State Problems With Your Rental Property

By Jason Watson, CPA
Posted Saturday, August 17, 2024

It is easy and common to overlook rental property and real estate investment nuances at the state level. Here are some random considerations-

Required to File Tax Returns with Tax Loss

Although your rental property has a tax loss, you are usually required to file a state tax return. Why? You have an income-producing asset in their state (taxing jurisdiction), and they have the right to inspect your books and records to ensure your reported tax obligation is as you say. Wow! We geeked out there.

The other big reason is variances in depreciation and tax deduction allowances. Keep reading!

Some States Do Not Recognize Accelerated Depreciation

California, for example, does not recognize bonus depreciation and has different limits for Section 179 expensing. According to California’s FTB Publication 1001–

The TCJA increased the amount of the additional first-year depreciation allowance from 50% to 100% for certain qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The 100% allowance is phased down by 20% per calendar year for property placed in service in taxable years beginning after 2022. The additional first-year depreciation deduction is allowed for new and used property. California does not conform to this provision.

It makes sense, right? The federal government can print money. States don’t have this luxury and must balance a budget (California notwithstanding).

When states do not follow the IRS, it is called state conformity or in some instances, decoupling. Many states do this in varying ways. Bloomberg Tax has a lovely list of state conformity to federal bonus depreciation.

This is another reason to prepare and file state tax returns for your rental property although it might have a federal tax loss. In other words, you could very easily have a tax loss on your Form 1040 individual tax return but have taxable income on your state tax return. Don’t shoot the messenger.

State Capital Gains on Your Rental Property

The federal tax code has a separate graduated tax system for long-term capital gains, and it is either 0%, 15% or 20% plus the possible net investment income tax of 3.8%. We call this a preferential tax rate.

For the 2024 tax year, a married couple pays 0% on long-term capital gains if their income is $94,050 or less. The rate is 15% if your income is between $94,050 and $583,750. It’s 20% if income is over $583,750. Single taxpayers are very similar ($47,025 and $518,900).

This sounds wonderful. However, most states do not have a preferential tax rate for long-term capital gains.

According to the Tax Foundation and as of the 2024 tax year, Minnesota and Washington state have a capital gains tax rate that is higher than ordinary income tax rates. Arkansas, Arizona, Montana, New Mexico, North Dakota, South Carolina, and the class favorite, Wisconsin, enjoy a long-term capital gains tax that is lower than their ordinary income tax rate.

So when you sell your rental property and enjoy a cushy federal tax rate, you might pay California’s top rate of 13.3% or New York’s 10.9%. Minnesota is up there too with 9.85% and their capital gains tax rate is 10.85%. Oh, and it’s cold too.

Tax planning is a must.

1031 Like-Kind Exchanges Across State Lines

As just mentioned, every state is unique in terms of conforming to federal tax code but it doesn’t stop at depreciation. Let’s pick on California since it is an easy target. According to California’s instructions, in part, for Form 3840,

In general, for taxable years beginning on or after January 1, 2015, California law conforms to the IRC as of January 1, 2015. However, there are continuing differences between California and federal law. When California conforms to federal tax law changes, we do not always adopt all of the changes made at the federal level.

The source of a gain or loss from the sale or exchange of property located in California is determined at the time the gain or loss is realized. The source of such gain or loss is preserved without regard to when such gain or loss may be recognized.

Form FTB 3840 must be filed for the taxable year of the exchange and for each subsequent taxable year, generally until the California source deferred gain or loss is recognized on a California tax return.

What does all this mean?

• California adopts federal tax code at its discretion. No kidding.

• The gain is computed when realized (time of sale) regardless of the gain or loss recognized in the future. This means you could have a taxable gain due to the California even if the eventual sale of the downstream property results in a loss.

• You must file Form FTB 3840 every year until the deferred gain or loss is recognized. You sell in 2024 and complete a valid 1031 exchange and have zero remaining footprint in California. You feel good. However, you will file FTB 3840 in 2024, 2025, 2026, etc. until some future sale triggers the recognition of a gain or loss for the 2024 transaction. Yay (not)!

Realized and recognized are terms of art in the accounting profession. In accounting geek-speak, realized gain is defined as the net sale price minus the adjusted tax basis. Recognized gain is the taxable portion of the realized gain. Don’t get too hung up on this.

Again, every state is unique, and every like-kind exchange is equally unique.

Backup Withholdings by Property Managers

Who wants to pick on California some more? Excellent. If you own a rental property in California and you are not a California resident, your property manager is legally obligated to do what the accounting industry calls “backup withholding.” Here is a blurb from their website–

California law requires withholding of tax by persons having the control, receipt, custody, disposal, or payment of items of income, commonly termed “withhold at source.” (Title 18 California Code of Regulations (CCR) section 18662-1(a)(1)). As a property manager providing services to nonresident property owners, including but not limited to renting, leasing, or collecting rent or lease payments on behalf of the nonresident owner, you are considered the withholding agent for California withholding purposes. As a withholding agent, you are required to withhold 7% on rent or lease payments to nonresidents when the total payments of California source income, excluding property management fees, exceed $1,500 for the calendar year.

Are there exceptions? Yes! Their website continues with-

For California withholding purposes, the following property owners are exempt from withholding:

1. California residents.

2. Corporations, Partnerships and LLCs registered with the California Secretary of State to do business in California, or who have a permanent place of business in California.

3. Estates where the deceased was a California resident at the time of death.

4. Nonresident owners whose gross payments do not exceed $1,500 in a calendar year.

Let’s say you lived in California, but you now reside in Texas leaving your home behind as an instant rental property. Your property manager is required to withhold 7% of your gross rent. This totally stinks if you have a tax loss since you now must file a California non-resident tax return just to get your tax refunded. California hopes you don’t of course.

Could you create a California LLC that owns your rental property to sidestep this requirement? Yes. However, you will be required to pay the annual Franchise Tax which is a minimum of $800 (for the 2024 tax year). We expand on the LLC fee next.

Doing Business in California

This section should be called California state return matters. We use California for a couple of reasons- first, they have aggressive tax law and second, a lot of states call it progressive tax law and adopt many of California’s initiatives.

Could you be considered doing business in California with your non-California rental property? Yes! Here is a blurb directly and very much self-servingly from California’s Franchise Tax Board 3556 LLC MEO–

Paul is a California resident and a member of a Nevada LLC. The Nevada LLC owns property in Nevada. The LLC hires a Nevada management company to collect rents and provide maintenance. Paul has the right to hire and fire the management company. He occasionally has telephone discussions from California with the management company in Nevada regarding the property. He is ultimately responsible for the property and oversees the management company. Paul conducts business in California on behalf of the LLC. The LLC must file Form 568.

It’s almost like they know you, right? Form 568 is California’s Limited Liability Company Return of Income where they assess your LLC’s tax obligation. Read the example about Paul above again. Although his LLC is in Nevada, he will have to file Form 568 as if his entity was registered in California.

California’s LLCs, including SMLLCs and MMLLCs, have an LLC fee based on gross receipts. On gross receipts! If your rental makes a $1,000,000 and incurs $950,000 in expenses, you still pay a franchise tax, called an LLC fee, computed on the $1,000,000.

The fee is “banded” as we say since it is not a straight calculation based on a percentage.

Gross Receipts	LLC Fee
250,000 to 499,999	900
500,000 to 999,999	2,500
1,000,000 to 4,999,999	6,000
5,000,000 +	11,790

Keep in mind the minimum Franchise Tax of $800 regardless of gross receipts. Is there an exception for rental property income? Nope! According to California’s website describing their shameless revenue generation-

LLCs are subject to an annual fee based on their total income “from all sources derived from or attributable to California” (R&TC Section 17942). Total income for LLC fee purposes is “gross income, as defined in R&TC Section 24271, plus the cost of goods sold, paid, or incurred in connection with the trade or business of the taxpayer.”

Yuck.