What is the Claw-back Rule? ...Another way California gouges investors

07 Mar, 2022  

Do you own an investment property?

If you do and you sell it, you can defer taxes by purchasing another property of equal or greater value. 

This is called a 1031 exchange. 

Have you heard of the Claw back rule?

California, Massachusetts, Montana, and Oregon have Claw back rules for 1031 exchanges.

I hadn’t either until AFTER I sold one of my rental units and was already in escrow. If you haven’t heard, real estate is Location, Location, Location. I had a small rental located in a very desirable area. Had the same unit been anywhere else, it would just be another rustic condo unit.  When an investment property is sold, you hopefully make some money. The profit is capital gains. When you make a profit, you have to pay state and federal taxes.

A 1031 exchange is when a rental property is sold for a profit and capital gains tax is deferred by means of reinvesting the profit by purchasing another ‘like-kind’ property. The new property(ies) must be of equal or greater value than the original property sold to defer taxes. As long as you keep buying property and rolling over the proceeds, you do not pay the tax on the sale. Once you sell your property, you must identify a replacement property within 45 days and then replacement property must be purchased within 180 days. If these rules are not followed, then you will be responsible to pay the capital gains tax. This rule does not apply to your primary property, only investment property and is not really meant for “flippers.” A 1031 exchange is a federal tax code.

Many investors think that you pay the state tax on the investment property in the state where the final property is sold. Well...Certain states have an additional clause called the Claw-back Provision. California of one of a few states that believes that any capital gains accrued on real estate in California will be subject to California tax when you sell the property, even if you leave California. That’s assuming you are a California resident also. The states that have this Claw-back rule as of this writing are California, Massachusetts, Oregon, and Montana. Some states also have other withholding requirements if you are a non-resident of the property being sold.

Let me illustrate this rule by this example as I understand it:

Mr. Sato buys investment property, a rental condo, in Hawaii for 150K and then sells that rental condo in Hawaii 5 years later to move to California for $250K. The profit/capital gain is 100K. Mr. Sato plans to buy a replacement property in California (where he is moving to) with a 1031 exchange. Once the sale is completed, the profit funds of 100K get held by a 1031 exchange account after closing. Mr. Sato does not have access to use the funds in any way without being charged capital gains tax. Mr. Sato has 45 days to identify ‘like-kind’ properties which must be equal to (250K) or more than the condo he just sold. If he does not identify a property(ies) within 45 days, the 1031 exchange expires and he has access to his funds minus the charge for the 1031 exchange process and he will be assessed federal and Hawaii state capital gains taxes.

Profits from sold property get held in a 1031 account. You cannot access the funds for other uses.

Let’s say, Mr. Sato does complete the 1031 exchange within 180 days and buys a condo in California for $250K. Then, 10 years later, Mr. Sato wants to retire and move to Idaho. He sells the condo for $500K and wants to do another 1031 exchange for a property in Idaho. In the simplest of terms, his profit was $250K + claimed depreciation minus his mortgage balance.  

Remember, the original condo was purchased in Hawaii. Then a 1031 exchange to California.

Now, does Mr. Sato do a 1031 exchange again for property in Idaho?

Let’s say the profit he makes is 300K after paying all seller and realtor fees and mortgage balance. This gain gets tacked on to his current income and raises his income tax bracket. If he just cashes out, he will pay capital gains taxes of approximately 100K. If he opts for a 1031 exchange, here is when the Claw-back rule needs to be considered. If the replacement property is outside of California, a taxpayer will be required to file an annual information return with the California (FTB) Franchise Tax Board (from January 2014 forward) to report that they still own this property and for as long as they own investment property from the originating California investment property. If the taxpayer fails to report it, the CA FTB may assess taxes with interest and penalties.   

So, someday in the future, when Mr. Sato sells this property and cashes out, he will owe California taxes on the amount he gained based on his current income at the time. If his income is less, his tax may be less, but he will still owe California a large sum of money, in addition to federal and Idaho capital gains tax.  The only way to avoid this tax is by dying and that doesn’t really benefit him at all. So, the Claw-back rule leaves anyone owning property in California to future double taxation when moving investment property out of state. Hawaii is not a claw-back state so there is no claw-back rule that says Mr. Sato owes taxes on his profits from there.

What to do will be a personal choice. Speak to your financial advisor, accountant, partner, and whoever could be affected by this choice. It might make sense to keep ‘kicking the can down the road’ if you plan to keep holding investment property until you die. Or it might make sense to take the money and use it for something else.

Things to consider:

• How much profit would be gained from the sale?

• How much income is this property generating after all expenses?

• Is the income stable? Average the income on an annual basis over the last 5, 10, 15 years…

• Is the future income stable?

• If you pay the taxes, how much would you be left with. Divide that by your average annual income. Would you benefit from the # years of profit up front in a lump sum?

• Looking at replacement investment properties in the new state, the property value should be equal or more than the property sold. Not all markets are the same. How much rent could you expect? Is it worth it?    

So let’s say…Mr. Sato makes about 50K a year of rental income on his best years on his California property, but has 30K (HOA dues, operating costs, etc.) in expenses. Other years have been affected by fires, snow, and the Covid-19 Pandemic and related travel restrictions. On average, rental income has netted him about $10K per year over the last 10 years and $15K per year over the last 5 years. If Mr. Sato cashes out and takes the $300K in profit, he might have to pay $100K in taxes, but he will still have $200K of net profit to work with that he didn’t have access to before so it is not a total loss. Even though paying $100K in taxes is mind boggling, he still walks away with $200K. In early 2022, real estate is still selling for astronomical prices. His condo will probably not see prices like this again for a long time. Could he have taken out an equity loan? Assuming there was no mortgage, he probably could. But if there’s still a mortgage balance, pulling out $200K might be tight and then, he would have another loan to be obligated to pay.

Looking at Idaho, home prices are also high at this time. Mr. Sato could buy a single family home in a nice neighborhood for about $500K. $500K does not buy any multi-unit properties that would generate much income. Rental prices are approximately $2000/month for a nice house with $2500/month considered expensive. This does not include expenses and property tax. Many people are moving to Idaho and are looking for short-term rentals while they search for their future home. Demand isn’t the problem- the amount you can charge for rent is. This doesn’t completely make sense because a $500K house would have a mortgage payment greater than $2500 per month. However, house prices have sky-rocketed and the rental market is not reflecting that. The same house probably would have cost $300K several years ago and then the current rents would be more in line with those prices.

Remember, the condo in California was purchased for $250K so the property tax was based on that amount. In Idaho, he would be paying property taxes for 500K. Interest rates are low, but for how much longer can he expect the real estate market hold up these prices? Mr. Sato decides to cash out his profits and forego the 1031 exchange. He had a good run and no longer wants to have a rental property to worry about in his retirement. He will use the money to make his retirement more comfortable and says goodbye to California!   

Anyway, the point of this story is that California has a rule that you might want to consider when selling investment property.

Name and scenario is fictitious for illustration purposes only. This story has no intention of providing tax suggestions or financial recommendations, just information here.  Please do your own research and review all current state and federal tax policies to make the best decision for you.