Liquidity Events, the Interim Home Problem, and Determining the Date for Changing California Residency: A New FTB Case Sheds Some Light

 

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The Case

A new case from California’s Office of Tax Appeals brings some clarity to how strictly California dates a change of residency for income tax purposes when a resident moves out of state shortly before a liquidity event. The case, Appeal of J. Bracamonte, OTA, Case No. 18010932 (May 2021), emphasized the importance of how much time a resident spends in California after the purported move. Bracamonte also sheds light on the “interim home” problem, which occurs when a resident moves into an out-of-state rental pending purchase of a permanent home in their new home state, while retaining ownership of their former primary residence in California. Finally, the ruling – probably inadvertently – seems to provide guidance on the date for determining when a taxpayer’s residency status is relevant to a liquidity event (the date of the closing, the date of the income receipt, or the date when an enforceable agreement is in effect). The case can be found here.

Background: How Does California Date a Change of Residency?

Changing residency from California is binary: it happens on a specific date. How do we know that? The Franchise Tax Board, California’s tax enforcement agency, requires that a resident leaving California identify the specific date of the residency change on Schedule CA of the Form 540NR “Part-Year” return, which exiting taxpayers, with few exceptions, have to file for the year they move. The exact question on the schedule is: “I became a California nonresident (enter new state of residence and date (mm/dd/yyyy) of move).” By the way, nonresidents moving to California also have to complete Schedule CA, conversely disclosing the date they become residents.

It bears mentioning that changing residency is a legal concept, and most taxpayers don’t know the rules or how to apply them to a calendar. This means there is no easy answer to when a residency change occurs. In fact, it can be totally counterintuitive. When the FTB asks an ambiguous question, it’s usually intentional. The FTB hopes the taxpayer will make a mistake that might be advantageous to the tax authority. Serendipitously, the taxpayers in Bracamonte did just that, originally putting a move-date on their 540NR that made no sense factually, something they were grilled about during trial, presumably eroding their credibility in the eyes of the court.

More to the point, since the date of a residency change can have enormous tax consequences, you would expect that California would have clear guidelines for calculating it. Simply put, recognition of gain is subject to California income taxes before the date a California taxpayer changes residency, whereas after that date, the gain is free of California taxation (leaving aside sourcing issues). In a large capital event, millions of dollars of income taxes can ride on what exact day a taxpayer’s residency status changed. That’s exactly the issue faced by the taxpayers in the Bracamonte case.

But in fact, California has provided almost no direction on how to fix the move-date for residency purposes. Only a handful of cases address the issue, all with various degrees of vagueness. The best we can say, stitching together the opinions, is that to change residency from California usually requires a showing of three elements, more or less: (a) the resident occupied an abode in their new jurisdiction; (b) the resident’s intent was to move there permanently or indefinitely; and (c) the resident arranges to have weightier contacts on the home-state side of the ledger than on the California side. Let’s dignify this bundle of factors with the name “the Move-Date Rule.”

This Move-Date Rule is actually a (somewhat incoherent) mash-up of the rules for determining domicile (discussed here) and the facts and circumstances/closest connection test (discussed here). The incoherency arises from the fact that the closest connection test includes a comparison of time spent in each jurisdiction after the move-date, which assumes that the move-date has already been established as a point of reference. But the move-date itself is determined in part by counting the days where the taxpayer spent time afterwards. The vicious logic is evident. In addition, all this is subject to the “two-year rule,” a court-created standard which states that normally, for purposes of determining residency, an absence for two years or less from California is considered only temporary and transitory. This would seem to imply that the move-date can’t even be determined until at least two years have passed after it has been asserted. A Catch-22.

But there is no point in cursing the move-date darkness. The rule, such as it is, leaves the taxpayer in a state of uncertainty as to what constitutes the date of a residency change. The situation, therefore, calls for erring on the side of caution, as the taxpayers in the Bracamonte case learned to their detriment.

The Interim Home Problem

This brings us to the Interim Home problem. It’s not uncommon for taxpayers to move out of state and rent a place for a period of time while they look for a permanent home to purchase, or while having a new home built. The interim home is just that: an abode where a former resident lives during the interim between leaving California and occupying their permanent dwelling in their new home state. The intent is to move permanently to the new tax jurisdiction, even if the interim home accommodations are temporary. The issue arises, can taxpayers claim the date when they occupied an interim home as their move-date on the 540NR, or does the Move-Date Rule require the date only apply to the subsequent move into the permanent home.

Arguing from general principles, there is no reason that moving into an interim dwelling can’t be used as the date for a residency change. This is made obvious in situations where the taxpayer sells a California home and moves into an interim home, pending purchase of a permanent residence. All other contacts being equal, it would contradict the Move-Date Rule for the FTB to argue that such a move didn’t show intent to relocate out-of-state permanently. The taxpayer literally wouldn’t have an abode in California to compete with the out-of-state interim home as a primary residence. But if occupying an interim home is sufficient to demonstrate intent to change residency to a new state in that case, there is no reason on its face that it is inconsistent with a residency change where a California property is retained after the move. It just means that the taxpayer still has to meet the burden of the closest connection test, which requires conduct sufficient to show intent to move to another state, not to a particular address.

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quote for NFT sourcing article

The lesson here is, never use the term “temporary” while describing your interim home in a residency proceeding

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In the normal course, the Interim Home problem has little consequences if the taxpayer in fact moves into a bigger, better dwelling in their new home state after only a short time during which the income taxes at issue aren’t substantial. At that point, the nonresident status is usually beyond doubt. With no real monetary incentive to challenge the earlier move-date, the FTB rarely does. But the Interim Home problem becomes acute in circumstances where a liquidity event is contemplated. In that case, if the gain is recognized while the taxpayer is still living in the interim home, it gives the FTB an incentive to argue that the move-date didn’t occur, if at all, until the permanent home was occupied. In contrast, if the taxpayer moves into the permanent home before the liquidity event, even just a day before (residency is binary), then that argument is forestalled. This is exactly the problem the taxpayers in Bracamonte faced.

Facts of the Bracamonte Case

The taxpayers were a married couple who lived in and were residents of California through 2007. They owned a valuable aviation services company, which would ultimately sell for over $17 million, the crux of the tax dispute. In early 2008, before contemplating the sale, the Bracamontes decided to move to Nevada. They rented an apartment in Henderson, Nevada, in anticipation of finding and buying a home there, and they undertook the usual formalities for changing residency (relocating financial accounts, noticing professionals of their new address, obtaining Nevada driver’s licenses, registering to vote in Nevada, registering a vehicle there, retaining medical professionals, and so forth).

In May 2008, the Bracamontes were contacted by a prospective buyer of their company. The parties signed papers in June, and the transaction closed on July 18.

Before the closing, but after their purported move to Nevada, the couple spent about 90 days at their large, expensive California home, with less than a month in Nevada, as well as some time at a second vacation home in Arizona. They also kept three vehicles registered in California (something the court remarked was “noteworthy”). The transcript of the oral hearing indicates the taxpayers claimed that the time was spent “wrapping up” their contacts in California.

After the closing, the couple terminated their post office box in California, registered the California vehicles in Arizona, and (finally) bought a home in Nevada, which they occupied in September of that year.

The taxpayers filed a nonresident return for 2008 (a Form 540NR), claiming they changed residency on February 26, 2008, the date they occupied their interim home. The FTB asserted that the couple failed to change their residency before July 18, but conceded the change happened in September, when they moved into their permanent Nevada dwelling. The tax consequences resulting from the differing dates was the basis of the dispute: if the Bracamontes changed residency before the $17 million transaction in July, they owed no income taxes to California on the gain (the basic rule is a nonresident’s’ taxable income is not subject to California income taxes unless it has a source in California, and capital gains from entity sales generally do not). In contrast, if they didn’t change their residency until after the sale closed, then the transaction resulted in over $1.5 million in California income taxes.

The court ruled against the taxpayers. The reasoning was as follows. Because the Bracamontes failed to show by their conduct that they intended to move permanently to Nevada before the closing date and that they had shifted the preponderance of their contacts to Nevada, their time outside of California was deemed temporary or transitory. Two factors played a prominent role in the opinion. The first was that the taxpayers rented a place in Nevada, buying a house only after the transaction closed (“their possession of their apartment was marked with impermanence,” according to the opinion). The second was that after their claimed move-date, they spent more time in California than in Nevada.

The court conceded that the Bracamontes were in the process of moving to Nevada and genuinely took action to find and purchase a permanent home there. But the “interim home” they rented before actually buying the permanent home was insufficient to support a residency change. The taxpayers didn’t help their case at trial by emphasizing the temporary nature of their interim home. From the transcript:

Q: Why did you want to go rent an apartment in Nevada?

A: Oh, well, we needed a temporary place to live. We didn’t know how long it would take to buy a house. So, we thought the best situation for us would be renting an apartment for a while, while we house hunted and found a house.

The lesson here is, never use the term “temporary” while describing your interim home in a residency proceeding. When asked about what personal property they moved into their interim home, Mr. Bracamonte answered all-too honestly: “[W]e only took from San Diego what we needed to as far as bedding, a bed, a nightstand, lamps, chairs, a table. We took linens, you know, towels, some dishes with us. It was just – it was just temporary as far as we were concerned.” Nor did it help that they retained ownership of their large expensive home in California and used it during this period for a significantly longer time than their interim home. They didn’t even hire a moving company, which suggested to the court that the center of their lives remained in their California home.

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quote for NFT sourcing article

There are costs and inconveniences related to becoming a nonresident while retaining significant contacts in California

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The Takeaway

The case offers some guidance for dating a change of residency, along with negotiating the related “interim house” issue, particularly in the context of a large liquidity event happening in the same tax year as the move out of state. The items potentially relevant to residency planning are as follows:

Spending Less Time in California Than Your Home State After the Move-Date

To bring some certainty to a claimed date of residency change, a taxpayer can’t spend more time in California than in their new home state after the residency change during the balance of the year after their move (something that shouldn’t be done in subsequent tax years either). It’s not that taxpayers can’t spend any time in California after a residency change. But any time in California after the move-date counts against you on the residency ledger. A reasonable amount of time, consistent with a temporary purpose (vacation, winding down affairs in California, business trips), is acceptable. But spending more time in California after a residency change during the same tax year vitiates the claimed move-date, as the Bracamonte court concluded. And note that it’s California vs. your new home state, not California vs. the world; a plurality rule, not a majority rule (that is, spending less than six months in California is not a sufficient way to conceive a residency plan). Time spent in other states doesn’t help you in the ledger analysis (see, “The Six-Month Presumption in California Residency Law: Not All It’s Cracked Up To Be”). This is particularly important where a liquidity event is contemplated. The taxpayers in Bracamonte apparently hadn’t anticipated the sale when they moved; it appeared on their radar scope after they occupied their interim home. But to comply with the Move-Date Rule, at the very least they needed to avoid spending more time in California than in Nevada. Of course, many residents leave California in full anticipation of a liquidity event. In that case, if enough is at stake, enduring the inconvenience of not only limiting time in California after the move-date, but not returning at all during the same tax year may be the prudent course of action (it cost the Bracamontes over $1.5 million in taxes for the pleasure of returning so frequently to California after the move).

There are costs and inconveniences related to becoming a nonresident while retaining significant contacts in California. Where the recognition of a large amount of capital gain is planned, spending little or no time after the move-date may be one of them. In the next tax year, the issue of spending more time in California can be revisited.

Moving into an Interim Home: the “Near and Dear” Test

The Bracamonte case didn’t foreclose a move-date related to occupying an interim home. It did make clear, however, the taxpayer has to actually move into the interim home. That means more than just buying pots and pans and a mattress. The concept (from other residency cases) is that the taxpayer has to move items into the interim home that constitute the center of their lives. During trial, while questioning Mrs. Bracamonte, the court called it the possessions that are “near and dear” to a person. The exchange bears repeating:

Q: Now, every family, especially, the mom and daughters and the like, and they always have things that they kind of consider to be – for a lack of a better expression – kind of, like, near and dear to them. It could be a momento. It could be a vase. It could be a number of things. Did you have any of those near and dear types of possessions in Nevada while you were in the apartment?

A:  Not while I was in the apartment, no.

Leaving aside the gratuitous mansplaining by the judge, the case was probably lost at this point.

What constitutes the “near and dear,” the items that are the center of your life, is different for every person. To expand on the court’s list, it might include things like important documents, family heirlooms, valuable artwork, your best china, your favorite lounge chair, whatever. What you don’t want to do is to have those items remain in your California property (as the Bracamontes did), because then, in retrospect, it may look like you never really moved to the interim home as a primary residence. Of course, you are entitled to have a nice vacation home in California with nice things in it, while having a principal residence in a new state. But there should be some indication that the center of your life was moved to your interim home pending the occupancy of your permanent residence to avoid having the interim home look like a vacation home, while the center of your life remains in California, which is what happened to the Bracamontes. While the particulars remain unclear, a resident moving to an interim home out of state should make some effort to move something important from their former California residence. And it needs to be memorialized, so that, if you are audited, you can say with evidentiary support that you “moved into” the interim home. One of the problems with the Bracamonte trial was that the couldn’t remember details such as this. It’s not surprising; the case came to trial 12 years after the events. This is why an effective residency plan involves systematically keeping a contemporaneous file of “residency facts” that may come up in a residency proceeding, such as what near and dear possessions were moved into an interim home.

To repeat the mantra: there are costs and inconveniences involved in effective residency planning. Where an interim home is involved, it may entail renting a large, unfurnished abode, enduring higher moving costs to furnish it with items from the former California residence, and undertaking a second move into the permanent home. The background question is always whether the taxes at stake warrant the burden.

Remember: It’s a Ledger

The taxpayers in Bracamonte had other options. They clearly wanted to keep their former residence as a vacation home (which is also true of almost all of our clients: comprehensive residency planning is usually only necessary for former residents who retain significant contacts in California after their move). But it’s not an either/or situation. The Bracamontes could have prevailed if they had listed their California property, moved into the interim home, and then later, after the liquidity event, purchased or rented a second home in California (preferably with accommodations inferior to their Nevada property, which by then they would have purchased). Or the taxpayers could have rented out the California home, essentially converting it to an asset rather than a second home competing with their interim home for the status of primary residence. Sometime after the liquidity event, when the lease terminated, they could have resumed using the property as a vacation home. Or the taxpayers could have transferred the California property to an irrevocable trust for the benefit of their children (if that made sense for estate planning purposes in any case). To summarize: whatever accommodations you have in your new home state are always evaluated in the context of the accommodations you retain in California. And you are in control of that, though it may mean delaying enjoyment of the property for a while. Again: cost and inconvenience is built into the system for nonresidents.

Our Thought Bubble

The FTB conceded that on the date the Bracamontes purchased the home in Nevada and moved into it (along with the other conduct they engaged in to reduce their California entanglements), they became nonresidents. The court’s opinion didn’t rely on this concession, so it is not part of the ruling. However, it provides insight into the FTB’s thought process in liquidity event situations. Taxpayers leaving California who purchase a home in your new home state which compares favorably with their California property, if any is retained, and occupy it before the recognition of gain in an entity sale, can point to the Bracamonte case if the FTB disputes the move-date. This assumes all the other factors of a residency change are met.

Our Second Thought Bubble

There was a second timing issue in the case, which the court didn’t address directly. Namely, the timing of the transaction itself. In the sale of an entity interest, is the relevant date for inquiring into the seller’s residency status (a) when the escrow closes; (b) when the income is actually received; or (c) when constructive receipt occurs based on the existence of an enforceable agreement. The court accepted the closing date as the date relevant to the taxpayer’s residency status, without comment. This is presumably helpful to residents moving from California pending an entity sale, since it’s often the case that an enforceable agreement comes into effect well before the closing date. Presumably, under Bracamonte, a taxpayer could enter into a purchase and sale agreement (or M&A agreement or an IPO plan), and move out of state before the date of the closing, and claim the gain is not subject to California income taxes. In fact, the case invites taxpayers selling an entity interest to delay the closing for just this purpose. However, this is probably wishful thinking. The court didn’t have to rule on the transaction date issue to reach its conclusion, and might have ruled differently if the matter had been central to the tax dispute. Further, there is other authority that argues California doesn’t use the closing date for application of residency status, but rather the existence of an enforceable agreement. This would seem to make sense to avoid the perverse incentive of delaying closing in order to get out of Dodge. But in a pinch, the case offers a favorable argument.

An historical note: California actually did try to define by statute how to determine the transaction date for residency change purposes. It took the form of Rev. and Tax. Code section 17596. It was a disaster. The statute read:

“When the status of a taxpayer changes from resident to nonresident, or from nonresident to resident, there shall be included in determining income from sources within or without this State, as the case may be, income and deductions accrued prior to the change of status even though not otherwise includible in respect of the period prior to such change, but the taxation or deduction of items accrued prior to the change of status shall not be affected by the change.”

Several cases determined under section 17596 focused haplessly on interpreting the meaning of income “accrued prior to the change of status,” a phraseology that California’s own tax agencies at the time found “obscure,” “troublesome,” and “enigmatic.” It led to contradictory and incoherent rulings, and ultimately, the section and its successor were repealed, leaving the issue in limbo.

Our Third Thought Bubble

During oral arguments, the FTB didn’t focus on the Move-Date Rule per se, but rather the benefits the taxpayers received from California, including legal processes and business ties, and the taxpayer’s confusion in using an earlier move-date in their nonresident return, which conflicted with Nevada voting law. Significantly, the court basically ignored these matters. File this under: parties put on one case; judges see another.

By the way, the transcript of the residency proceeding can be found here. It should be required reading for residents thinking of moving from California to an interim home pending a liquidity event, as a blueprint for how not to plan a residency change when a large amount of capital gain is expected to be recognized shortly after a move-date. Virtually every error that could be made in planning for a residency change in those circumstances, was.

 

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Manes Law is the premier law firm focusing exclusively on comprehensive California residency tax planning, on a fixed-fee basis. We have over 25 years of experience in successfully assisting Californians to change their legal residency, businesses relocating to other states, and nonresidents purchasing vacation homes or investment property in California. We serve a clientele of successful innovators and investors, including founders exiting startups through a sale or IPO, Bitcoin traders and investors, professional actors and athletes, and global citizens able to live and work anywhere. Learn more at our website: www.calresidencytaxattorney.com.

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No information contained in this post should be construed as legal advice from Justia Inc. or the individual author, nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction.

 

 

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