PRC Shell Game

(This is a little lengthy and, while specifically describing the situation in California, its points are relevant to other states that follow the PRC’s examples.)

In their typical incompetent fashion, the rulers of the PRC have painted themselves into a corner with their budgets. When the dot-com stocks were flying high, the geniuses in Sacramento made the assumption that they would continue to rise in value every year from then until eternity, and then set up new generous government programs to spend that money. When reality hit, the capital gains taxes dried up and the revenues slowed accordingly. However, the spending is still increasing, putting them into a position of having a deficit of anywhere from $16 to $20 billion for the upcoming fiscal year. While this is a mere drop in the bucket for the Feds, California, as with most States, is required by law to have a balanced budget every year. They can’t print money to cover their shortfalls, as can our masters in DC.

Another illustration of how incompetent the PRC rulers are at financial matters is with the few times when the State government has had a budget surplus, which has happened a few times over the past 25 or so years. Rather than hold the excess money over to compensate for future leaner years, they set up an inefficient multi-million dollar program to send taxpayers rebate checks of around $65 each. Then, a year or two later, when they are desperate for money, they have to raise taxes and fees; which is where they are right now. They are playing all kinds of financial tricks to try to get close to a balanced budget, almost every one of which would land a corporate executive in prison for doing the exact same things.

One trick that they are using to get interest free loans from the taxpayers is to force many people to prepay much more in taxes than they will really owe through mandatory over-withholding. Even though much of that money will end up being refunded back to the taxpayers, it will be in a later fiscal year than when the money was received. It’s the same kind of classic shell game that has sent several corporate executives to prison. However, when our rulers do it, it’s considered a work of genius. For those of you not too bored by such minutia, here are the details.

This latest trick that caught my attention was in an announcement from Spidell Publishing that the rulers of the PRC have widened the scope of mandatory tax withholding from sales of California real estate. This subject is something I have been very familiar with since it was first started in the mid 1980s.

During the mid-1980s, as California real estate values were skyrocketing, many people from outside of the state were making a lot of money by buying and selling property. The tax law had always required that they share those profits with the rulers of the PRC by filing Calif. non-resident income tax returns. However, many people didn’t do that, either out of ignorance of the law or just the knowledge that there was nothing that the FTB (Franchise Tax Board) could do to them for not filing.

In what was actually a wise move, the PRC rulers passed a law requiring that income tax be withheld by the escrow companies from sales of Calif. real estate of $100,000 or more by people or companies that had addresses outside the State. The withholding was set at 3.333 percent of the gross sales price. I can still remember the panic this caused among the Realtor community because I was teaching real estate seminars around the Bay Area back then. They were freaking out, calling this a new tax on real estate. I had to explain that it was not a new tax; but a method of motivating real estate sellers to comply with the already existing tax law and file Calif. tax returns to report the sales.

Because the withholding is based on the gross sales price, when the sellers actually file their tax returns and report their net profit or loss on the sales, they normally get part or all of the withheld money back from the FTB. After the PRC blazed this trail, other states, such as Virginia, instituted the exact same kind of mandatory withholding for sales by out of state parties.

The rule had always had some exceptions to the withholding, such as a sales price of less than $100,000, use by the seller as a qualifying primary residence, and if the seller is doing a Section 1031 tax deferred exchange. This latter exception is one I have been very familiar with as part of my duties assisting Sherry in her exchange work. We have handled several exchanges where people disposed of rental properties in the PRC and reinvested the proceeds into properties in other States. We filed Form 597-E with the FTB to have them issue a waiver of the withholding. Overall, I must say that the FTB has been very cooperative with these requests.

Now for the change.

Beginning January 1, 2003, the mandatory withholding rule will also apply to sellers inside California. Escrow companies will be required to withhold 3.333 percent of the gross sales price of any real estate sold for more than $100,000 that was not a qualifying primary residence, and not part of a 1031 exchange, 1033 involuntary conversion or a foreclosure. The only exception to the withholding requirement is if the seller signs under penalty of perjury that there is a loss on the sale. This means that even if there is just one dollar of gain on a sales price of $400,000 (for example), the escrow company must withhold $13,332 and remit it to the FTB within 20 days following the close of escrow. Unlike current law for nonresident real estate withholding, the FTB cannot allow a reduced amount of withholding based on the true gain.

Some tips to deal with this:

Cost Basis

Keep track of the cost basis of your properties. I am constantly asked how much tax someone will have to pay on the sale of a property based on a certain sales price. My very first question is to determine what is the cost basis of the property. Almost nobody knows what the cost basis means; and if they do know what that means, they still have no clue as to the dollar amount. Income and capital gains taxes are calculated on the net profit or loss, not the gross sales price. The cost basis is the most important aspect of determining whether or not there will even be a taxable gain. With this new withholding rule, if you can prove that you are selling for a net loss, you will avoid having thousands of dollars needlessly withheld from your transaction. This is the reason I always give all of my clients a complete detailed depreciation schedule, showing the depreciated basis of all assets. It frustrates me to no end that so many other tax preparers refuse to provide their clients with this valuable information.

Accumulate Losses

I prepare several tax returns for people who have left the PRC, but still have rental properties there. With depreciation and other expenses, these normally generate net losses, with no State income tax. I still prepare California non-resident tax returns in order to show those losses and let them accumulate over several years. By the time the property is to be sold, there is often $100,000 or more of carried forward losses that can be used to offset the gain that would otherwise be taxable to the PRC, including recapture of depreciation. I consider this the long term approach to tax returns. While not required to be filed each year, the documentation of accumulated losses will pay off in the long run.

As I said earlier, you can be sure that other States will copy this trick and start requiring taxes to be withheld from more types of real estate sales by State residents.

Adjust Tax Payments

If you are caught by the mandatory withholding, and you have determined that those additional amounts will be more than enough to cover the tax on the gain from that sale, you should modify your other State tax payments, such as reducing your estimated tax payments or adjusting your W-4 with your employer to have less tax withheld from your paychecks. As I constantly have to remind people, getting a large tax refund is nothing to brag about. It just means that you loaned the government some of your hard earned money at a zero percent interest rate.

KMK