Beware of the California Claw Back!
Monday, November 21, 2011 at 05:06PM | Wealth Legacy Series 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 1031 Exchanged into and/or out of California real estate.
Section 1031 if a Federal Tax Code
The 1031 Exchange is a great tax-deferral strategy (see "1031 Exchange Quick Facts") for owners of investment property who wish to defer the payment of their capital gains and depreciation recapture taxes. It allows investors to indefinitely defer their tax liability if they continue to 1031 Exchange throughout their lifetime. However, it is important to note that Section 1031 is a Federal Tax Code, and not all states administer or recognize the 1031 Exchange strategy precisely the same as the Federal government does.
Most States Conform to Federal Tax Code
The majority of states with in the U.S. conform to the Federal income tax treatment of Section 1031 of the Internal Revenue Code ("1031 Exchanges") in that all capital gains and depreciation recapture taxes are deferred until ultimate sale or disposition of the property.
Common sense would lead you to believe this would mean investors are only subject to capital gain and depreciation recapture taxes in the state where the investment property is actually sold (i.e. the investor stops structuring 1031 Exchanges). For example, if the investor 1031 Exchanges out of California property and into Florida property, where Florida has no state income taxes, one would assume that when the Florida property was sold there would be no state income taxes dues.
The California Claw-Back
However, the State of California is a notable exception to this, and takes the position that any increase in fair market value of investment property in California is subject to California income taxes. They take this position regardless of whether or not that property was exchanged for another property located in another state before its ultimate sale. This means that California investment property owners cannot escape State of California income taxes, even if they 1031 Exchange out of California real estate and into replacement property located in another state.
The State of California employs what is referred to as a "claw-back" provision, entitling California to tax any gain on property that occurs in California, regardless of where the property is eventually sold. So, the sale of the Florida property mentioned above would be taxable in California to the extent that any of the gain was realized in the State of California.
Case Study
Say Mr. Jones bought a California investment real estate for $200,000. After appreciating to $300,000, Mr. Jones 1031 Exchanges the investment real estate for one in the State of Arizona. While in Arizona, the investment property continues to appreciate in value to $500,000. Feeling that he has had enough of investment real estate headaches, he sells the real estate for $500,000, equating to a total capital gain of $300,000. Mr. Jones would not only be liable for capital gain taxes on the $300,000 in capital gains in the State of Arizona, but would also owe capital gain taxes on $100,000 of capital gains taxes that appreciated in California.
So, beware of the California Claw-Back.
