If you have been involved with the sale or purchase of real estate during the last several years, whether as an investor, broker or escrow officer, you are likely familiar with California’s withholding requirements. In a nutshell, California law requires a buyer to withhold 3.33% of the sales price and send it to the Franchise Tax Board as a “prepayment” of the state tax a seller owes on the sale of real estate. Typically, escrow agents assume this obligation and are required to send these funds to the Franchise Tax Board unless one of the specified exclusions applies.
The withholding is really a deposit towards the tax that will be due once the seller files a return. It is computed based on an arbitrary number – 3.33% of the sales price – rather than the amount of tax that will actually be due based on the gain. Because of this, many investors criticized the law for requiring them to pay substantially more than is due, with the refund of the difference only coming months later.
The California legislature responded to this criticism by amending the withholding law. Since January 1, 2007, sellers of real estate have the ability to choose a different method of withholding that is a closer approximation to the actual amount of tax that will be due. The seller can choose between the traditional withholding equal to 3.33% of the sales price, or withholding based upon computing the amount of tax that would be due on the actual gain using the maximum tax rate.
For example, if an investor is selling property worth $1 million, under the traditional scheme the withholding would be 3.33% of that, or $33,300. If the investor’s gain was equal to $300,000, under the new withholding method, that gain would be multiplied by the maximum tax rate in California, which for individuals is 9.55%. This method would result in a withholding amount of $28,650.
If the seller elects to use this alternative withholding method, it is necessary to certify in writing under penalty of perjury what the withholding amount will be. The Franchise Tax Board has forms and tools on its Web site to help investors compute the amount of tax due. The law requires that the Franchise Tax Board forms notify investors that title, escrow and exchange personnel are not allowed to give investors legal or accounting advice about the amount of the withholding. For this reason and because the certification must be done on or before the closing, investors are urged to discuss this issue with their tax advisors well before the sale of real property.
For some transactions, the specified exclusions apply and therefore investors need not worry about withholding. For example, no withholding is required upon the sale of a principal residence or if the seller is a partnership or is a corporation that is either formed in California, qualified to do business in California, or has a permanent place of business in California. In addition, if the investor completes a 1031 exchange, withholding is only due on the boot, and only if the boot exceeds $1,500.
As mentioned above, it is wise to do some advance planning before closing to determine which withholding method is the best. The Franchise Tax Board’s Web site contains additional information, and forms are available for this purpose.