For those fans of high-brow culture, there is a scene from one of the Austin Powers movies where our hero is attempting to “eliminate” one of the bad guys. In true James Bond fashion, the villain refuses to go down, after absorbing all manner of lethalities. In exasperation, Austin finally yells “Why won’t you DIE?.” So it is with California’s real estate withholding law, which seems to be the subject of legislative proposals every year, and 2006 is no exception.

In case readers are unfamiliar with this long-running soap opera, the state withholding program was created in the early 1990’s, to parallel the U.S. Foreign Investment in Real Property Tax Act. The idea, much as we hate to admit it, made a certain sense. Just as a non-U.S. resident could sell property in this country and leave without paying federal taxes, so could a non-California resident sell property in this state and not pay the Franchise Tax Board. The solution: require withholding of a certain percentage of total sales price.

From the beginning, escrow and the FTB have had a largely productive working relationship to make the program successful. But when the program was expanded early in this decade, to include residents as well as non-residents, the issues relating to withholding really started bubbling to the surface. First off, a lot more transactions required withholding, meaning a lot more checks from escrow and a lot more administration by the FTB. But second, there are lots more complaints from taxpayers about over-withholding.

As property values have increased rapidly, withholding of 3 1/3 percent based upon sales price can amount to a lot of money, and the amount may have little or no relationship to the eventual tax obligation of the seller. A few years ago, a bill proposed to give sellers the election of having withholding calculated on gain rather than total sales price, to avoid over-withholding where the seller has big sales price but little gain. The downside was a rather substantial revenue loss, at least on paper, to the state. The estimated loss was $30 million, easily enough to kill the idea in times of state budget shortages.

The Franchise Tax Board reports that complaints concerning over-withholding continue to grow. To respond to the problem, this year the FTB is sponsoring AB 2962 by Assembly Member Benoit. The bill proposes to give both individual and corporate sellers the ability to certify a withholding amount of not less than the gain on the transactions, multiplied by the highest tax rate applicable to them. Although the wording is different than prior proposals, the idea is the same: permit an election to withhold based upon gain, rather than total sales price.

Time marches on, and the estimated revenue loss from AB 2962 has reportedly risen to $45 million. To put it mildly, this would appear to be a significant challenge for the bill. But the idea still has a certain merit. Taxpayers are permitted to align their income tax withholding based upon a rough idea of their eventual tax liability…why subject property sellers to more withholding than they need?

For CEA and CLTA, the additional issue is the role of escrow officers. Obviously withholding on gain is far more complicated than the calculation using sales price. Imagine nearing the conclusion of the transaction, asking sellers whether they wish to withhold based upon gain or sales price, and having them respond: “What is gain?” With loan commitments expiring and the buyer’s moving van en route, the seller will return home to find the shoe box with the receipts for the home improvements necessary to calculate gain. This will make it imperative that sellers make the withholding election as soon as possible in transactions.

Worse yet is the seller who asks the escrow officer: “I put a new roof on my house three months ago-do I get to count that money in calculating my gain?” There is often a very fine line between maintenance items which are not added to tax basis in determining gain, and improvement items which do become part of basis. Escrow officers neither can nor should be put in a position to be counseling sellers on tax issues. Should the bill move forward, Assembly Member Benoit has pledged to help address this issue.

After listening to this, occasionally a legislator suggests just eliminating resident withholding altogether. As Austin would have said: “YEA BABY!” But that idea carries with it about a $1 billion paper revenue loss.

by Michael D. Belote
California Advocates, Inc., Sacramento

FIRPTA, Yet Again!