As a result of Assembly Bill 1338, introduced by state assemblyman Ed Chavez, D-Industry, and signed into law by Gov. Schwarzenegger in September, there have been a few changes to California law requiring tax withholding on the sale of real estate. Like most changes to tax laws, not everyone is affected but there may be a significant impact on those that are.

     Anecdotal evidence tells me that many persons —— including those affected —— are not familiar with California’s withholding requirements. Thus, it seems worthwhile to review some of the basics as well as to address the recent changes in the law.

     Basically, buyers of California real estate are required to withhold, for the Franchise Tax Board, 3.33 percent of the gross sales price of a real estate transaction unless an exemption applies.

     The basic exemptions are easy to understand and they apply to most real estate sales:

• The sale of the property is for less than $100,000. 
• The property being sold is the principal residence of the sellers. 
• The sale is of the principal residence of a decedent, and the sale is conducted by the estate or trust.
• The sale is by a corporation with a permanent place of business within California.
• The sale is structured as an IRC §§1031 tax-deferred exchange.
• The sale is a loss for California income-tax purposes.

     Basically, then, the withholding requirement applies to sales of non-residences that are not tax-deferred exchanges.

     Although it is generally not much of an issue these days, it is relevant to point out that withholding is required, even if a transaction is "cash poor." Suppose, for example, that you purchased an investment property for $200,000 some years ago, and also suppose that you "took your money out" by refinancing it last year for $400,000. What if you sold it today for $430,000? Well, you might have selling and transaction costs in the neighborhood of $30,000. If that were so, and your loan amount were $400,000, would you still owe withholding? Yes, you would owe the 3.33 percent —— approximately $14,332 —— to the taxing authority.

     Where might the money come from? That’s your problem.

     It is also worth noting that there is no exemption to the withholding requirement for relocation sales. If a relocation company takes title to a property, then, if it does not have a permanent place of business in California, the relocation company owes the withholding amount at the time of sale.

     Although it is required that the buyer must withhold this amount, for all practical purposes it is the seller who does the withholding. That is, the mechanism for complying with this law is to instruct escrow to withhold the amount from proceeds due to the seller. That money is then sent, by escrow, to the Franchise Tax Board.

     The most important aspect of recent changes to California withholding requirements is that the exemption requiring the sale of personal residences has been broadened. Until now, a personal residence exemption could only be claimed if the property met requirements established by Internal Revenue Service codes. That is, to qualify as a personal residence, the property had to be used as such for at least two of the past five years. Now, an exemption will be granted if the property has been used as a personal residence up until the time of sale —— even if that use has not been for as long as two years.

     So, for example, if you bought a property in July 2004, lived in it as a personal residence, and were to sell it in February 2005, under the old rules you would have to ship off 3.33 percent of the purchase price to the Franchise Tax Board. Under the new rules, you are not subject to the withholding requirement. (You may still, ultimately, owe a capital-gains tax.)

Call or e-mail me if you have any questions!  -"Chili"