Brown & Streza Blog
Apr 9

Written by: David Keligian
4/9/2018 9:12 AM  RssIcon

Most Californians with higher incomes and homes will probably end up with higher federal income taxes as a result of the new income tax bill. Our federal income tax law now imposes a $10,000 limit on federal deductions for state and local income taxes. For example, any person who owns a home in California with an assessed value of $1,000,000 will be limited in their federal income tax deductions for the California taxes on their home alone—regardless of how much state income tax they pay.

That makes a ballot initiative slated for the November 2018 California ballot especially painful. Named “The College For All Act of 2018”, it is an attempt to re-institute the estate tax in California. Unlike the federal estate tax rules, which were recently liberalized, the proposed California estate tax starts to kick in on estates of more than $3,500,000 at a 12% rate, increasing to a rate of 22% on estates of more than $5,490,000. The initiative, backed by the California Federation of Teachers, establishes priorities to use any revenues for tuition relief for higher education.

Some noteworthy points about this proposal. First, it applies to all real and tangible property located in California, regardless of where the owner lives. Anyone who owns property in California will be subject to the tax. Second, it will provide yet another incentive for high net worth Californians to leave California and further erode California’s tax base. Think of every Silicon Valley billionaire—if the initiative passes, every billion of net worth means an extra California estate tax of $222,000,000. Finally, the initial threshold for applicability of the tax--$3,500,000 - - will have a drastic effect on California’s small businesses and farms.

The new tax initiative will follow the rules of the federal estate and gift tax, and if passed, will be effective January 1, 2019. If enacted, many people will be forced to consider estate planning for state purposes, even if they are nowhere near being exposed to federal estate taxes due to the higher federal exemptions currently in effect.

There will be many Californians (even if they don’t consider themselves wealthy) who will be impacted by this tax. Consider a single individual with a $2,500,000 house, a $1,000,000 IRA, and a $1,000,000 life insurance policy they bought for their children. On death, they will be subject to a $135,000 California estate tax even though they are nowhere close to incurring any federal estate tax liability.

The proposed estate tax raises all kinds of questions. For example, for income tax purposes, California allows Section 1031 exchanges of California property for non-California property. However, California maintains it has the right to tax the deferred gain on the California property at the time the non-California property is sold. The issue does not exist for federal estate tax purposes, but it means a non-California resident can presumably do 1031 exchanges of their California property for non-California property and save the California estate tax on that property.

Similarly, for non-California residents, the California estate tax can be avoided on California real estate by transferring ownership of the real estate to legal entities which i) don’t die, and ii) which would be characterized as intangible assets. This type of planning wouldn’t help a California resident though—their solution is to leave California.

Because the initiative is designed to duplicate the federal transfer tax rules, all of the federal transfer tax planning we do will also work for California purposes. However, if passed, there will also be state gift tax and estate tax returns required, as well as a mechanism for auditing those returns. Suffice it to say that at present, the California Franchise Tax Board may have neither the ability nor capacity to start enforcing the new rules in 2019. And unfortunately, if the measure does pass, there will be only a very limited window (November and December of this year) to do any planning.

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