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California Legislation Threatens Tax-Free Exchanges

California’s anticipated $20 billion budget shortfall is well-known and legislators are understandably scrambling for solutions.  Newly proposed AB 2640 was introduced in the California Assembly on February 19 and would raise revenues immediately.  In fact, its terms are retroactive to January 1, 2010.
Among other provisions, AB 2640 would tax gain from certain exchanges that are tax-free under federal law.
For example, Section 1031 of federal tax law provides that no gain or loss is recognized when business or investment property is exchanged for property of a “like kind.”  California has long-respected this non-recognition provision, but AB 2640 would require that those gains, exempt from federal tax, be taxed in California.  While 1031 exchanges apply to many types of property, they are most commonly used for real estate, allowing gains from the sale of one investment property to be rolled over into another investment property so long as the entire proceeds of the sale of the original property are used for the purchase of new property.  If AB 2640 is enacted into law, gain on the transaction will be taxed at California’s rates and, in order to qualify for the full federal tax exclusion, anyone wishing to complete a 1031 exchange will have to pay the California taxes from funds other than the proceeds of the sale of the original property.
AB 2640 also takes aim at two valuable corporate non-recognition provisions.  Currently, when a corporation issues its stock, whether in a public or private offering, it does not recognize gain or loss.  Section 1045 of the Internal Revenue Code also allows gain to be rolled over if a taxpayer sells “qualified small business” stock and rolls over the proceeds to another “qualified small business” stock within 60 days of the sale.  These two provisions allow corporations to effectively raise capital and favor investment in small businesses.  Both of these provisions will be eliminated with AB 2640, causing corporations to pay tax on stock issuances and discouraging additional investment in small businesses.
There are a number of other exclusions AB 2640 would eliminate, including the exclusion of gain on transfers between spouses when they are divorcing, non-recognition provisions that apply if property is destroyed or condemned and other provisions that relate to exchanges of insurance policies and corporate securities.
It seems unlikely that AB 2640 will become law with its sweeping changes.  It will, however, only require a majority vote in the California legislature to enact it.  The bill does not create any new taxes (which would require a 2/3 majority to enact), it simply removes some existing exemptions and exclusions.  It would certainly generate current revenues and alleviate the present budget crisis.  Over the long term, however, it does not increase overall revenues but accelerates them to the present.  The Legislative Counsel of the State of California allows you to track the bill’s progress at by entering “AB 2640” into the search line.
Anne E. Senti-Willis, Business Group