A 1031 exchange lets you defer federal capital gains tax by rolling your equity from one investment property into another. But when the relinquished property sits in California or Oregon and the replacement property is somewhere else, two things happen that most exchangers do not see coming.
First, the state wants money held back at closing — withheld from your proceeds — unless the right form is signed before escrow closes. Second, the state reserves the right to collect its share of the deferred gain years or even decades later, no matter where you live when you finally sell.
California calls this the "clawback." Oregon has its own version. Both create an annual filing obligation that follows the replacement property for as long as you own it.
This article covers the mechanics of both states' regimes: the withholding at closing, the form that avoids it, who is responsible if it goes wrong, the annual filing requirement, and the amount each state will eventually tax when the replacement property is sold.
The California Withholding: Form 593
California requires withholding on every sale of California real property. The default rate is 3⅓ percent of the total sales price — not the gain, the entire sales price. On a $2 million property, that is $66,667 held back and sent to the Franchise Tax Board before you see a dollar of your exchange proceeds.
The withholding obligation falls on the buyer — or, in a deferred exchange, on the Qualified Intermediary. The escrow company (technically the "Real Estate Escrow Person" or REEP) is responsible for notifying the buyer of the requirement, but the legal liability for withholding sits with the buyer or QI.
How to Avoid It
The seller avoids withholding by certifying on Form 593 that the transaction qualifies as a like-kind exchange under IRC § 1031. Specifically, the seller checks Box 10 in Part IV of Form 593, which certifies that the transfer is a simultaneous or deferred like-kind exchange. This form must be completed and delivered to the escrow company or QI before escrow closes.
If the seller does not sign the certification — or if the form is not delivered to escrow in time — the withholding happens automatically. Recovering withheld funds from the FTB requires filing a California tax return and waiting for a refund, which can take months.
What Happens If the Exchange Fails
If the exchange is never completed — the identification period expires, or no replacement property is acquired — the QI becomes the responsible party for withholding. The QI must withhold 3⅓ percent of the sales price from whatever funds remain and remit them to the FTB. If the QI has already disbursed the funds to complete a replacement property purchase and the exchange later fails, the QI's obligation is limited to whatever funds are still available (the "cash poor" rule, effective since January 1, 2022). The QI must certify the transaction as cash poor on Form 593 and attach supporting documentation.
Boot
If the seller receives boot — cash, debt relief in excess of new debt, or other non-like-kind property exceeding $1,500 — withholding is required on the boot at 3⅓ percent, unless the seller elects to use an alternative withholding calculation based on estimated gain.
The California Clawback: Form 3840
Here is where California gets serious.
When you exchange California real property for replacement property located outside of California, the state does not forget the gain you deferred. California treats the gain accrued while the property was on California soil as California-source income — permanently. The 1031 exchange defers that tax. It does not eliminate it.
Annual Filing Requirement
Under Revenue and Taxation Code § 18032, any taxpayer — resident or nonresident — who exchanges California property for out-of-state replacement property must file FTB Form 3840 (California Like-Kind Exchanges) with the Franchise Tax Board. This filing is required:
- In the year the exchange occurs, and
- In every subsequent taxable year for as long as the replacement property is held.
This is not optional. This is not a one-time form. You file it every single year until the deferred gain is recognized. If you exchange California property for a rental house in Arizona and hold that rental for twenty years, you file Form 3840 twenty times.
The form requires:
- The address (or assessor's parcel number) of both the relinquished and replacement properties
- The California-source deferred gain
- The adjusted basis of each property
- The dates and details of the exchange
If you are not otherwise required to file a California tax return — because you have left the state and have no other California-source income — you must still file Form 3840 as a standalone information return.
What Happens If You Do Not File
The FTB uses an AI-driven matching system called EDR2 (Enterprise Data to Revenue) that cross-references federal Form 8824 filings with state records. If the FTB sees that you filed a federal 8824 reporting a 1031 exchange of California property but did not file Form 3840, it will issue a Notice of Proposed Assessment.
When that happens, the FTB estimates your income, assumes the replacement property has been sold, and demands payment of the entire deferred tax — plus interest and penalties. The burden of proof shifts to you to demonstrate that the property has not been sold.
How Much California Will Tax
When the replacement property is eventually sold in a taxable transaction — meaning you do not roll it into yet another 1031 exchange — California taxes the original deferred gain at ordinary income tax rates. California does not offer a preferential rate for long-term capital gains. All capital gains are taxed as ordinary income, with rates reaching 13.3 percent on income over $1 million.
The critical question: what about the additional appreciation?
If the replacement property gains value after you acquire it in the exchange, and you are a nonresident of California at the time of the final sale, California generally taxes only the original deferred gain — the gain that accrued while the property was in California. The additional appreciation that occurred on the out-of-state replacement property is not California-source income if you are not a California resident.
But — if you move back to California and become a resident before selling the replacement property, California will tax your entire worldwide income, including both the original deferred gain and all subsequent appreciation. Residency changes the calculation entirely.
When the Clawback Ends
The Form 3840 filing obligation — and the deferred California tax liability — ends only when:
- The replacement property is sold in a fully taxable transaction and the California tax is paid
- The owner dies (step-up in basis eliminates the deferred gain)
- The property is donated to a qualified nonprofit
- The replacement property is exchanged for property back in California (file a final Form 3840 with an explanatory statement)
If you continue doing 1031 exchanges — California to Arizona, Arizona to Texas, Texas to Florida — the California-source deferred gain follows every replacement property in the chain, and you must file Form 3840 every year tracking each successive property.
Oregon's Regime: ORS 316.738 and Form OR-24
Oregon has its own clawback provision, codified at ORS 316.738. The structure is similar to California's, but the rates and mechanics differ.
Withholding at Closing
Oregon requires withholding on real property sales by nonresidents. The withholding amount is the lesser of:
- 4% of the total consideration (sales price)
- The net proceeds (cash to the seller)
- 8% of the gain includable in Oregon taxable income
To avoid withholding in a 1031 exchange, the seller must submit Form OR-18-WC (Withholding Certificate for Oregon Real Property Transfers) at least seven business days before closing. Seven business days — not seven calendar days. Miss this deadline and the withholding happens automatically. Recovering it requires filing an Oregon tax return and waiting for a refund, which can take six to eighteen months.
The Clawback Calculation
When a taxpayer exchanges Oregon property for out-of-state replacement property and eventually sells the replacement property in a taxable transaction, ORS 316.738 requires the taxpayer to add back the deferred gain to their Oregon taxable income. The statute calculates the amount as the difference between:
- The adjusted basis of the replacement property at the time of the original exchange, and
- The lesser of: (a) the fair market value of the replacement property at the time of the exchange, or (b) the fair market value at the time of the final sale
In practical terms, Oregon is taxing the gain that was deferred during the original exchange of the Oregon property. Oregon's top income tax rate is 9.9 percent — lower than California's 13.3 percent, but still significant on a large gain.
Annual Filing: Form OR-24
Like California, Oregon requires an annual information return. Taxpayers who exchange Oregon property for out-of-state replacement property must file Form OR-24 with the Oregon Department of Revenue every year until the replacement property is disposed of. If the taxpayer is not otherwise required to file an Oregon return, the form may be submitted online as a standalone filing.
Side-by-Side Comparison
| California | Oregon | |
|---|---|---|
| Withholding rate | 3⅓% of sales price | Lesser of 4% of price, net proceeds, or 8% of gain |
| Form to avoid withholding | Form 593, Box 10 (at closing) | Form OR-18-WC (7 business days before closing) |
| Annual clawback filing | Form 3840 (every year) | Form OR-24 (every year) |
| State tax rate on deferred gain | Up to 13.3% (ordinary income) | Up to 9.9% (ordinary income) |
| Enforcement tool | FTB EDR2 AI matching system | Department of Revenue |
| Penalty for non-filing | FTB estimates gain, assesses tax + interest + penalties | Department estimates gain, assesses tax + interest + penalties |
| Clawback ends at death? | Yes (step-up in basis) | Yes |
Practical Takeaways for Exchangers
If you are selling California property:
- Make sure Form 593 is completed, Box 10 is checked, and it is delivered to escrow before closing. This is the seller's responsibility, but your QI should be coordinating it.
- If the replacement property is outside California, prepare to file Form 3840 every single year — for as long as you own that property.
- If you move back to California before selling the replacement, the tax picture changes dramatically. California will tax your entire gain, not just the deferred portion.
If you are selling Oregon property:
- File Form OR-18-WC at least seven business days before closing. Calendar days do not count — plan accordingly.
- Prepare for annual Form OR-24 filing if your replacement property is outside Oregon.
For any out-of-state exchange:
- Your QI should be flagging these requirements before closing, not after. At Olympic Exchange Accommodators, we track state-specific withholding and filing obligations as part of every exchange involving California or Oregon relinquished property. When your QI is also an attorney, these issues get addressed before they become problems.
Exchanging out of California or Oregon often makes excellent investment sense. But it comes with strings attached — strings that follow your replacement property for as long as you own it, wherever it is located. The withholding at closing is avoidable with proper planning. The annual filing is not avoidable at all. And the eventual tax bill is real.
If you are considering a 1031 exchange out of a clawback state, contact Olympic Exchange Accommodators. As a Qualified Intermediary and attorney-led firm serving Tacoma, Pierce County, and the greater Puget Sound region, we handle the state-specific compliance so the exchange works the way it should — tax-deferred, properly documented, and free of surprises.
Jeff Helsdon is a Certified Exchange Specialist® who has been facilitating tax-deferred like-kind exchanges since 1990. He is the principal of Olympic Exchange Accommodators in Tacoma, Washington, serving investors throughout Pierce County, the Puget Sound region, and Washington State.
Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Every exchange has unique facts and circumstances. Consult your own attorney, CPA, and financial advisor before making decisions about your 1031 exchange.
