I. WHY LEAVE CALIFORNIA?
California’s beautiful. Why are so many real estate investors running away?
Many are pulling real estate investments out of California because they have become increasingly difficult to manage in recent years.
First is the high cost of doing business in California. For example, California has one of the highest minimum wages of any state, and owing to other employment laws, the cost of labor in California is very high. California has the highest annual fee for a Limited Liability Company, at $800 per year, even in years when the LLC doesn’t make money. But a California LLC won’t necessarily provide the limited liability that it would provide in other states. California courts are quick to pierce the corporate veil and expand liability.
The US Chamber of Commerce Institute for Legal Reform rates California among the worst five states for lawsuits and places Los Angeles and San Francisco on the list of “Cities or Counties with the Least Fair and Reasonable Litigation Environment.” The American Tort Reform Foundation includes California among the worst “Judicial Hellholes” in the nation, commenting: “Lawsuit abuse and excessive tort costs wipe out billions of dollars of economic activity annually” in the state.
Investor groups often rank California as the worst state for landlords. California’s Tenant Protection Act of 2019 implemented statewide rent control and eviction laws, while some cities have their own rules and regulations.
Finally, if you leave your California investment property to your heirs, those properties will be reassessed for property taxes. The combination of rising costs of doing business, the inability to meaningfully raise rent, and a sudden jump in property tax assessments may leave your heirs scrambling to sell those properties after you pass. In view of these factors, many are shifting real estate investments out of California to more favorable markets.
II. THE 1031 EXCHANGE AND CALIFORNIA
How do real estate investors pull their investments out of California without getting hit by a huge capital gains tax? The 1031 Exchange makes this possible.
Section 1031 of the Internal Revenue Code provides a mechanism for selling investment properties to purchase other investment properties without incurring capital gains tax. This often results in significant savings. Federal capital gains tax rates are up to 20%, depending upon the filing status and income of the taxpayer. California taxes capital gains as regular income, again depending on filing status and income. The tax can be up to 13.3%.
California also allows the deferral of capital gains tax under what it calls Like-Kind Exchanges. California’s requirements for a Like-Kind Exchange generally match the requirements of a Federal 1031 Exchange. For more on the 1031 Exchange, see my post and video titled 1031 Exchange Explained. Like the federal 1031 Exchange, California’s Like-Kind Exchange requires: Real property used for business or investment must be replaced with “like kind” property – that is, with other real property used for business or investment. The Replacement Property must be of equal or greater value to the Relinquished Property. The same taxpayer must sell the Relinquished Property and purchase the Replacement Property. And California requires the same deadlines as the federal 1031 Exchange.
California is stricter than the IRS with “drop and swap” exchanges. The “drop and swap” is a strategy to deed title to real property out of a partnership in preparation for a 1031 Exchange where some partners wish to cash out rather than to reinvest their share of proceeds. Before the exchange, the partnership deeds the property to the partners, who then own it as tenants in common. Then the tenants in common who wish to exchange their interests do so under their own taxpayer identification numbers. California’s Franchise Tax Board reviews these transactions more strictly than the IRS and has warned that it will closely scrutinize such tenancy in common arrangements. The Exchangors must carefully manage these transactions to be sure that there’s no suggestion that the real owner of the property at the time of the sale is the partnership.
III. ANNUAL REPORTING AND CALIFORNIA CLAWBACK
After completion of the Like-Kind Exchange to replace a California property with an out-of-state property, the taxpayer must file an information return concerning the out-of-state property with California every year. That’s right – you can check out any time you like, but you can never leave California’s taxes behind.
More specifically, the taxpayer must file the Franchise Tax Board Form FTB 3840 annually, starting with the taxable year of the exchange until the gain or loss is recognized, the gain or loss is reported to California, and the California capital gains tax is paid. If the gain or loss is never recognized, then the taxpayer must file the return annually until the taxpayer dies or donates the Replacement Property to a non-profit. If the taxpayer fails to file the annual report, the Franchise Tax Board may issue a Notice of Proposed Assessment informing the taxpayer that the FTB will assess additional tax and/or penalties.
The California Clawback Rule requires any capital gains accrued from California real estate to be subject to California tax upon the ultimate sale of the real estate. Note that a few other states have similar clawback rules, including Oregon, Montana, and Massachusetts. The clawback will especially hurt if the new property is in a state that also assesses a capital gains tax; the California-sourced gain will be subject to double taxation on the state level. When the out-of-state property is sold, the taxpayer must report to California and pay California tax on the lesser of the deferred California gain or the recognized gain from sale of the out-of-state Replacement Property. Let’s consider an example.
Pat sells a California Relinquished Property (RQ) in 2017 for $450,000 as part of a 1031 exchange. Because Pat’s basis in the property was $100,000, Pat’s gain was $350,000 ($450,000 – $100,000).
Following the rules of the 1031 Exchange, Pat buys a Replacement Property in Texas for $500,000. Pat’s adjusted basis in the Texas property is $150,000 ($100,000 carryover basis + $50,000 additional cash paid). Pat defers her $350,000 California source gain and therefore does not have to pay taxes on it.
Pat annually files FTB 3840 with the Franchise Tax Board.
In 2019, Pat sells the Replacement Property for $450,000. Pat must report and pay tax on the $300,000 California sourced gain on her 2019 California income tax return because the actual gain on the sale of the Texas property ($450,000 – $150,000 = $300,000) is less than the deferred $350,000 amount. Luckily for Pat, she does not also have to pay a capital gains tax to Texas because Texas does not have one.