California Legislative Analyst's Office Revenue-Raising Proposal
Eliminate Exclusion for “Like-Kind” Out-of-State Property Exchanges
Background
California permits investors to exchange business or investment property for property of a like kind without paying any capital gains that might have accrued on the first property. A similar federal program also exists. Commonly referred to as Section 1031 exchanges, these nontaxed transactions can be repeated over time, with the tax on the accumulated capital gains from all transactions not assessed until the final property is eventually sold. These tax-free exchanges are allowed even when in-state property is exchanged for out-of-state property. Subsequent sales of out-of-state property, which ought to trigger deferred capital gains taxes, are rarely, if ever, reported to California. Such factors as the absence of a California estate tax, the stepped-up basis rule for real estate, and the ability to move assets into family trusts without property tax reassessments, also interact with these exchanges to enable many capital gains to go untaxed.
LAO's Proposal
Eliminate the income tax exclusion for capital gains on like-kind exchanges involving out-of-state commercial property. Revenue gain of approximately $25 million in 2008-09 and $50 million in 2009-10.
LAO's Rationale
Capital gains on real property transactions constitute the income earned from such activities and as such should be taxed, just like other types of income. It can be argued that these taxes should be deferred until the investment is ultimately liquidated. We see no justification, however, for allowing these gains to escape taxation completely. Given the administrative difficulty in taxing these gains once the exchange involves an out-of-state property, we recommend that existing law be amended to capture these gains.
