At first glance, you might think the California Claw-Back is some kind of wild animal native to the State of California. It is wild, and it is native to California, but it's not an animal. It does rear its ugly head and bite investors when they have sold California investment real estate and subsequently acquired non-California investment property through a 1031 Exchange.
The 1031 Exchange is still an important and highly effective tax-deferral strategy for owners of investment property who wish to defer the payment of their capital gain and depreciation recapture taxes, and it still allows investors to indefinitely defer their tax liability if they continue to 1031 Exchange throughout their lifetime.
It is important to note that 1031 Exchanges are part of the Federal Tax Code (Section 1031 of the Internal Revenue Code) and that not all state governments administer or treat the 1031 Exchange strategy in precisely the same manner as the Federal government does.
The majority of states generally conform to the Federal treatment of tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. Capital gain taxes are deferred indefinitely until the final property is sold (i.e. cashed out). Advisors generally interpret this to mean that an investor is only subject to taxes in the state where the final property is sold.
However, the State of California has historically (and continues to) taken a different position. The State of California's position has been that any capital gains accrued on California real estate will be subject to California tax upon the ultimate sale of the real property even if the investor had sold his or her California real estate and subsequently 1031 Exchanged into investment property located outside of California. This has become known as the California Claw-Back Provision.
Say Mr. Newcombe bought a property in CA for $100. After appreciating to $200, he exchanges it for one in ID. While in ID the property further appreciates to $400. Feeling he has had enough of owning property, he sells it for $400, showing a total capital gain of $300. Mr. Newcombe would not only be liable for $300 of capital gains taxes in ID, but $100 of capital gains taxes in CA as well.
Note: The reciprocal of this situation does not come into effect. If Mr. Newcombe owned property in ID and exchanged for property in CA, he would only be subject to CA state taxes, not those of ID.
From the above example it is clear that owning property in California and exchanging it for property in another state leaves one open to double taxation. There is no way to avoid this situation unless one stays out of CA entirely or performs the final sale there. Being taxed in CA would of course be undesirable because it has some of the highest income tax rates, 9.55% and 10.55% for earnings over $47,055 and $1,000,000 respectively.
The California Claw-Back Provision really hurts people when they try to exchange out of California's stringent tax system into a friendlier state tax system such as Nevada, Texas or Florida, which has no state income tax.
The California State Assembly recently enacted legislation that added new sections to the California Revenue and Taxation Code (New R&TC Sections 18032, 24953 added by AB 92). These sections provide that investors involved in a 1031 Exchange transaction who sell California property and purchase NON-California Replacement Property will be required to file an annual information return with the California Franchise Tax Board (FTB), reporting this NON-California property.
The California taxes that were previously deferred will be due when and if taxpayers sell their new properties and elect to take their profits rather than continuing to defer taxes through another 1031 Exchange. If taxpayers fail to file the annual return, the FTB may estimate taxes due and assess tax, interest and penalties.
The new California Like Kind Exchange reporting requirements shall apply to 1031 Exchanges of property that occur in taxable years beginning on or after January 1, 2014. You can review a complete copy of AB 92 here:
The California Franchise Tax Board ("FTB") added the following to its FTB Publication 593 under the heading "What's New:"
Like-Kind Exchanges — For taxable years beginning on or after January 1, 2014, California Revenue & Taxation Code (R&TC) Sections 18032 and 24953 require California resident and non-resident taxpayers who defer gain on the sale or exchange of California property for out of state replacement property under Internal Revenue Code Section (IRC) 1031 to file an annual information return with the Franchise Tax Board (FTB). Taxpayers are required to file an information return for the taxable year of the exchange and in each subsequent taxable year in which the gain or loss attributable to the exchange has not been recognized. If a taxpayer fails to file the required information return, the FTB can estimate the net income, from any available information, including the amount of gain deferred, and propose to assess the amount of tax, interest, and penalties due.
California Franchise Tax Board Issues Guidance on Reporting Requirements
The California Franchise Tax Board issued new requirements for reporting California Like Kind Exchange transactions, including its new California FTB Form 3840 — California Like Kind Exchanges. The new California Form FTB 3840 will be required for taxpayers who complete a 1031 Tax Deferred Exchange after January 1, 2014 when they sell relinquished property in California and purchase replacement property outside of California.
This new California Like Kind Exchange reporting requirement will merely be an inconvenience for most investors that sell California real estate and 1031 Exchange into non-California real estate, but it will not be the end of the world for the California investor. Investors will merely have to continually file an information return with the State of California each year. Investors will never have to pay the California taxes due under the California Claw-Back Provisions as long as they continue to 1031 Exchange from property to property throughout their lifetime.