[Special thanks to Leonard Spoto, Principal, Asset Exchange Company, LLC. whose impressive presentation and consultation alerted me to the issue and whose editing contributed to the content of the article. Asset Exchange Company is one of the most active intermediaries in California in both simple and complex exchanges.]
In high-tax states like California (CA), Oregon, Colorado and Arizona, like-kind exchanges make up between 10-18% of real estate transactions. Of these, 90% are delayed exchanges and 10% are reverse or construction exchanges.
Because business is good and the market is healthy, buyers and sellers are trading real estate and often considering the use of 1031 deferred tax exchanges to build wealth using the deferral. The bad news is that both the IRS and the FTB have increased their scrutiny and auditing of these transactions to ensure strict compliance with the rules. In many instances in tax law, the guiding principal is substance over form. In 1031 exchanges the reverse is true. Form is strictly enforced and there are many nuanced rules regarding timing and handling of funds that present potential pitfalls and challenges to effecting an exchange. This is true more than ever.
Further, possible tax reform poses a certain urgency to complete any exchanges in the event Congress eliminates exchanges under proposed tax reform measures.
The majority of states generally conform to the Federal treatment of tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. Capital gain taxes are deferred indefinitely until the final property is sold (i.e. cashed out). Generally, this has been interpreted to mean that an investor is only subject to taxes in the state where the final property is sold.
California Claw Back Provision
California has a different position. In California, any capital gains accrued on California real estate will be subject to California tax upon the ultimate sale of the real property even if the investor had sold his or her California real estate and subsequently 1031 Exchanged into investment property located outside of California. This has become known as the California Claw-Back Provision, which was formalized in 2014, and could potentially subject a California taxpayer to double taxation on any gain pursuant to the ultimate sale.
If a CA taxpayer sells CA property and exchanges it into out of state property (in a state with a capital gains tax), the taxpayer will have the original basis in the property in both states. When the property (out of state) sells, the CA taxpayer will be subject to capital gains tax in the selling state (Tax = (sale price less basis) x tax rate), and CA capital gains tax. (Tax = (purchase price of the acquired property less the original basis) x the tax rate).
California law now requires that taxpayers who exchange into out of state property are required to file an annual information return with the FTB, reporting this NON-California property. Previously deferred CA taxes will be due when and if taxpayers sell their new properties and elect to take their profits rather than continuing to defer taxes through another 1031 Exchange. If taxpayers fail to file the annual return, the FTB may estimate taxes due and assess tax, interest and penalties.
Note, that if taxpayer exchanged out of state property into CA property, then tax on the ultimate sale will only be paid in CA.
Possible strategy: The exchange involves two taxable transactions, one an exchange under federal law and one under state law. In California, a taxpayer targeting out of state property to acquire after selling California property, could elect to pay the tax on the California property while invoking the exchange under federal law. This will avoid the California tax and possibly double tax on the back end.
It is well known that Congress is considering substantial tax reform. The reforms being considered include: simplification and lower rates are primary goals with individual brackets of 12, 25 and 33%; Pass thru entities will pay 25%; C-Corps highest rate will be 20%; the Alternative Minimum Tax and the estate tax will be eliminated; and capital gains, and taxes on dividends and interest will be substantially reduced.
The Congress is likely to use the Budget Reconciliation process, which does not permit –the use of filibustering so that the tax reform measure can’t be held up using the filibuster.
In order to gain support for passage of tax reform as described above, Congress is considering elimination of most deductions and inclusions, however a larger standard personal exemption is being considered, interest expenses will not be deductible, and 1031 tax deferred exchanges may be eliminated or capped.
When considering the possibility of a 1031 exchange there are many issues to keep in mind but be sure to remember that: (1) the selling taxpayer must be the same taxpayer that acquires replacement property; (2) don’t take any cash out of the deal during the escrow process because this will be considered taxable boot: (3) the time limits for identifying target properties and the time period for closing on the target properties are strictly enforced: and (4) the properties must be held for investment or business use. Although the Code fails to define how long one must hold property to qualify the IRS (and a number of Courts) have imposed a 2-year waiting period before a property sold can qualify.
Due to the potential for elimination or reduction in benefits presently associated with a 1031 exchange, if you are considering implementing an exchange you may want to consider doing it sooner than later so that the transaction is complete before Congress acts.