California puts teeth in their 1031 Exchange Claw-Back rule

Several years ago, the State of California adopted a claw-back rule for 1031 exchanges when the sale property is in the State of California and the replacement property is in a different state.

Like most states, California does not tax sales of real estate when the taxpayer does a 1031 exchange and rolls the gain over to a replacement property. Typically, when you sell a property in one state and buy in another state (doing a 1031 exchange), the selling state loses the tax revenue that would have resulted from the sale if it were not a 1031 exchange.

Several years ago California broke with that tradition and revised their 1031 law to hold that when the taxpayer ultimately sells the property in the replacement state in a taxable transaction, the taxpayer must report the original gain to California and pay tax on it. For example, Sue sells a rental property in California and rolls a gain of $100,000 into a property in Denver, Colorado by doing a 1031 exchange.

. . . Their response was they weren’t going worry about it. Well, now they need to worry about it. . .

The law required that when Sue ultimately sold the Denver property and did not do another exchange, she owed tax on the $100,000 to California at that time (hence the term “claw-back”). Keep in mind, however, that if Sue’s gain on the Denver property was $150,000, she’d owe tax to Colorado on that amount and tax to the State of California on the original $100,000 gain. In other words, she’d be paying state tax on $250,000 of gain in the year of the Denver sale, even though the gain was only $150,000.

The response by most of my clients when I informed them of this rule regarding their California sale was that there was probably no way that California would know of their Denver sale and they weren’t going worry about it. Well, now they need to worry about it.

California recently modified their claw-back rule to require that if you exchange out of state on or after January 1, 2014, you must file an annual information return with California reporting the status of your non-California replacement property. If you don’t file the annual return, the state will estimate the amount of tax you owe on your California gain, and send you a bill. Naturally they’ll assume that you’re in the highest tax bracket.

So what’s my advice to our clients who are subject to this law? If it were me, I’d consider not doing a California exchange. When you sell a property and do a 1031 exchange, you’re actually doing two exchanges: one for federal income tax purposes and one for state tax purposes with the state of the sale. If you’re selling a California property, consider doing an exchange with federal tax purposes, but not doing an exchange with California and instead pay tax on the gain to them.

To explain how this would work, let’s go back to Sue’s sale. Assuming that her sale takes place during 2014, she could do a 1031 exchange and report it as such on her IRS Form 1040. However, she could report the gain as taxable with the State of California and pay the tax with her 2014 California tax return. On the Denver side, her tax basis for Federal income tax purposes is $100,000 less than she paid for the property (reflecting the gain that she rolled over via her 1031 exchange). Her tax basis for Colorado purposes, however, is what she paid for the property – reflecting the fact that she did not roll any gain over for state tax purposes. When she ultimately sells the Colorado property, her Colorado gain will be $100,000 less than her federal tax gain.

Granted, doing this creates a certain hassle every year at tax time: because your basis is different for federal and state purposes, your depreciation deduction will be different for federal and state purposes. Yes, you have to keep track of this, but in this age of easy access to good tax preparation software, like Turbo Tax, the differences are easy to handle – especially considering that you won’t have to file the annual report with California or worrying about forgetting to file it.