New Law Puts State, U.S. Tax Codes Out of Sync

By KATHY M. KRISTOF

Aug. 13, 1997 12 AM PT

SPECIAL TO THE TIMES

The newly enacted federal tax law creates a huge discrepancy between California and federal laws that will translate into an excruciating headache for many taxpayers, analysts say.

“From a tax preparation standpoint, it’s going to be a nightmare,” said Carolyn Kwock, analyst with tax publisher CCH Inc.’s state tax group. “There are definite differences between California and federal tax law, and we have no idea when--or if--the state is going to conform to the federal changes.”

A bill that would conform to some changes has been introduced in the state Legislature, but it wouldn’t go far enough. And it appears highly unlikely that a bill addressing the new, bigger changes would be passed in time for next tax season.

Although state and federal tax laws were once nearly identical, the newly enacted tax law vastly widens the current “conformity gap” between California and federal tax laws in such areas as capital gains, Social Security benefits, pensions, real estate and business deductions.

This gap, which began to yawn open in 1993, leaves California taxpayers vulnerable to a host of possible land mines that could result in their paying too much--or too little--tax to the state, tax experts say.

Even before the new federal tax law was passed, California and federal tax codes deviated from each other in more than 100 areas, said Tim Hayes, senior manager of the multi-state tax group at Deloitte & Touche in San Francisco. But those differences are less significant in comparison to the differences that will now exist as a result of the new tax bill, analysts said.

“What this means is Joe Taxpayer, if he’s careful, can file an accurate California return if he doesn’t sell his residence, or sell stocks at a profit, or own a limited partnership,” Hayes said. “But once he does any of those things--or if he starts his own business--he’s going to need a tax accountant.”

What makes the state tax morass most troublesome is a simple--and once reasonable--method of handling state tax forms. Back in 1987, when state and federal laws were parallel, California authorities revamped tax forms to use income figures that were reported on federal tax returns.

As a result, the starting point for filing a state tax return is to report the “adjusted gross income” figure that is reported on the federal form 1040.

But because California now allows some deductions that the federal government rejects and rejects some that the Feds accept, the state’s taxpayers have to go through the Byzantine exercise of “adding back” income that didn’t count for federal purposes or deductions that the state doesn’t allow. Conversely, taxpayers are advised to “subtract out” other income that doesn’t count for state tax purposes but does get taxed on federal returns.

Discrepancies between state and federal law occur in myriad areas, including capital gains, Social Security benefits, pensions and business deductions. But the area that might now be the most troubling to many California taxpayers is that of real estate sales.

The newly enacted federal tax law allows each taxpayer to exclude up to $250,000 in home sale profits from federal income taxes--regardless of whether he purchases another home. That rule, which took effect May 7, supersedes real estate “rollover” rules that allowed Americans to defer federal taxes on profits on residential real estate only if they bought another home of equal or greater value within two years.

The bottom line: If a person sells his home now and doesn’t roll the profit into another residence, he is likely to be pushed into the state’s highest marginal tax bracket, 9.3%, paying $9,300 in state taxes on each $100,000 in real estate profits.

That’s a lot less than the $28,000 or even $39,000 that person would have paid before the change in federal law, but it still may give pause.

Also, because of the way that state tax payments interact with taxable income on the federal return, paying state taxes on real estate profits could trigger the onerous federal “alternative minimum tax” because of high state income tax deductions.

To try to narrow this gulf between the laws, the state is weighing a tax conformity bill that aims to bring the state up to compliance with some--but not all--of the federal tax changes that were enacted in 1993 and 1996.

The bill is now hung up in an assembly appropriations committee. Whether it will actually pass this year is unclear. No one has even contemplated trying to mesh California law with the new federal tax changes yet, state legislators say.

“It would literally be next year before we would conform on some of these new issues,” said state Sen. Dede Alpert (D-Coronado). “Since some of the federal changes are retroactive, it does appear at this point that there will be some windfall [to the California treasury] if people are motivated by the federal law to do something before the end of the year.”

However, for taxpayers who don’t plan to take immediate advantage of the new tax changes in federal law, the biggest disadvantage to the increasing disparities between state and federal law is purely practical. It gets tougher and tougher to file a state tax return.

“The really sick thing is our [California’s] tax code consistently refers to [federal] Internal Revenue Code sections for guidance, but the code sections we’re referring to were only good as of Dec. 31, 1992,” said an Assembly staffer who asked not to be identified. “There’s a joke going around our office that if this tax conformity bill doesn’t pass, we’re all going to go into business selling copies of 1992 federal tax codes because they’re out of date and out of print. But having one would be the only way you could file your California return.”

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Tax-Time Headaches

These are just a few of the discrepancies between California and federal tax laws:

* Capital Gains

Federal: Allows the individual to pay a maximum of 20% on gains and securities sales as long as he or she held them for more than 18 months.

State: The individual pays at the ordinary income tax rate.

* Real Estate Rollover

Federal: Allows taxpayer to exclude up to $250,000 in profit from home sale regardless of whether he or she buys another home.

State: Allows taxpayer to defer tax on real estate profit only if he or she buys another home of equal or greater value.

* Social Security

Federal: Allows taxation of up to 85% of benefits.

State: Does not allow taxation of Social Security income.