California clawback law for 1031 exchanges can be sharp

California can be pretty aggressive when it comes to collecting taxes. Let’s look at a hypothetical example of a sale of non-California real estate in a taxable transaction to illustrate how one of the provisions of the California clawback law applies in a particular scenario.

Californians who dispose of California real estate and then acquire non-California real estate as part of an IRC Section 1031 exchange must file form FTB 3840 to comply with the clawback law. To assist California taxpayers with this requirement, the Franchise Tax Board has provided a set of instructions that offers detailed guidance on how this form is to be filled out. Within these instructions, the FTB says the source of gain is determined at the time the gain is realized rather than the time when it may be recognized. The instructions state: “The source of a gain or loss from the sale or exchange of property located in California is determined at the time the loss or gain is realized. The source of such gain or loss is preserved without regard to when such gain or loss may be recognized.”

This instruction is consistent with the state of California’s reputation as being relatively aggressive in its tax collection efforts. Based on this instruction, a conclusion can be drawn that California would be entitled to the entire gain realized at the time of the sale of the California relinquished property regardless of whether this entire gain were recognized when the taxpayer cashes out of the non-California replacement property in a taxable transaction.

Let’s look at one scenario to clarify how this provision of the clawback rule operates in reality. This particular scenario is not likely to occur often, but it highlights that part of the clawback law relating to the timing of the disposition of the California relinquished property. Tax attorneys, CPAs and 1031 facilitators who have clients in possession of California real estate should be sure to offer counsel which is consistent with the clarification offered here.

Suppose a taxpayer owns a California property that has a current fair market value of $1 million and an adjusted basis of $500,000. This taxpayer sells the property as part of a Section 1031 tax-deferred exchange and acquires a non-California property — in this case, let’s suppose it is located in Wyoming. In order to defer the full $500,000 gain associated with California ownership, the taxpayer acquires a property that has a price of $1 million. Consistent with Section 1031 basis transfer rules, the basis in the Wyoming replacement property would be $500,000 at the time of acquisition. Then let’s further suppose that the taxpayer sells the Wyoming replacement property one year later in a taxable transaction, and that the sales price was $1.2 million.

In this example, it’s simple to see that the taxpayer would incur a liability to the state of California based on the full gain of $500,000 associated with California ownership. In this example, the taxpayer cashed out of the Wyoming replacement property and had a recognized gain of $700,000, so there’s no objection to paying state tax to California based on the realized gain of $500,000 associated with California ownership. But what if the recognized gain is lower than the in-state California realized gain? This is where our clarification will assist tax professionals with California real estate.

Instead of selling the Wyoming replacement in one year, let’s suppose our hypothetical taxpayer waited two years before cashing out in a taxable transaction. Let’s also assume that, when this taxable sale does occur, the value of the Wyoming property decreased to just $700,000. When the taxpayer sells the Wyoming property for $700,000, the taxpayer will incur a federal liability based on a recognized gain of $200,000, but what about the California realized gain of $500,000? Again, this is where tax professionals need to be on point so they can assist their clients in the best possible way. Based on how California enforces its clawback law, the taxpayer in this latter example will actually be liable to the State of California for a sum based on the full realized gain of $500,000, as opposed to the (lower) recognized gain of $200,000. Depending on the circumstances, this can have a serious impact on a given taxpayer’s financial situation.

California wants to collect taxes based on whatever gain is realized at the time of the disposition of California real estate, not based on whatever gain is recognized whenever a taxable transaction occurs. In other words, California will not tax you based on the benefits you actually receive, but based on the benefits you hypothetically could have received had you simply cashed out of the California real estate in a taxable sale. We can see that this clarification really does reinforce California’s aggressive reputation.

The law could just as easily be written to say that a taxpayer will be liable for a sum based on the amount of gain recognized whenever a taxable transaction takes place. And if it were so written, this would be consistent with California’s decision to (at least temporarily) acknowledge the tax advantage conferred by Section 1031 of the IRC. Obviously, the state of California has its own budgetary concerns to worry about, and this clawback law was crafted so as to show deference to those concerns. But given that California is one of just a few states in our union to contemplate such a law, it’s hard not to be a bit critical of this type of aggressive behavior.

In any case, tax attorneys, CPAs and others need to consult with their clients and remind them of this clarification so their clients can plan accordingly. Depending on the situation, a client may need to postpone an outright sale in the expectation that market trends will positively affect the value of his or her property and eventually make the future tax burden more reasonable.