Feature
by Terry Lease
Beginning in 2003, California property sellers may be disappointed with the net proceeds they take away from the closing table. The state legislature, in response to the state’s budget problems, agreed to mandate (Assembly Bill 2065) some budget assistance from real estate sellers by imposing stronger withholding rules on sales of real property closing on or after January 1, 2003. The new withholding law essentially extends withholding rules that were already in effect for nonresidents of California to all individuals selling property. Bottom line: tax that ultimately may not be owed or would at least not be due until April 15th of the following year may now have to be paid at the closing.
New Withholding Requirement
If you sell real property located in California and escrow closes on or after January 1, 2003, you may be required to have 3 1/2 percent of the gross sales price withheld from the proceeds. The buyer, usually through the title company, will remit the amount withheld to the California Franchise Tax Board (FTB). The 3 1/2 percent withholding is not a separate tax on the sale. it will be applied, along with your other withholdings and estimated tax reported on your California Income tax return for the tax year in which the closing occurred.
The changes in the withholding rules only apply to individuals. If you sell real property held in an entity, you might notice some changes in the paperwork, but the exemption and waiver requirements have not changed. Individuals, however, face a new set of rules and should know how they will be affected and what, if anything, they could do to minimize undesirable consequences.
Exemptions:
Individuals selling real property may claim an exemption from the withholding requirement if the sale falls into one of the specified categories, including sales where the:
- sale results in a loss for California income tax purposes;
- property is transferred in a like-kind exchange to which IRC §1031 applies;
- property is transferred in an involuntary conversion to which IRC §1033 applies;
- property is transferred in certain types of foreclosures.
If you qualify for one of the exemptions, the title officer will have you fill out the required form, which must be signed under penalty of perjury. Stiff penalties may apply if the seller knowingly files a false exemption certificate.
But My Gain Is So Small
An entity may still qualify for reduced withholding depending on the size of the gain. But for individuals, the withholding applies even in the case of a small gain, and the amount can no longer be reduced for that reason.
Like-Kind Exchanges
If the real property is transferred in a qualified like-kind exchange, the 31 Installment Sales Even if the property is sold on an installment basis, the general rule requires the calculation of 31l sales price. The withholding may be deferred, however, if the buyer agrees (irrevocably and in writing) to withhold 31
Avoidance Strategies
If you do not qualify for an exemption and the tax on the gain is substantially less than the 3 1/2 percent withheld, you may want to look for ways to reduce other tax payments (your payroll withholding and/or your estimated quarterly payments).
Individuals who do not qualify for an exemption could transfer the asset to an entity that does qualify. You should first weigh the costs of such action against the benefit received from avoiding the withholding. What is the time value of holding onto the additional proceeds? If the entity does not already exist, forming it will create additional costs, and title transfer will create costs and may cause difficulties (and perhaps additional costs) if the property is mortgaged. Shifting the gain to an existing entity may increase its taxes. Having the sale occur through the entity may restrict your use of the proceeds. We can expect this loophole to be closed to prevent a taxpayer from transferring property to a related entity if a primary effect is to avoid the withholding requirements. Taking steps to qualify for an exemption and avoid the withholding requirement may be possible, the cost of taking those steps may outweigh the benefits.
In the end, the new withholding requirement is difficult to avoid. You may be best served by accepting the early and hopefully temporary loss of the use of some proceeds as a new cost of being involved in the California real estate market. Hopefully, in the future, the legislature will look to other industries to cover the estimates of growing budget deficits. Happy New Year!
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. Terry M. Lease, CPA, Ph.D., works for Shwiff, Levy & Polo, CPAs in San Francisco and is also an Associate Professor of Accounting at Sonoma State University. Every transaction is unique, and your circumstances may cause your tax situation to be different; therefore, we recommend that you discuss potential transactions with your CPA or tax advisor before entering into them. Copyright © 2003 San Francisco Apartment Magazine