BILL ANALYSIS
SENATE REVENUE & TAXATION COMMITTEE
Senator Lois Wolk, Chair
SB 1316 - Romero
Amended: June 16, 2010
Hearing: June 23, 2010 Tax Levy Fiscal: Yes
SUMMARY: Enacts a California New Markets Tax Credit;
Prohibits Out-of-State Properties from Qualifying
Taxpayers for Deferral of Capital Gains Taxes
under IRC 1031.
I. New Markets Tax Credit
EXISTING FEDERAL LAW provides a new markets tax credit
for taxpayer's qualified equity investments in community
development entities, the primary mission of which must be
serving, or providing investment capital for, low-income
communities or low-income persons, as certified by the
Secretary of the Treasury. The federal credit is equal to
39% of the qualified equity investment, and is spread over
seven years.
EXISTING LAW provides various tax credits designed to
provide incentives for taxpayers that incur certain
expenses, such as child adoption, or to influence behavior,
including business practices and decisions, such as
research and development credits and Geographically
Targeted Economic Development Area credits. The
Legislature typically enacts such tax incentives to
encourage taxpayers to do something but for the tax credit,
they would otherwise not do.
EXISTING LAW established the Community Development
Financial Institution credit (CDFI). Taxpayers may claim a
credit equal to 20% of qualified investments in the form of
deposits, loans, or equity investments of at least $50,000
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held for at least 60 months in California CDFIs certified
by the California Organized Investment Network. The
Franchise Tax Board (FTB) may recapture the credit within
the 60 month period if the taxpayer reduces or withdraws
the investment.
THIS BILL authorizes the California New Markets Tax
Credit Program to provide tax credits against the Personal
Income Tax and the Corporation Tax for a taxpayer that
holds a qualified equity investment on a credit allowance
date of the investment which occurs during the taxable
year, administered by the State Treasurer. The credit
shall be allowed for taxable years on or after January 1,
2011. The measure defines an equity investment as stock in
a corporation, other than nonqualified preferred stock, or
a capital interest in a partnership. The credit is equal
to:
5% of the qualified equity investment for the first
three credit allowance dates
6% of the qualified equity investment for the
succeeding four credit allowance dates.
THIS BILL defines a qualified equity investment as any
equity investment in a qualified community development
entity (QCDE) where the investment is acquired by the
taxpayer at its original issue, directly or through an
underwriter, solely in exchange for cash. The QCDE must
invest corporation invests 85% of the aggregate gross
assets for qualified low-income community investments, and
the corporation designates the investment for purposes of
this tax credit. Qualified low-income community
investments mean:
Any capital or equity investment in, or loan to, a
qualified low-income community business, a real-estate
project in a low-income community.
The purchase from another QCDE of any loan made by
that entity which is a qualified low-income community
investment.
Financial counseling and other services to
business and residents of low-income communities.
Any equity investment, or loan to, a qualified
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community development entity
THIS BILL defines a QCDE as a domestic corporation or
partnership that has as its primary mission serving, or
providing investment capital for, low-income communities
and low-income persons, low-income persons are represented
on the corporation's governing or advisory board, and the
Treasurer certifies the corporation as a QCDE. A domestic
corporation or partnership shall be deemed a QCDE if it is
either a specialized small business investment company or a
community development financial institution under the
Internal Revenue Code.
THIS BILL defines a qualified active low-income
community business as a corporation, non-profit
corporation, partnership, or sole proprietorships that:
Derives at least 50% of its total gross income from
the active conduct of a qualified business in a
low-income community.
A substantial portion, defined as 40% or more of
the tangible property of the entity, of the use of
tangible personal property of the entity, whether
owned or leased, is within a low-income community.
Less than 5 percent of the average if the average,
unadjusted base of entity's property is attributable
to collectibles.
Less than 5 percent of the average of the aggregate
unadjusted base of the property of the entity is
attributable to nonqualified financial property.
THIS BILL defines low-income community as census tracts
where:
The poverty rate is at least 20%, or
The tract is not located within a metropolitan area
and the median family income does not exceed 80% of
the statewide median family income, or.
The tract is located within a metropolitan area and
the median family income does not exceed 80% of the
greater of the statewide median family income or the
metropolitan area median income, or.
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The tract is designed within a high migration rural
county, defined as a tract with net out-migration of
10% of the county population in the last twenty years,
and the median income does not exceed 80% of the
statewide median family income.
THIS BILL also allows a community in a location that
is not tracted for population census tracts to qualify by
using equivalent county divisions instead of tracts.
Communities with populations of less than 2,000 within
federally-designated empowerment zones also qualify if it
is contiguous to a tract that qualifies under the above
criteria.
THIS BILL provides that the Treasurer shall allocate
the credit, with priority to applications that either
demonstrates a record of successfully providing capital or
technical assistance to disadvantaged individuals and
communities. The measure requires the Treasurer to
prescribe regulations, guidelines, or procedures to
implement the credit.
THIS BILL requires the taxpayer to recapture
credits previously utilized to reduce tax if the QCDE
redeems the investment, the investment ceases to be used in
the required manner, or the entity ceases to be a QCDE.
THIS BILL caps the aggregate amount of credit in any
calendar year shall be equal to the aggregate revenue
increase from limiting like kind exchanges to property
inside California (see Part II). A qualified community
development entity is required to sell equity interests
eligible for the credit to investors within five years of
the date the entity receives allocation from the Treasurer.
THIS BILL makes findings stating that the purpose of
the program is to promote economic development and hasten
California's economic recovery by granting tax credits for
investment in California.
II. Out-Of-State Like Kind Exchanges
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EXISTING LAW provides that all income, including
wages, capital gains, dividends, and interest, is taxed at
the same marginal rate according to the taxpayer's taxable
income. A capital gain is realized and taxable at the time
of sale of a capital asset; however, federal law (Section
1031 of the Internal Revenue Code), to which California
conforms, allows taxpayers to defer capital gains taxes
when they acquire real or business property of a "like
kind" 180 days after selling property properties of a
similar nature and character, such as an apartment complex
in Tustin for an apartment complex in New York City, or
trading in an old taxi cab for a new one, but not financial
instruments. The basis of the property received, usually
its cost must be equal to the basis of the property sold,
less any cash received by the taxpayer, and further
adjusted for any loss or gain on the exchange. Exchanges
among multiple parties qualify for deferral, and must be
arranged by third-party intermediaries.
THIS BILL provides that the deferral for capital gains
shall not apply to out of state real property that is
received in exchange for real property located in
California.
THIS BILL makes findings regarding the lack of
benefits of out-of-state like kind exchanges to the people
of the State of California, the legitimate purpose for
disallowing like-kind exchanges to instead foster greater
economic development within California's borders, that the
lion's share of the tax benefit of like kind exchanges
exists at the federal level, and that the current economic
climate precludes achieving economic development purposes
through a non-discriminatory alternative.
FISCAL EFFECT:
According to FTB, if amended according so amendments
suggested in Comment E, SB 1316's revenue increases
attributable to limiting like kind exchanges equals revenue
losses attributable to the California New Markets Tax
Credit for the 2010-11, 2011-12, and 2012-13 fiscal years.
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COMMENTS:
A. Purpose of the Bill
The author provides the following statement:
"California currently offers a range of tax credits
that are of no direct benefit to the state. In a time of
economic uncertainty, it is prudent to examine such tax
credits and consider a better use of General Fund dollars.
One such program is the 1031 exchange program, offering tax
credits for real estate investments. A portion of this
program (ten percent) awards tax credits to private
investors who purchase out-of-state properties. This
portion of the 1031 exchange program is of no direct
benefit to California.
With California's economy still faltering, it is more
prudent use of General Fund dollars to stimulate direct
investment in California, rather than continue to fund tax
credits for investments in out-of-state properties -
essentially subsidizing private investment activity outside
California."
B. Do You Kind of Like Like-Kinds?
Since 1921, Congress has allowed like kind exchanges
to defer capital gains taxes, helping to facilitate
transactions for real and business property. The IRS's
Publication 544 is an excellent guide to understanding how
these exchanges work. Basically, if a taxpayer holds
non-personal property and sells it, the difference between
the sale prices and the basis, which is usually a taxable
capital gain, can be deferred if the taxpayer subsequently
purchases property of a similar nature and character. An
investor buys an apartment complex for $200,000 (her cost
basis). After six years she sells the property for
$350,000, typically resulting in a taxable capital gain of
$150,000. If the investors invests the proceeds from the
$350,000 sale into another apartment complex identified
within 180 days, then she could defer any taxes on the gain
at that time. If she subsequently sells the replacement
apartment complex without another like-kind exchange, the
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gain would be taxable. SB 1316 precludes an investor from
deferring the gain if the taxpayer purchases replacement
property that is not in California, and does not affect the
ability for the taxpayer to defer the gain for federal
purposes.
Critics of these exchanges state that Congress enacted
like-kind exchanges to avoid disputes and litigation
between the IRS and taxpayers over valuation issues, which
are no longer relevant because of modern technology and the
evolution of third-party brokers, which facilitate many
exchanges.<1> Additionally, critics argue that many
taxpayers simply defer gains over multiple transactions
until they die, resulting in taxpayers never incurring
capital gains taxes on a lifetime of buying and selling
investment property. Critics add that the federal
government could realize $4 trillion in a decade by
repealing this deferral. Proponents of SB 1316 state that
state conformity is undesirable because many taxpayers will
make the same transactions without state deferrals because
federal tax consequences are much greater than state ones,
and add that out-of-state exchanges make even less sense
because the taxpayer is rewarded for economic activity
taking place in other states.
Opponents of SB 1316 argue that disqualifying
exchanges for out-of-state property will be less likely to
invest in California if they know that a subsequent
transaction may be treated as taxable. Opponents also
assert that the tax benefit leads to additional real estate
investment, thereby stimulating the economy. Opponents add
that taking California out of conformity with federal law
will create additional administrative burden,
C. New Markets and Old Credits
California currently offers a tax credit very similar
to SB 1316's proposed new markets tax credit, the Community
Development Financial Institution (CDFI) credit, which the
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<1> Johnson, Calvin. "Impose Capital Gain on Like-Kind
Exchanges." The Shelf Project, Tax Notes Vol.121, p. 475
(2008)
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taxpayer can only claim for loans of $50,000 or more made
to CDFIs. According to FTB, only $113,000 worth of credit
was applied for in 2006. SB 1316 proposes a much larger
program, equal to the annual amount of revenue recovered by
prohibiting out-of-state properties from qualifying an
investor for a like-kind exchange deferral, around $44
million annually. SB 1316's credit is almost identical to
the federal New Markets Tax Credit, enacted in 2000 and
intended to draw in additional investment to low-income
communities. Under the federal program, the U.S. Treasury
allocates credits to QCDEs, which then award the tax
credits to investors in exchange for cash. The qualified
community development entity then directly invests in
low-income communities. According to the CDFI Fund, more
than $26 billion in new market tax credits have been
allocated since its inception. SB 1316's credit is not a
state credit for the same investments currently applied
against federal income taxes; instead, the measure allows a
separate credit against California income and corporation
taxes for qualified investments made in QCDEs designated by
the Treasurer.
D. The Not So Dormant Dormant Commerce Clause
The United States Constitution grants the power to
Congress to "regulate Commerce with foreign nations, and
among the several states, and with the Indian Tribes;" a
provision widely known as the Commerce Clause (Article I,
Section 8). If Congress fails to regulate interstate
commerce wholly or in part, the United States Supreme Court
has asserted consistently that the Constitution still
precludes states from doing so, known as the "dormant" or
"negative" Commerce Clause.
Opponents argues that SB 1316's preclusion for
taxpayers to defer capital gains in a like kind exchange
when acquiring out-of-state property violates the Commerce
Clause by inhibiting flows of capital across state lines.
Without the same tax treatment, they argue that SB 1316
provides an unconstitutional preference for in-state
commerce. Proponents counter that disqualifying
out-of-state property from exchanges and enacting a New
Markets Credit meets the Constitutional muster because the
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bill serves a legitimate state purpose by reallocating tax
benefits for activity out-of-state for much better uses
within the State. No clear case law on the subject exists.
E. Suggested Amendments
FTB suggest the following amendments to SB 1316 to
make the New Markets Credit a credit based on a one-year
investment.
Taxpayers may claim the New Markets Tax Credit
beginning in the 2012 tax year, not the 2011 tax year
for one year. However, the investment must be
maintained for seven years or be subject to recapture.
Instead of taxpayers claiming five percent of the
equity investment for the first three credit allowance
dates, and six percent of the equity investment for
the succeeding four credit allowance dates, the credit
shall be equal to 39% of the investment in the first
year.
Removes the ability of the Treasurer to reallocate
unused credits after five years.
FTB shall estimate, not certify, the revenue effect
to ensure revenue neutrality.
Instead of permanently limiting taxpayers from
using out-of-state property as replacement property in
like kind exchanges, the limit applies only for the
2011 taxable year.
Support and Opposition
Support:AFSCME
Oppose: California Association of Realtors, First
American Corporation, Federation of Exchange
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Administrators, California Apartment Association,
Investment Property Exchange Services, California Bankers
Association, California Chamber of Commerce, California
Building Industry Association, California Taxpayers'
Association, California Financial Services Association,
Building Owners and Managers Association of California,
California Business Properties Association, Commercial Real
Estate Development Association, International Council of
Shopping Centers, and California Land Title Association
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Consultant: Colin Grinnell