The Tax Prophet April, 2004 Hot Topics, [part 1 of 2].

THE TAX PROPHET: Hot Topics: April, 2004

New California Franchise Tax Board (FTB) Withholding Rules

Part 1 of a 2-part series

Introduction

Faced with unprecedented fiscal woes, the State of California is taking strong measures to ensure that those who receive income from property located within the state pay their taxes. California has instituted a wide-ranging withholding regime on income emanating from California sources and paid to non-California residents - regardless of whether the owner is an entity or individual. These new rules ensnare out-of-state landlords and property owners receiving non-residential rents and royalties on the use of their California property, and the compliance burden falls squarely on the backs of property managers.

New rules also apply to the sale of California real estate by resident individuals. A person living in California and owning a vacation or second home, commercial or investment property, should be prepared to pay 3 1/3% of the transaction value as a withholding tax when they close escrow on a sale. It is estimated that as many as 300,000 transactions will be affected by this new law.

Rents Paid to a Non-California Recipient

The New Income Withholding Rules

The California Franchise Tax Board (FTB) now requires that when making payments to non-California resident owners for rents paid in the course of lessee's business on California property, agents must withhold when distributions exceed $1,500 for a calendar year. This new procedure is required when distributions of California source income are made to nonresident beneficiaries. To avoid this rule, the withholding agent must receive authorization for a waiver or a reduced withholding rate from the Franchise Tax Board.

The withholding rate is 7% of gross rent or royalty payments made to California nonresidents. Although withholding agents are not required to notify nonresident payees about the withholding, agents should warn them anyway to avoid anger and surprise when funds are withheld from expected payments.

Types of income subject to withholding include payments of leases, rents and royalties for property (real or personal) located in California, and include not only payments to non-resident individuals, but also to corporations, limited liability companies, and partnerships that do not maintain a permanent location in the State. Withholding is required when all of the following conditions are met:

Payments on rents or leases must be made in the course of the lessee's business; (Tenants of residential property are not required to withhold on payments made to nonresident owners);
The rented or leased property must be located in California; and
The total payments in a calendar year must exceed $1,500.

Remember: Withholding only applies when the rent-payers are renting or leasing property from a non-California owner in the course of their business. Thus, payments by residential tenants are excluded. An agent who manages a purely residential building will have no withholding requirements with respect to rents received from that building, but an agent who manages properties containing one or more non-residential tenants must withhold on rents paid by those tenants. Therefore, the withholding obligation is determined on a building-by-building, unit-by-unit basis.

New Rules Regarding Withholding on Sales of Real Property

Effective January 1, 2003, individual taxpayers, regardless of residence, who sell California real property, including vacation homes (or any residence not considered their principal residence), business and investment real estate, may be subject to withholding. Buyers are now required to withhold 3 1/3% of the total sales price on any purchase of California real property over $100,000, regardless of the amount of actual profit, unless the property is -

A principal residence as defined in the Internal Revenue Code (IRC);
Involved in a tax-free exchange (although cash received in the exchange will be subject to withholding),
Subject to an IRC Section 1033 involuntary conversion, or
Involved in a foreclosure (but not a sale by the debtor in lieu of foreclosure).

To illustrate the reach of these withholding requirements, consider the sale of a vacation or rental property located in California for a total sales price of $650,000. The buyer must withhold $21,645.00 and pay that amount to the FTB immediately - even if the taxable gain is merely $1.00. To actually owe the $21,645.00 in state taxes, the seller would need a $232,742 profit (assuming a 9.3% tax bracket).

This disparity is akin to over-withholding on salary - a person is entitled to claim it as a refund, but they must wait until the following year to file their tax return. Unfortunately, if someone owes child support or taxes to IRS, California or another state, their refund may be used to offset those liabilities and they could receive nothing. Note: Oversized refunds could trigger federal Alternative Minimum Tax because state income and prperty taxes are not deductible under the AMT.

Because FTB retains the amount withheld until the taxpayer files for a refund in the subsequent year, those selling property at the beginning of the year will lose the time-value of the monies withheld for the entire year. In effect, the taxpayer is forced to make an interest-free loan to FTB for this period.

Also, transactions in which the seller receives little or no proceeds may fall through when the withholding tax is factored into the deal.

Example, assume that a taxpayer sells property for a total sale price of $300,000, with an adjusted basis of $100,000. The taxpayer will have a taxable gain of $200,000 upon sale (assuming no costs of sale). If the debt on the property is $300,000, then the taxpayer will walk away from the deal without payment. Under the new withholding rules, there needs to be an additional $10,000 paid to FTB ($300,000 gross proceeds x 3.33% = $10,000). This is true even if the taxpayer has sufficient losses from other transactions to offset the taxable gain on the transaction.
Note: Taxable gain is measured by the adjusted basis in property, not by the amount of debt owed - thus, sellers may receive no money from a transaction and still owe taxes.

As illustrated above, equity-thin sellers, when they discover that 3 1/3% of the sales price may be withheld, may attempt to back out of sales - possibly triggering lawsuits in the process. Other sellers may manipulate the sales process by re-titling property in the name of a single-member LLC, S Corporation or other entity that would be exempt from withholding.

Caution: Transferring the property to an entity to avoid withholding tax could trigger severe adverse federal and state income taxes, depending on the entity chosen and the property involved. For instance, transferring property to a C corporation could subject the gains to regular federal corporate tax rates, rather than favorable long-term capital gains rates. Also, efforts to deliberately defeat the withholding requirements through a sham transaction could subject the taxpayer to additional penalties, or worse.

Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.