debits & credits

California Real-Estate Withholding Requirements

by Douglas Schultz & Kristie Carvalho

One of the California tax-law changes enacted a few years ago was the requirement for withholding on real-estate sales. Before 2003, California law only required withholding on real-estate sales when the seller was an out-of-state resident. The new law expanded the real-estate withholding requirements to California residents. This year, the California tax law related to real-estate withholding was amended once again by Assembly Bill 2962. This bill adds a handful of changes to the withholding requirements that most of us already know. Individuals and businesses that take part in California real-estate transactions in 2007 should be aware of the general withholding requirements, the changes to the law and the withholding requirement exemptions.

Example This article will discuss the general California real-estate withholding rules that individuals, real-estate investors, and small businesses should be aware of for 2007. Both buyers and sellers of real estate need to be informed of the real-estate withholding rules when entering into a property transaction in California.

Real-Estate Tax
Withholding Requirements
California requires the prepayment of tax on real-estate sales in an effort to balance the budget and accelerate state tax revenue. Real-estate-tax withholding is a prepayment of a seller’s state income tax, related to the real-estate sale. The withholding is not an additional tax on the sale of real estate; it is simply the prepayment of the income taxes owed by the seller on the property sale.

It is the responsibility of the buyer (also called the transferee) of the property being sold to withhold the tax from the total sales price. California law requires that the “real-estate escrow person,” most commonly the escrow officer, notify buyers in writing of their withholding requirement. If the transfer is being done without an escrow, then the person responsible for ultimately closing the transaction (such as the real-estate attorney or title company) is required to notify the buyer of the withholding requirements.

Ordinarily, buyers and sellers of real estate engage the services of an escrow officer, attorney or title company to assist them with their real-estate transactions. For this reason, most people will delegate the withholding responsibility to a third party, which is most commonly the escrow officer.

The rate of withholding mandated by the Franchise Tax Board is 3 1/3% of the total sales price or the alternative withholding amount. The alternative withholding amount is one of the changes provided by AB 2962 that became effective for sales occurring on or after January 1, 2007. In order to claim the alternative withholding amount, sellers will need to complete Form 593-E and return the form to the withholding agent before the close of escrow. The alternative withholding amount is calculated as a percentage of the net gain on the sale of the property multiplied by one of the following maximum tax rates:

Individuals 9.3%
C Corporations 8.84%
S Corporations 1.5%
Financial S Corps 3.5%
Banks and Financial Corps. 10.84%

Withholding is required on sales or transfers of California real estate when the sales price exceeds $100,000 and 1) the seller is an individual or any other entity type except for a partnership or an LLC (be aware that single-member LLCs do not qualify under the partnership/LLC exemption) or 2) the seller is a corporation, if the corporation immediately after the sale does not have a permanent place of business in California, or is not organized and existing under the laws of California, does not qualify with the California Secretary of State to transact business in the state, or does not maintain and staff a permanent office in California.

Exemptions from Withholding
There are some instances in which a real-estate sale will qualify for an automatic exclusion from the withholding requirements: the total sales price of the real estate is below $100,000; the seller is a bank acting as a fiduciary for a trust; or the property is being foreclosed upon.

If the sale does not qualify for one of the automatic exclusions referenced above, the sale may be exempt from withholding by meeting one of the requirements on Form 593-C: Real Estate Withholding Certificate. In order to claim an exemption for withholding, the seller must complete Form 593-C and return it to the withholding agent before the close of escrow.

There are several common certifications per Form 593-C that will exempt a sale from real-estate withholding:

1. The property being sold is the seller’s principal residence within the meaning of Internal Revenue Code (IRC) Section 121 (or decedent’s residence if being sold by the decedent’s estate).

2. The last use of the property was as the seller’s principal residence within the meaning of IRC Section 121 without regard to the two-year time period. For example, if you have owned a home for less than two years and are living in it at the time of sale, you will qualify for the withholding exemption even though you have not lived there for two years as required by IRC Section 121. If you have owned the home for less than two years and are renting it or using it as a vacation home at the time of sale, then it is not your principal residence at the time of sale and you do not qualify for the exemption.

3. The sale of real estate will result in a zero gain or a loss for California income tax purposes. Substantiation for the zero gain or loss must be provided by the seller by completing Form 593-E and providing the form to the withholding agent.

4. The property is being involuntarily converted under IRC §1033. An involuntary conversion is when the property is destroyed, condemned or disposed of under the threat of condemnation. An example of an involuntary conversion is when the government notifies the seller that their property will be acquired for public use.

5. The transfer qualifies for nonrecognition treatment under IRC Section 351 (transfer to a controlled corporation by the seller) or under IRC Section 721 (contribution to a partnership in exchange for a partnership interest).

6. The seller is a corporation or LLC classified as a corporation that is either qualified through the California Secretary of State or has a permanent place of business in California immediately after the sale.

7. The seller is a partnership or LLC classified as a partnership with recorded title to the property in the name of the partnership or LLC. Single-member LLCs do not qualify for this exemption.

8. The seller is a tax-exempt entity under either California or federal law.

9. The seller is an IRA, insurance company, qualified pension, profit-sharing plan or charitable remainder trust.

The sale may qualify for a partial or full exemption if the transfer qualifies as a simultaneous or deferred like-kind exchange under IRC §1031, or the transfer of property will be an installment sale and the buyer has agreed to withhold on each principal payment rather than withholding the full amount at the time of transfer.

If you are transferring your property as part of an IRC §1031 exchange, watch out for the receipt of boot. If more than $1,500 of boot is received then standard withholding on the total proceeds or the alternative withholding amount will be required.

Summary of
Reporting Requirements
The party responsible for withholding will provide the sellers of the property with a number of California tax forms to complete. The completed forms will inform the withholding agent if withholding on the transaction is required. If withholding on the sale is required, then the type of withholding elected by the seller will be indicated on the forms completed by the seller.

The forms that are required to be provided to the sellers are Form 593-C: Real Estate Withholding Certificate; Form 593-E: Real Estate Withholding Computation of Estimated Gain or Loss; and Form 593-B: Real Estate Withholding Tax Statement. In addition, the withholding agent must complete Form 593: Real Estate Withholding Remittance Statement. This form summarizes the total amount of withholding and the number of Form 593-Bs that will be transmitted to the Franchise Tax Board.

When the withholding agent receives the completed forms mentioned above back from the seller, the withholding agent must mail Form 593 and Copy A of Form 593-B to the Franchise Tax Board. The withholding agent must mail these forms within 20 days following the end of the month in which the transaction occurred. If the seller is electing the alternative withholding option, then the withholding agent must ensure that the sellers have signed Part 2 of Form 593-B before the form is mailed to the Franchise Tax Board.

The withholding agent must provide the sellers with Copy B & C of Form 593-B. The seller must attach copy B of Form 593-B to the front of their California return in order to claim the withholding. The sellers will also claim the withholding as a tax payment on line 38 of their California tax return.
The Franchise Tax Board charges interest on late withholding and payments. The interest is calculated from the date the original withholding payment was due until the date the payment is actually received by the FTB.

If the real-estate escrow person fails to inform the buyers of their withholding requirement then the penalty is the greater of $500 or 10% of the required withholding amount.

Record Keeping
Sellers should make sure that they keep very good records of all costs associated with the property being sold. Having good records available will assist sellers in accurately completing Form 593-E: Real Estate Withholding Computation of Estimated Gain or Loss, and taking advantage of the alternative withholding rates enacted by AB 2962. As a result of AB 2962, Form 593-E is now available online in an electronic format so that sellers can easily calculate the gain on their real- estate transaction and determine if the alternative withholding amount is beneficial.

The withholding rules for real estate are quite detailed, especially when transactions involve like-kind exchanges, installment sales and sales involving multiple parties. The above information is a general discussion of the real estate withholding rules required by the state of California. If you or your business is involved in a complex real-estate transaction, we suggest that you consult your tax advisor to ensure that you have chosen the best withholding option and/or have not missed an opportunity to defer or exempt the transaction from withholding.

More information on withholding requirements for real-estate transactions is available at www.ftb.ca.gov or by calling the withholding services and compliance section of the Franchise Tax Board at 888-792-4900 or 916-845-4900. You may also contact the authors at the number listed below for more information.

The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or SF Apartment Magazine. Douglas Schultz is a CPA and partner in the tax practice in the San Francisco office of Burr, Pilger & Mayer, LLP. Kristie Carvalho is a CPA and tax manager in the Walnut Creek office of Burr, Pilger, & Mayer, LLP. Both can be contacted at 415-421-5757. Copyright © 2007 by SF Apartment Magazine. All rights reserved.