California Puts Claw in Claw Back Law

Sale of Real Estate Triggers Tax

When a taxpayer and/or investor sells real property the sale generally triggers a capital gain tax (or loss), and if it is rental, investment or business use real estate, it may also trigger depreciation recapture tax.  These taxes are due in the year in which you sell or dispose of the real estate.  However, there are methods for deferring the payment of these taxes, including a tax-deferred exchange transaction for investment real estate pursuant to Section 1031 of the Internal Revenue Code ("1031 Exchange"). 

Defer Tax With A 1031 Exchange

Real estate investors normally do not realize and pay these capital gain and depreciation recapture taxes because they structure their sale of the real estate through a 1031 Exchange.  In fact, most investors rarely pay these taxes because they will continue to 1031 Exchange throughout their lifetime and their heirs will receive a step-up in cost basis (i.e. the capital gain and depreciation recapture taxes completely go away) at the investor's death.   

Selling Property In One State; Buying In Another

However, what happens when the investor sells their relinquished property in one state - say the State of California - and then reinvests through a 1031 Exchange in replacement property located in a different state?  The majority of states just look the other way, and those that have tried to address it via legislative action do not really enforce it.  The State of California is a different matter and investors need to be aware of recent changes to California tax law. 

California Claw Back Requirement

California has always taken the position if you sell rental, investment or business use real estate in California and defer the payment of your capital gain tax and depreciation recapture tax through a 1031 Exchange by acquiring replacement property in another state other than California that they want their fair share of the capital gain and depreciation recapture taxes if and when the investor ultimately sells the real estate, "cashes out" and pays their tax in the future.  This tax policy is often referred to as the California Claw Back because the State of California insists on "clawing the tax revenue back" from the other state when the investor ultimately sells and incurs the tax liability.  However, the State of California had no effective way to track, monitor or police taxpayers when they 1031 Exchange out of California investment property and into real estate located in another state, until now. 

California Puts The Claw In The Claw Back Law

The State of California passed new legislation in 2013 that effectively puts the "claw" into the California Claw Back.  The new law is effective for any sale of rental, investment or business use property that closes on or after January 1, 2014.  It requires that the investor file an information return with the State of California.  The information return must also be filed each year thereafter keeping California in the loop so that they know if and when the investor ultimately sells and cashes out and therefore owes California their share of the taxes.