California Revises Real Estate Withholding Statement (CA FTB Form 593)

The California Franchise Tax Board (“FTB”) announced changes to real estate withholding forms on November 5, 2019.  The California FTB consolidated California FTB Forms 593, 593-C, 593-E, and 593-I into one California FTB Form 593 to eliminate confusion among taxpayers and their tax advisors.  However, they have actually created more confusion and more paperwork for all parties involved. 

FTB Form Now Required for Every Sale of Real Estate

Beginning January 1, 2020, the new California FTB Form 593, Real Estate Withholding Statement, must be completed and signed during the each and every closing or escrow process.  The California FTB Form 593 should be submitted to the California FTB whenever a sale of real property occurs no later than the 20th day of the month following the month in which the real estate sale closed.  In the past, the California Form 593 was submitted to the California FTB if, and only if, there was actual withholding required.  The new form must now be submitted to the California FTB on every real estate sale transaction regardless of whether there is withholding required or not.

California FTB withholding is required when California real estate is sold or transferred unless the seller qualifies for certain withholding exceptions. The real estate escrow person (“REEP”) is anyone involved in closing the real estate transaction which includes any attorney, escrow company, title company, QI, or anyone else who receives and disburses payment for the sale of California real property.  The REEP is required to notify buyers of California FTB withholding requirements, unless the buyer is a Qualified Intermediary (“QI”) in a tax-deferred exchange pursuant to Section 1031 of the Internal Revenue Code. The amount withheld from the seller or transferor is sent to the California FTB as required by R&TC Section 18662. 

Exemptions to Withholding 

There are certain withholding exemptions such as Sections 121 (tax free exclusion on the sale of a primary residence), 721 (tax free contribution to a partnership), 1031 (tax-deferred exchange of investment property), 1033 (tax-deferred exchange due to a natural disaster or eminent domain action) of the Internal Revenue Code as well as others. 

Buyers Now Responsible for Withholding on Installment Notes 

The REEP reports the sale or transfer as an installment sale if there will be at least one payment made after the tax year of the sale. The withholding is 3 1/3% (.0333) of the down payment during escrow. Buyers/Transferees are required to withhold on the principal portion of all payments made following the close of the real estate transaction.  

Happy Holidays From Exeter 1031 Exchange Services, LLC

Tax Planning When A Tax Deferred Exchange Fails at Year-End

What happens when you start a Tax Deferred Exchange transaction, but you are unable to acquire any of the replacement properties that you identified within the prescribed Tax Deferred Exchange deadlines?  The bad news is your Tax Deferred Exchange is now taxable. The good news is your Tax Deferred Exchange may not be immediately taxable.

It is possible to defer all or some of your taxable gain into the following income tax year even with a failed Tax Deferred Exchange transaction.  It will, of course, depend upon the individual facts and circumstances in your specific Tax Deferred Exchange transaction.  It is critical that you consult with your Tax Deferred Exchange Qualified Intermediary and your income tax advisor when your Tax Deferred Exchange transactions appears to be headed for failure.  

Partial Tax Deferred Exchange

For example, if multiple identified replacement properties are part of the same Tax Deferred Exchange but not all of the replacement properties will or can be acquired, it can result in a partial Tax Deferred Exchange.  Partial Tax Deferred Exchanges can mean that you have traded down in value or have exchange proceeds that were not use and are left over from the sale of your relinquished property.  Partial Tax Deferred Exchange transactions can still defer part of your taxable gain in certain circumstances.  

Installment Sale Treatment Under Section 453 

Section Numbers 1031 and 453 of the Internal Revenue Code ("Code") work in conjunction with each other and can provide significant benefits even when a Tax Deferred Exchange fails.  You may be able to defer all or part of your taxable gain from a failed or partial Tax Deferred Exchange into the following tax year rather than the current tax year under Section 453 (Installment Sale Code).  It will depend on whether your Tax Deferred Exchange Agreement includes language prohibiting your right to access your Tax Deferred Exchange funds until the following income tax year.

For example, if you dispose of your relinquished property as part of a Tax Deferred Exchange and the relinquished property sale closes on December 1st of a specific taxable year, the 45th calendar day identification deadline and the 180th calendar day exchange period both land in the following income tax year.

If you did not identify any replacement property(ies) within the 45 calendar day identification period your taxable gain will be recognized in the following tax year because you did not have the legal right to access your Tax Deferred Exchange funds until the 46th calendar day, which would be in the following income tax year.

Likewise, if you did not acquire some or all of your identified replacement property(ies) during the 180 calendar day exchange period your taxable gain would be recognized in the following tax year because you did not have the right to access your Tax Deferred Exchange funds until after the 180th calendar day deadline has passed, which is also in the following income tax year.

You can also elect — at your sole discretion — to recognize and report the taxable gain in the current tax year in which the relinquished property sold instead of deferring it into the next tax year should you chose to do so. 

California FTB To Assess Penalties When a Deferred Sales Trust is Used to Save a Failed 1031 Exchange

The California Franchise Tax Board ("FTB") has ruled that certain types of installment sale transactions that have been "structured" or "drafted" pursuant to Section 453 of the Internal Revenue Code ("Code") and have been promoted and used to "save" failed 1031 Exchange transactions will not qualify for tax-deferred treatment in California when used in this manner.

California FTB is Aware of Certain Installment Arrangements

The FTB is aware of certain arrangements in which a 1031 Exchange investor and/or Qualified Intermediary attempt to convert proceeds from the sale of the investor's relinquished property that is part of a failed 1031 Exchange, or any unused proceeds from a partial 1031 Exchange, into an installment arrangement such as an installment note or other similar arrangement in which payments are to be paid out over two or more years.

It was made clear by the FTB that these arrangements do not qualify for a deferral of gain recognition under Sections 453 or 1031 of the Code since, among other reasons, these sections and the federal doctrine of constructive receipt do not support such a deferral of gain recognition.

These tax-deferred installment sale transaction structures have been promoted under various names over the years, including Private Annuity Trusts, Deferred Sales Trusts, Monetized Installment Sales, Self-Directed Installment Notes, among others.

Qualified Intermediaries Put On Notice

1031 Exchange Qualified Intermediaries must withhold and remit certain amounts to the California FTB when a 1031 Exchange either fully or partially fails.  Qualified Intermediaries were put on notice by the California FTB through the issuance of California FTB Notice 2019-05 dated September 24, 2019.  This notice was issued specifically to let Qualified Intermediaries know that the California FTB will impose failure to withhold penalties against the Qualified Intermediaries who actively participate in these installment sale transactions where boot or proceeds from a failed 1031 Exchange are converted into an installment sale or note or similar arrangement in which payments are to be paid out over two or more years.

Investor and Qualified Intermediary Beware

It is critical that investors have both their legal and tax advisors review any real estate transaction structure before proceeding, especially in cases where there is no guidance from the Internal Revenue Service and/or state taxing authorities.  Interest and penalties can be devastating, so it is important that the investor knows and understands the risks involved with such transaction structures. 

Personal Property 1031 Exchanges Still Allowed by California Franchise Tax Board

Update to Blog Post as of December 26, 2020 

The California Franchise Tax Board has now conformed in late 2019 to the changes affecting Section 1031 of the Internal Revenue Code that were contained in the Tax Cuts and Jobs Acts of 2017.  Personal Property 1031 Exchanges no longer qualify in California. 

The Like Kind Exchange (LKE) is a tax deferred transaction or strategy allowed under Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations ("1031 Exchange").  This means it is a Federal tax code.  However, most state governments conform to (or follow) the Federal tax code, with certain limited exceptions or adjustments made at the state level.  

Pennsylvania Does Not Recognize 1031 Exchanges

Perhaps the most notable exception is the State of Pennsylvania, which does not recognize the 1031 Exchange for state tax purposes. Investors can still sell property and defer the payment of Federal capital gain and depreciation recapture taxes, but would recognize and pay Pennsylvania taxes.  

California Franchise Tax Board 

California is no exception.  The California Franchise Tax Board (FTB) has generally conformed to Section 1031 of the Internal Revenue Code, although they take a much more aggressive position on certain issues during audits than does the Internal Revenue Service. 

Personal Property 1031 Exchanges Still Allowed in California 

However, California did not conform to (or follow) the changes affecting Section 1031 of the Internal Revenue Code that were contained in the Tax Cuts and Jobs Act of 2017.  The Tax Cuts and Jobs Act of 2017 eliminated the ability to structure a 1031 Exchange on the sale of personal property (non-real-estate) at the Federal level.  

Investors can still use the 1031 Exchange to defer the payment of their California taxes on the sale of personal property that is held and used as rental, investment or business use property.  They would, of course, have to pay the Federal capital gain and depreciation recapture taxes, but would at least be able to defer the payment of the California taxes.