Clawback Regimes and Continuing Reporting

This chapter sets out the principle and the three regimes that can be confirmed from the States' own statutes, regulations, and instructions.

58.1 The sourcing principle

California's instructions state the principle in two sentences. The source of a gain or loss from the sale or exchange of property located in California is determined at the time the gain or loss is realized. The source of that gain or loss is preserved without regard to when it may be recognized.¹

The consequence follows directly. A taxpayer who exchanges California property for property elsewhere has realized California-source gain. Section 1031 defers recognition, but it does not change the source. When the gain is later recognized, on a taxable sale of the replacement property or of a later property in the chain, California treats it as California-source income.

Two practical results follow from that principle, and clients rarely expect either.

Moving does not end the claim. A taxpayer who becomes a resident of a State with no income tax still owes the first State tax on the deferred gain when it is recognized.

A later exchange does not end it either. The deferred gain rides forward through each replacement property, as Chapter 35 describes, and the source rides with it.

58.2 California

For taxable years beginning on or after January 1, 2014, a taxpayer who exchanges real property located in California for like-kind property located outside California must file an annual information return, Form FTB 3840, with the Franchise Tax Board.²

When it is filed. The form must be filed for the taxable year of the exchange and for each subsequent taxable year, generally until the California-source deferred gain or loss is recognized on a California return.³

Who must file. The requirement applies to individuals, estates, trusts, general and limited partnerships, limited liability partnerships, limited liability companies, and corporations, regardless of residence or commercial domicile. A taxpayer that is not otherwise required to file a California return must still complete and sign the form and file it.⁴

What happens without it. If a taxpayer fails to file Form FTB 3840 as required and fails to file a return, the Franchise Tax Board may estimate net income and assess tax, together with applicable penalties and interest.⁵

Where a Maryland practitioner meets this. A California investor who exchanges California property for Maryland property brings a continuing California filing obligation into a Maryland transaction. The obligation is not satisfied by anything done in Maryland, and it continues through later exchanges. The intake questions for a client whose chain includes California property should ask whether the form has been filed every year since the California exchange.

58.3 Oregon

Oregon reaches the same result through a computation rather than a declaration of source.

Where gain is deferred under section 1031 or 1033 and the property acquired in the exchange has a situs outside Oregon, then on a later sale or other disposition of that property in which gain or loss is recognized for federal purposes but is not taken into account in computing federal taxable income for Oregon purposes, Oregon adds to federal taxable income the difference between two figures: the adjusted basis of the acquired property on the date the exchange was completed, and the lesser of the property's fair market value on that date or its fair market value on the date the gain or loss is recognized.⁶ Where the adjusted basis is the larger figure, the difference is subtracted instead.⁷

Read the measure closely. Oregon reaches the appreciation that existed when the exchange was completed. The lesser-of rule means Oregon does not reach appreciation in the out-of-state property after the exchange, and if the property declines in value before it is sold, Oregon's reach declines with it.

The annual report. The statute authorizes the Department of Revenue to require an annual report on the acquired property.⁸ The Department uses Form OR-24 for that purpose. It is used only for exchanges of Oregon business or investment property for property outside Oregon, not for exchanges within Oregon. It must be filed for the tax year of the transfer and annually after that until the like-kind property is disposed of, with a separate form for each exchange. A taxpayer without an Oregon filing requirement may submit it through the Department's online system.⁹

58.4 Montana

Montana's rule is stated in a regulation addressed to nonresidents, and it includes a worked example that tracks Form 8824 line by line.

Gain realized on the transfer of Montana real or tangible personal property retains its Montana-source character and must be reported if and when the gain is recognized for federal income tax purposes.¹⁰

When Montana property is relinquished in a section 1031 exchange, the gain realized as shown on Form 8824 is generally the amount of Montana-source income. There is one adjustment: where the Montana property was itself acquired as replacement property for property located outside Montana in a prior exchange, Montana-source income does not include the gain attributable to that out-of-state property that was deferred in the prior exchange.¹¹

The regulation's first example. A nonresident relinquishes unimproved Montana land with a fair market value of $100,000 and an adjusted basis of $10,000 for Wyoming property worth $90,000 plus $10,000 in cash, with $2,000 of exchange expenses. The $88,000 of realized gain on Form 8824 is Montana-source income. Of it, $8,000 is recognized and reportable in the year of sale, and $80,000 is deferred and must be reported if and when it is recognized for federal purposes.¹²

The example also illustrates the point developed at 39.1 about exchange expenses. The regulation reduces the $10,000 of cash by the $2,000 of expenses to reach $8,000 of recognized gain, which is the line 15 treatment where the expenses are applied against boot.

58.5 Maryland and other States

Maryland. The Comptroller's current technical bulletin addresses section 1031 by reference to federal adjusted gross income: gain excluded from federal adjusted gross income is excluded from Maryland adjusted gross income.¹³ It does not describe a continuing report comparable to California's Form FTB 3840 or Oregon's Form OR-24, and none has been identified in the course of preparing this work. Whether deferred gain on Maryland property is Maryland-source income when a nonresident later recognizes it is a separate question, and it is treated at 61.5 as an open practice question rather than a settled rule.

Other States. Practitioner literature describes additional States as sourcing deferred gain or requiring reporting after an exchange. Those descriptions vary, and several are out of date. A practitioner should confirm any such rule against the State's own statute, regulation, or form instructions before relying on it, as this chapter has done for California, Oregon, and Montana.

The practice checklist.

When a client exchanges out of California, Oregon, or Montana, calendar the continuing obligation. For California and Oregon it is an annual filing; for Montana it is a reporting obligation that arises when the gain is recognized.

When a client exchanges into Maryland property from one of those States, ask about the obligation at intake. The Maryland closing does not satisfy it, and the client may not know it exists.

When a client with a multi-State chain proposes a taxable sale, identify every State whose property is in the chain. Each may treat part of the recognized gain as its own, and the allocation depends on the records of every exchange in the chain. The record-keeping obligation described at 37.4 therefore has a State dimension as well as a federal one.