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Golden State Considers Increased Taxes: California Legislative Update

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Several proposals are under serious consideration in California aimed at increasing taxes imposed by the state; these include proposed legislation that would regularly assess property tax values for commercial properties (reversing Proposition 13) rather than only on a change of ownership; other proposals would retroactively increase taxes on higher-income individuals, and impose a new individual “wealth” tax. The impact of these proposals is discussed below.

Split-Roll Property Tax Legislation

California’s acquisition-based system for real property valuation was passed by voters 42 years ago under Proposition (“Prop.”) 13 in an effort to curb ballooning property taxes caused by rising property values. The system establishes a base assessed value from the purchase price of the property. Thereafter, increases in a property’s assessed value are capped at 2% per year until there is a change of ownership or new construction value is added. Property tax is then determined by multiplying the property tax rate by the assessed value.

Prop. 15, the California Schools and Local Community Funding Act of 2020, as proposed on the November ballot, would convert most commercial property to a current market valuation system. If passed, California counties would assess “commercial and industrial” real property at current market value. However, Prop. 13 would continue to apply to residential properties and excluded commercial properties.

Excluded commercial properties are properties with a market value below $3 million, adjusted every 2 years at the county level for inflation. For purposes of this exemption, however, a property’s market value is calculated in combination with the market value of all commercial properties in the state in which any direct or indirect beneficial owner of the property owns a direct or indirect beneficial ownership interest. As such, if a property owner has an ownership interest in multiple properties, and the aggregate sum of all those properties exceeds $3 million (as adjusted), all properties would be subject to the new proposed current market valuation system, even though, standing alone, each individual plot of real estate may be worth far less than the $3 million safe harbor figure.

Solar energy systems, which are currently shielded from assessment under a “new construction” exclusion, would be subject to the new market valuation system under the bill. In an effort to rescue California solar projects from new economic pressures if voters pass Proposition 15, Assembly member Ting introduced AB 105, a legislative measure which would treat solar energy systems as personal property, effectively exempting such projects from Prop. 15.

If passed, the first tax year would be 2022-23 (for July 1, 2022 through June 30, 2023). Thereafter, the bill provides for a phase-in of reassessment over several years, but leaves the process to be determined by the California Legislature.

Prop. 15 is subject to a vote on the November ballot, and if enacted, could significantly disrupt the California commercial real estate market and cause increased costs to businesses operating in California. It would introduce a clear “split-roll” system in which commercial property would bear a disproportionate share of the tax burden.

Proposed Income Tax Rate Increase

California legislators considered an additional tax on high income which would apply retroactively to taxpayers with incomes over $1 million. Specifically, AB 1253 would impose a surcharge on incomes (joint or single) at the following levels:

  • 1% on income between $1,181,484 and $2,362,968 (a marginal tax rate of 14.3%);

  • 3% on income between $2,362,968 and $5,907,420 (a marginal tax rate of 16.3%); and

  • 3.5% on income over $5,907,420 (a marginal tax rate of 16.8%).

The thresholds of $1 million, $2 million, and $5 million are adjusted for inflation.

Currently, California’s income tax rates, which are 13.3% at the highest bracket, are the highest in the nation. If such a proposal were enacted, California’s top income tax rate would rise further, to 16.8%. While the rate increase was not enacted before the legislative session ended on August 31, it is likely that rate increase may be reintroduced in the next session.

New Wealth Tax

A wealth tax proposal introduced by Rob Bonta in the California Assembly, AB 2088, would impose a 0.4% tax each year on a “resident” individual’s worldwide net worth exceeding $30 million (or, in the case of a married taxpayer filing separately, net worth exceeding $15 million).

Generally, individuals subject to the wealth tax would report the value of all assets to the California Franchise Tax Board, including stock in publicly and privately traded corporations; interests in partnerships, private equity or hedge funds; cash, bonds, and savings accounts; mutual funds, futures and options; art and collectibles; offshore financial assets; pension funds; and non-mortgage debt.

The wealth tax proposal has some specific carve-outs. For example, certain liquidity-constrained taxpayers, such as startup businesses, could elect to defer liability. In addition, directly held real property value and mortgages or liabilities secured by directly held real property would not be considered in calculating a taxpayer’s worldwide net worth.

California “residents” subject to the proposed bill’s wealth tax include full and part-year residents who are already subject to California income tax as residents. The bill also creates new categories of “Temporary Residents” and “Wealth Tax Residents” subject to the tax. High-net worth “temporary residents” include individuals who maintain domicile elsewhere and are not in the state long enough to be subject to income tax; they would have their worldwide net worth taxed at a percentage reflecting the number of days they were in the state.

The “wealth tax resident” category is defined broadly to include wealthy ex-Californians for 10 years after they leave the state; they would owe 90% of the wealth tax in the first year they left, 80% in the second year, and with continuing reductions thereafter.

The bill was not passed before the legislative session ended on August 31, but Bonta has already announced plans to introduce the bill again next session.

If passed, a California wealth tax would be the first of its kind in the United States and would be challenging to implement. For example, assessment of a person’s net wealth presents complex administrative hurdles (e.g., the Franchise Tax Board would have to determine the value of various assets, such as fine art). In addition, the use of a resident taxation methodology to impose the wealth tax on individuals who are no longer California residents may be subject to constitutional challenge.

Impact on California Business and Individuals

Supporters of these initiatives believe that these measures are necessary to counter widening budget deficits and income inequality, particularly given the economic difficulties associated with the COVID-19 pandemic. California, however, is already a high tax state, and the pandemic has shown many businesses they can conduct business from almost anywhere. As a result, further increases in taxes may influence many businesses and individuals to consider relocating to states with more favorable tax regimes and economic incentives, such as Texas (which has no personal income tax, does not have a “split-roll” property tax, and offers significant state and local level incentives to encourage businesses to invest within Texas).

 

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