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July 2, 2024
Last Updated : July 2, 2024

California Real Estate Investing: Tax Issues to Be Aware Of

California Real Estate Investing: Tax Issues to Be Aware Of

California real estate investing can be lucrative.

But it also comes with steep tax consequences.

A recent LinkedIn post from Ryan Carriere, a CPA and senior advisor here at Hall CPA, summarized how California taxes real estate investors.

In this post, I’m going to expand on some of the issues Ryan calls out:

California Disallows Real Estate Professional Status (REPS)

You may qualify as a real estate professional on your federal return, but if you have rentals in California, you cannot use real estate professional status to make the California rentals non-passive.

Qualifying as a real estate professional requires that you meet two statutory tests:

  1. Spend 750 hours working in a real property trade or business; and
  2. Spend more time working in real property trades or businesses than you do anywhere else.

You must also demonstrate “material participation” in your rentals (usually a non-issue if you are a full time landlord).

It is hard work to qualify as a real estate professional.

And California real estate investing will reduce your total tax benefit by not allowing losses from rentals to offset your income.

Note: this is only impacts the California tax return. You can still qualify as a real estate professional at the federal level and claim the benefits (tax losses) on your 1040. But you won’t see the benefits flow through on your California state return.

Many of our clients live in California and invest in California real estate.

Decoupled from Federal Bonus Depreciation

California real estate investing comes with another drawback: no bonus depreciation is allowed on the state return.

California requires an addback of the amount by which depreciation claimed for federal purposes exceeds the allowable California depreciation deduction, which is computed without regard to federal bonus depreciation.

This requires keeping two separate tax depreciation schedules, one for federal and one for California, which will increase your compliance costs.

California Real Estate Investing – The 1031 “Clawback rule”

A 1031 exchange, also known as a tax deferred exchange allows real estate investors to defer the recognition of capital gains tax they would have had to pay if they sold their property outright.

Capital gains taxes are deferred through the 1031 process until the investor ultimately decides to liquidate all or a portion of their real estate portfolio. Further, capital gain taxes can be eliminated if a real estate investor holds, dies, and passes on their assets to their heirs – the heirs receive a stepped up basis.

A 1031 exchange related to California real estate investing is not as straight forward.

California employs a “clawback” rule that requires any gain in the property’s value, accrued in California during the hold period, to be subject to California taxes regardless of whether or not that property was exchanged for one in another state.

A 13.3% Marginal Tax Rate (The Highest of All States)

California employs very high tax rates compared to other states.

The highest marginal rate in California is 13.3% and there are always talks of increasing it.

This may not be a big deal if your primary income source is from rental properties in California – losses from rentals should offset income from rentals.

But it can be painful when you have a high income W2 job or are running a business.

Worse still if you sell stock or real estate at a gain – you will move up tax brackets in California.

Many taxpayers move states prior to large income events in order to avoid the high tax rates California imposes. But it’s important to note that California is an aggressive tax collector. They will follow you around the country demanding you pay taxes on such income events.

Be careful.

Summary

California real estate investing can do wonders do your wealth building if you have a long time horizon.

But California is one of the more complicated states regarding taxation.

Make sure you work with a real estate CPA to help you navigate the nuances.