation works.
• Charitable Remainder Trusts. Transferring appreciated property to a CRT before sale can sidestep both federal and state capital gains taxes at the time of sale. This is a separate strategy from a 1031 exchange and is not available for all investors, but it deserves analysis when the state tax component is large and charitable intent exists.
• Residency planning matters less than you think for clawback states. Moving to Nevada before selling a California rental sounds appealing, but California's clawback applies based on where the property was located, not where you lived when you sold it. A California rental sold in a 1031 exchange triggers Form 3840 regardless of whether you were a California resident at the time of the sale.

What a Fee-Only Advisor Models on the State Tax Side

The federal exchange math is the starting point, but the state-level analysis is often where the most surprises occur — particularly for California investors who underestimate the annual Form 3840 obligation and the long-tail liability it represents. A fee-only financial advisor working alongside your CPA can:

• Model the full state tax exposure by layer — current-year withholding, deferred clawback liability, and ongoing annual filing obligations
• Compare the state tax cost of exchanging-then-selling versus taking a taxable sale now at current state rates
• Evaluate whether the replacement property's hold period and estate plan support the step-up-at-death elimination strategy or whether another exit is more realistic
• Analyze DST versus direct replacement property from a clawback-interaction standpoint if the California gain is large and a DST is under consideration
• Coordinate the exchange closing paperwork (Form 593, IT-2663, and related state withholding forms) with the QI and title company so cash flow is not impaired at closing

See the financial advisor for 1031 exchange guide for what the full advisory team looks like and when to engage each member before the 45-day clock starts.

Sources

1. Pennsylvania Act 53 of 2022 — IRC § 1031 conformance for Pennsylvania Personal Income Tax, effective tax years beginning January 1, 2023. revenue.pa.gov
2. California Revenue and Taxation Code §§ 18032 and 24953 — California like-kind exchange tracking; FTB Form 3840 annual filing requirement. ftb.ca.gov — 2024 Form 3840 Instructions
3. Oregon SB 407 / Oregon income tax capital gains rate change — 5% flat rate on net capital gains for tax years beginning on or after January 1, 2025. Oregon Department of Revenue. oregon.gov/dor
4. IRC § 1031 — Like-Kind Exchanges of Real Property Held for Productive Use or Investment. law.cornell.edu/uscode/text/26/1031
5. IRS Form 8824 — Like-Kind Exchanges (and Section 1043 Conflict-of-Interest Sales). Required on the federal return in the year of any 1031 exchange. irs.gov/pub/irs-pdf/i8824.pdf

State tax rates reflect 2026 law for California (up to 13.3% ordinary income rate on capital gains), Oregon (5% flat, effective 2025), Montana (3.0%/4.1% tiered LTCG rates), Massachusetts (5.0% flat), and Idaho (up to 5.8%). Pennsylvania conformed to federal 1031 treatment effective tax years beginning January 1, 2023. All 50 states and the District of Columbia now recognize the federal IRC § 1031 deferral for purposes of state income tax. Clawback state obligations persist until the deferred gain is recognized or eliminated (e.g., via step-up at death). Values current as of June 2026 — consult a qualified CPA and tax attorney for your specific state-crossing exchange scenario before making any irreversible decision.

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