California Claw-Back Provision: What Happens in California, Will be Taxed

Written by admin on May 21st, 2011

            The 1031 exchange is a great instrument for property owners who wish to defer their capital gains tax. However, not all states treat 1031 exchanges equally. California regulations stipulate that any appreciation in property value accrued in California is subject to their state taxes, regardless of whether or not that property was exchanged for one in another state before its sale. This means that CA property owners cannot escape CA state taxes, even if they exchange their property for one in another state.

            Most states conform to federal income tax treatment of like kind (1031) exchanges, where all capital gains taxes are deferred until the properties eventual sale. This is generally interpreted to mean that one is only subject to taxes of the state where the property is sold, discounting the state taxes of any state where the property was exchanged from.  Meaning that if I owned a property in NV, exchanged it for one in ID and subsequently sold it, I would only be responsible for federal and ID taxes, not those from NV.

            California is a notable exception to this. It employs a “claw-back” provision, entitling the state to tax any gain on property that occurs in California, regardless of where the property is eventually sold.


For example:


Say Mr. Newcombe bought a property in CA for 0. After appreciating to 0, he exchanges it for one in ID. While in ID the property further appreciates to 0. Feeling he has had enough of owning property, he sells it for 0, showing a total capital gain of 0. Mr. Newcombe would not only be liable for 0 of capital gains taxes in ID, but 0 of capital gains taxes in CA as well.


Note: The reciprocal of this situation does not come into effect. If Mr. Newcombe owned property in ID and exchanged for property in CA, he would only be subject to CA state taxes, not those of ID.


            From the above example it is clear that owning property in California and exchanging it for property in another state leaves one open to double taxation. There is no way to avoid this situation unless one stays out of CA entirely or performs the final sale there. Being taxed in CA would of course be undesirable because it has some of the highest income tax rates, 9.55% and 10.55% for earnings over ,055 and ,000,000 respectively. The claw-back provision really hurts people when they try to exchange out of California’s stringent tax system into a friendlier one such as Texas, which has no income tax. In situations such as this, the “claw-back” provision acts like a hand reaching out of the grave to grab and tax people one last time. Needless to say, before making an investment in CA, ensure it will be worth the high amount of taxes you will eventually pay for it.

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