Is California’s clawback provision a sign of future tax policy in other states?

When contemplating a 1031 exchange, one of the most commonly overlooked issues by investors is state taxation.

Section 1031 of the Internal Revenue Code provides non-recognition of gains when real property held for investment or business purposes is exchanged for like-kind real property. However, this non-recognition treatment applies to federal taxation; individual states are still free to impose whatever taxes they see fit on these types of transactions. Currently, all but a few states acknowledge the non-recognition provision of Section 1031 and allow taxpayers to defer the tax liability that would be incurred as a result of the sale of business or investment real estate. In most cases, states require taxpayers to file a form to avoid the obligatory withholding requirement imposed on in-state real estate sales. Certain states, such as Pennsylvania, do not acknowledge the provisions of Section 1031 of the IRC and collect state income taxation whenever someone sells a piece of Pennsylvanian real estate.

Unlike Pennsylvania, taxpayers who conduct a Section 1031 exchange in California may still defer the tax liability that would normally be owed to the Franchise Tax Board, but they must comply with a law that has been known to be a source of irritation among those in the 1031 industry: California’s clawback provision.

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Because of its domestic fiscal situation, the state of California requires taxpayers to file an additional form whenever they sell California real estate and then acquire out-of-state real estate as part of a 1031 exchange. This form keeps track of the gains specifically associated with the taxpayer’s ownership of the California real estate. Taxpayers must continue to file this form on a yearly basis with the Franchise Tax Board of California for as long as the taxpayer owns the replacement property acquired in the exchange. If at any point the taxpayer “cashes out” of the replacement property in an outright sale, at that moment the taxpayer would become liable to California for the full amount owed if no 1031 exchange had taken place.

Clearly, this clawback tax law is consistent with the aggressive reputation of California’s Franchise Tax Board. It’s also a reflection, at least in part, of the condition of California’s state pocketbook. Barring some highly unusual series of events, it’s very unlikely that many states around the country will adopt similar laws to aggressively police 1031 exchanges. But might at least a few other states follow California’s aggressive stance?

Necessity May Drive Imitators

An English proverb says, “Necessity is the mother of invention.” Necessity may be precisely what propels more states to adopt clawback provisions similar to the one developed by the state of California. Beyond the rhetoric, necessity is primarily driving the behavior of California’s Franchise Tax Board: California’s clawback rule was passed in 2014, and during that time the state was struggling to find ways to combat its sizable budget deficit. As of 2018, California has managed to make positive strides toward achieving a financially healthier budget; the most recent budget passed in California saw an expected surplus of approximately $9 billion, a substantial improvement from where the state was just a few years prior. Determining the exact degree to which this financial turnaround is the result of the state’s clawback provision can’t be answered with the research for the present article, but enough real estate is sold in California as part of 1031 exchange transactions to say that the degree must be considerable.

Again, it’s not likely that too many states will follow suit and push laws as aggressive as California’s. But if you consider the financial condition of many states across the nation, it’s not unreasonable to assume that at least a few will implement similar rules. This means that professionals from all over the nation need to be aware of this phenomenon – Minnesota qualified intermediaries, Milwaukee tax consultants, New York City tax lawyers and so forth. To date, aside from California, the states of Massachusetts, Oregon and Montana have all openly debated the merits of instituting a law such as California’s clawback rule, and not surprisingly each of those states has had its fair share of fiscal troubles. In 2017, for instance, the state of Montana faced a budget deficit for the year that surpassed $100 million. The state of Oregon arguably faces an even worse situation: as of May 2017, that state was grappling with a budget deficit of roughly $1.6 billion.

Massachusetts also appears to be having fiscal difficulties of its own. If states such as these are unable to develop workable solutions to their financial problems, the likelihood that we’ll see more aggressive rulemaking improves.

Clawback Laws Have Significant Impact on 1031 Industry

California’s clawback law is only triggered when a taxpayer conducts an outright sale and “cashes out” of their real estate. If a taxpayer files the correct form — which is form FTB 3840 with the state — then the in-state California gains will be deferred indefinitely. However, whether other states take a cue from California is something most tax professionals should be concerned about, particularly those professionals working directly within the 1031 industry. Clawback laws discourage transactions for those people who are affected by them; even though the requirement of form 3840 isn’t too oppressive for taxpayers, there’s no question that this provision causes at least some taxpayers to avoid conducting their exchange, and we should expect other clawback laws to have the same kind of impact. Professionals who benefit from 1031 exchange transactional activity — not just intermediaries, but escrow agents, title companies, independent consultants and so on — have a clear interest in preventing such aggressive tax recovery tactics. It may be a simple case of clashing interests: states have an interest in recovering as much tax revenue as possible, while private citizens have an interest in seeing as much economic productivity as they can generate.

We don’t know for sure if other states will imitate the policymaking behavior of California. If states such as Massachusetts, Montana and Oregon continue to be bogged down by significant budgetary troubles, it seems reasonable to expect we will see at least several other clawback rules surface around the country. Clawback laws on in-state real estate sales represent some of the more aggressive behavior displayed by state tax collection organizations, and generally this sort of aggressiveness only occurs in the right contexts. Depending on how different states manage to handle their internal finances, we may see the right context more and more frequently.