Effective January 1, 2003, California started mandatory withholding of
3 1/3% of the gross sales price on real estate sales in California.

The impact of this change is easier to understand by comparing it with the pre-2003 rules.

Prior to 2003, California only required withholding on out-of- state sellers. This made sense, because California was concerned that out of state sellers would take their sale proceeds out of state, and never pay the California tax due on the sale of their California real estate.

Now (as of January 1, 2003), California residents are subject to this withholding requirement. The question is: where are they going with the money? Well, they are probably not leaving California. So what’s going on? California is forcing you to loan California your money interest free, so that you can help balance the California budget.

Of course the rich and powerful interests made sure the legislature did not apply this law to them. Corporations, partnerships, and limited liability companies are exempt from withholding. So as not to cause a rebellion among homeowners, sales of principal residences are exempt as well.

So who’s left? You, the apartment owner… However, the legislature generously exempted you if you sell at a loss, are foreclosed on, or are condemned.

But if you are in the business of apartment ownership to make money, the State has its hand firmly in your pocket.

California does not give you an exemption if your withholding will exceed your estimated California tax. (In contrast, wage earners get this privilege by taking more exemptions, and reducing their W-2 withholding).

California’s new scheme is not truly withholding, though the State tries to justify it as such. When you look at the business exemptions, and the lack of a waiver for small gains, it is obvious this is merely a way to unfairly take your money.

Since the withholding tax is calculated on 3 1/3% of the gross sale price, this can be a large number that is far in excess of your California tax liability.

How do you protect yourself? One possibility is to form an LLC, deed your building to the LLC, and then have the LLC sell the building. Of course, the LLC has costs and taxes on it that must be considered first.

Another possibility is to deed the building to a partnership, and have the partnership sell the building. Perhaps a partnership could be formed between you and your spouse, or you and a friend.

Another solution is to do an exchange. A totally tax-free exchange is exempt from the California withholding requirement.

Please note this article contains general tax advice. See your tax advisor for tax advice for your specific situation.