Some day, someone should write a book about the history of California’s real estate withholding program. Absolutely no one will buy or even read the book, admittedly, but it would tell an interesting story of how government works, and how budgets are “balanced.” The point of this column is not to tell the whole, sad story, but rather to provide an update on the 2006 major changes to the withholding program. Because the new law takes effect on January 1, 2007, CEA members will need to be aware of the changes.

The changes to the withholding law enacted this year by the California Legislature were contained in AB 2962 (Benoit). AB 2962, in turn, was one of 910 new laws passed by the Legislature and signed into law by Governor Schwarzenegger. While a number of other bills have relevance to escrow practices in a variety of areas (there are, for example, changes relating to mobilehomes, property taxes, liens, and other subjects), this column is limited to the withholding issue.

In order to help balance the state budget in a year of deep deficits, the withholding program was expanded from non-residents to residents as well. Never mind the question of whether the money represented real revenue to the state, since they had to send most of the money back when the tax return was filed.

A brief recap of the withholding issue is necessary. In the early 1990’s, the California Legislature enacted the real estate withholding program. The program was modeled after the federal Foreign Investment in Real Property Tax Act (FIRPTA). The idea behind both the federal and state programs was the same: taxpayers might sell California (or in the case of FIRPTA, United States) property and leave town without filing the proper tax return and paying the appropriate income tax. Initially the program in California applied only to non-residents.

While escrow officers did not cheer the arrival of yet another duty, CEA members and the staff of the Franchise Tax Board worked hard to make the program successful. Long-time escrow officers will recall that prior law allowed the FTB to issue “waivers” from withholding in certain circumstances; almost universally CEA heard reports that the FTB worked very hard to accommodate the needs of escrow and process waiver requests quickly.

While the original program was based upon the need for tax compliance (making sure sellers paid their rightful taxes), several years ago the program was expanded for purposes of tax revenue. In order to help balance the state budget in a year of deep deficits, the withholding program was expanded from non-residents to residents as well. Never mind the question of whether the money represented real revenue to the state, since they had to send most of the money back when the tax return was filed. The Legislature was told that the expansion would “raise” $265 million, that was their story and they were stickin’ with it!

The problem is that the new law required withholding on a lot more transactions, which exacerbated a basic flaw in the system. Since the withholding rate was set at 3 1/3% of total sales price, too many sellers were being subjected to big withholding when they had small gains. In other words, the amount being withheld was much bigger than the ultimate tax obligation, which was based on the gain realized in the transaction.

For several years, the Legislature toyed with the idea of basing withholding on gain, rather than on total sales price. The problem was that this appeared to represent a revenue “loss” to the state, again leaving aside the question of whether the money was ever real money in the first place. In years of tight state budgets, the idea did not move forward.

The state revenue picture this year was much more rosy, and this enabled the Legislature to again consider this disconnect between big withholding and small gains. The answer is contained in AB 2962, which gives sellers the right to elect whether they wish to have withholding based upon sales price, or upon gain. It is critical that CEA members familiarize themselves with the new law, contained in Section 18662 (e)(2) of the California Revenue and Taxation Code.

Under the new law, sellers may elect to have withholding calculated at 3 1/3% of total sales price, or upon a higher percentage of gain. For corporation sellers making the election, the amount withheld will equal gain multiplied by the tax rate specified in Section 23151 or 23186 of the Revenue and Taxation Code. For all other taxpayers, withholding may be calculated as gain multiplied by the highest tax rate specified in Section 17041.

The election authorized by the new law must be executed by sellers on a written certification developed by the Franchise Tax Board. At CEA and CLTA request, the certification must contain the following proviso:

“Title and escrow persons and exchange accommodators are not authorized to provide legal or accounting advice for purposes of determining withholding amounts. Transferors are strongly encouraged to consult with a competent tax professional for this purpose.”

Further, AB 2962 requires the FTB to develop a form or worksheet to help taxpayers estimate their gain in transactions, so that they may make the proper withholding elections. Once again, this form or worksheet must contain the warning described above.

It is extremely important that escrow officers not become involved with the calculation of gain in transactions to which withholding applies, and not provide counsel on which option to choose. The concept of gain can be very technical and will depend upon a host of factors in individual transactions. While anyone can multiply the sales price by 3 1/3%, withholding based upon gain is immeasurably more difficult. Escrow officers should point to the forms, certifications, and information developed by the Franchise Tax Board, and advise sellers to contact their lawyer or accountant for assistance.

We are advised that the FTB is now in the process of developing the necessary documents to implement the new law. Will the 2006 change represent the last word in the withholding saga? If the past is any indication, probably not!

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

Real Estate Withholding,
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