The Tax Prophet - Hot Topics May, 2004

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Part 2 of a 2-part series

		New California Franchise Tax Board (FTB) Withholding Rules

Principal Residence Defined		The IRC 121 definition of a principal residence requires that a taxpayer own and live in their home as their principal residence for at least 24 of the preceding 60 months prior to sale. The rules apply to the sale of a residence no more than once every two years. A home may still qualify as a principal residence if the taxpayer owned and lived in it for less than 24 months, but had to sell the residence for health or job-related reasons or other unforeseeable circumstances, including: death; becoming eligible for unemployment compensation; a change in employment that leaves the taxpayer unable to pay the mortgage or reasonable basic living expenses; multiple births resulting from the same pregnancy; damage to the residence resulting from a natural or man-made disaster, or an act of war or terrorism; and condemnation, seizure, or other involuntary conversion of the property. Thus, a vacation home, second residence, and a principal residence, owned but not meeting the IRC Section 121 rules described above, are all subject to withholding.
Who is Targeted?		The withholding on sale rules apply to all non-resident sellers and resident individual sellers of California real property. This means that non-individual sellers (including corporations, estates, partnerships, LLCs, and irrevocable trusts) are exempt from this withholding, provided they have a permanent place of business in California. Non-individual owners may request a waiver or reduced withholding by completing Real Estate Withholding Exemption Certificate & Waiver Request for Non-Individual Sellers, FTB Form 593-W. Payment and the completed FTB Form 597, Withholding Remittance/Tax Statement for Real Estate Sales, are both due on the 20th day of the month following the month that title is transferred. For example if title transfers anytime during the month of May 2003, payment is due no later than June 20, 2003.
Who is Responsible for Withholding?		The Buyer must comply with the withholding requirements; real estate agents are not responsible. Usually, the buyer will appoint the escrow officer as the responsible party for the withholding. The penalty for failure to withhold is the greater of $500 or 10% of the required withholding amount. This means that buyers purchasing property directly from a seller without using an escrow company must comply with these withholding rules or face penalties.
The Loss Exception		There is one major exception to the withholding requirement - where the seller signs under penalty of perjury that there is a loss on the sale. Even $1 of gain triggers the 3 1/3% withholding. For example, on a total sales price of $400,000, the escrow company must withhold $13,332 and send it to FTB by the 20th day of the month following the month of the close of escrow. For example: If closing occurs on March 5th, payment must be sent by April 20th. Clearly, if the gain on property is minimal and the withholding is substantial, the parties might want to consider lowering the sales price to produce a loss and thereby avoid the withholding obligation. Unlike the transfer to a sham entity, lowering the sales price to avoid a gain is permissible under the new rules. Of course, if the loss is merely on paper and the buyer provides additional consideration outside of escrow, the seller runs the criminal risk of committing perjury and the buyer may be penalized for failing to withhold.
Installment Sales		Property sold on an installment basis is subject to the full 3 1/3% withholding, although withholding may be partially deferred, provided the buyer agrees to withhold 3 1/3% of the down payment and 3 1/3% of each subsequent payment. A Real Estate Withholding Installment Sales Agreement, FTB Form 593-1, must be entered into by the buyer.
Owner's Claim for Refund		Owners with California source property are required to file tax returns reporting income and expenses related to their property. If the amounts withheld on sale exceed the actual tax liability, the taxpayer will be due a refund. Of course, if the amount due exceeds the withholding, the taxpayer will owe the difference. Taxpayers receive a Form 593-B, Real Estate Withholding Tax Statement and then attach the form to the front of a California personal income tax return which is then filed with the state at the beginning of the following year.
Conclusion		FTB should provide individuals with the option to claim reduced withholding on sales of real property. There is no justifiable reason why an entity can reduce the withholding amount, but an individual cannot. Also, all taxpayers should be entitled to claim a refund after the property is sold and not have to wait until the beginning of the subsequent year. The refund request should be based on the tax liability of the property sold and not the taxpayer's overall potential tax liability. After all, if the purpose of the withholding requirement is to ensure that California receives the taxes owed from the sale of property, the withholding rules should be narrowly tailored to meet that objective. Currently, the rules are overly burdensome and unfair, especially when a property is sold with little or no taxable gain.

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