If you live in California and own a second home, investment property or other home that isn't your primary residence, be prepared to immediately pay the state a tax that amounts to 3.33 percent of the transaction value when you close escrow on its sale.
Controversial eleventh-hour legislation passed earlier this year to accelerate tax receipts for California's sagging budget applies an older law to a larger group of property sellers. The income tax isn't new or larger, but it previously applied only to non-residents.
That changes effective Jan. 1, 2003, when the California Investment in Real Property Tax Act (Cal FIRPTA) will requires residents to withhold in escrow an income tax amounting to 3.33 percent of the sales price and have it forwarded to the state's Franchise Tax Board.
An estimated 300,000 transactions will be affected by the new law which, unlike the old law for non-residents, does not grant waivers or reduced withholding rates for sales with small taxable gains.
The new law does offer exemptions for sales of primary residences, sales when the total price is less than $100,000, sales that result in a taxable loss and other sales as described by the law.
The California Association of Realtors was working with the Franchise Tax Board to postpone adoption of the new regulations because the bill was amended with the new provisions, passed by the state Legislature and signed by the governor in just days with no time made available for examination in print.
"It's a brand new law, passed with the budget package, that got no public input, was crafted and approved within 48 hours, courtesy of your elected officials, and is indeed, outrageous," said Stephen J. Hanleigh, president of the Santa Clara County Association of Realtors.
Under the new law, if you sell a vacation or rental property for $500,000 the state mandates you pay it $16,650 in withholding -- even if you make only $1 in gain. To actually owe the $16,650 in tax, you would need a $180,000 profit.
"It's like over withholding on your paycheck. You get a refund, but you have to come up with the money, assuming you have the proceeds. Some people sell to get rid of a liability and come out of pocked to pay the debt, but they are not exempted on that bases," and still have to come up with the tax even if it is not owed and will be refunded," said Sam Gilstrap, an enrolled agent in San Jose, CA.
Some fear the change will force equity-thin sellers to dig deeper than they can and that could cause sales to fail. If the failure is outside the realm of the contract that could trigger a lawsuit. Some sellers may attempt to game the sale and retitle the property into a corporation or other entity that is exempt from withholding.
Other critics say oversized refunds could trigger the federal Alternative Minimum Tax or boost the following year's adjusted gross income forcing a property seller to pare back deductions and exemptions.
Tax professionals should be consulted for proper compliance with the law and to make the necessary adjustments to tax returns.
"The seller should take the advance payment to FTB into consideration when doing his, her or their after-sale estimated tax payment. If that doesn't reduce the excess amount, then the seller should reduce his, her or their withholding to account for the excess FTB payment," said Marie Sternberger, an enrolled agent in Sunnyvale, CA.