Investors Fleeing California's High Tax, Urban Markets, Experts Say

The coronavirus pandemic appears to be intensifying an outflow of commercial real estate investment from California, West Coast real estate tax and investment experts said this week.

Chay Lapin, senior vice president at Kay Properties & Investments, was among several panelists in Bisnow's Tax Tips for Landlords webinar Tuesday who said a greater number of investors are looking to exit California's high-tax, urban markets. Lapin also said investors are already hedging against potentially significant cuts to the federal government's 1031 exchange program that could come with the election of former Vice President Joe Biden.

Before this year, California had already seen a mass of corporate relocations and watched plenty of residents leave, many of whom decamped because of the state's high cost of living, among other reasons like high taxes. Now, there is even greater uncertainty about the state's economy as residential and commercial rents are pushed down by the recession and remote work. 

“COVID and the election have caused investors to want to get out of metro areas," Lapin said. 

Kay Properties & Investments, a national Delaware Statutory Trust investment firm, is on track to facilitate about $500M in investment for the year, and a large portion will have come from investments leaving California, especially ever since the IRS-extended 1031 exchange deadline passed in July, Lapin said.

"Between that end of the extension and now, that’s when like 80% of our almost half a billion dollars of equity has come in, and all of that has been placed out of California," he said.

Lapin also said investors are already preparing for the possible election of Biden, the Democratic presidential candidate, whose campaign has proposed phasing out the 1031 exchange program for real estate investors earning over $400K in income.

“With the DSTs, people are diversifying, so they’re taking their couple million dollars and chopping it up into $200K to $300K chunks," he said. "As these DSTs roll over the next five to 10 years, they’d potentially maybe be under that and will be able to continue to defer."

Greenberg Glusker partner Michael Wiener, a tax attorney on the Tuesday webinar, said his firm has "consulted with a number of clients about potentially exiting California." Fewer clients actually end up leaving, Wiener said, because of an extreme difficulty to do so. 

"The shorthand way of saying it is, it’s like going into witness protection," he said. "You get to keep your name but not much else."

Wiener said he has seen a lot of California investors looking to do 1031 exchanges into out-of-state real estate, but many are surprised to learn they have to continue to file a return in California each year.

"When they eventually do a cash sale of whatever property they wind up exchange into, they’re going to be taxed in California on the California portion of the gain, and that’s something a lot of people don’t realize but are learning quickly," he said.

Scott Saunders, senior vice president with Asset Preservation, a Roseville, California-based intermediary company for 1031 exchanges, said a number of 1031 exchange investors haven't been able to find a new asset given this year's market volatility. That makes the Opportunity Zone program, which offers a tax deferral and tax-free gains, a good backup for many.

“We do have a fair number of exchanges that may set out to do an exchange but because of the markets today, they’re having a hard time finding replacement assets that meet their requirements," he said. "On day 46, they say, they haven’t identified anything and kind of change gears and go into an opportunity zone.”

Saunders, himself located in the Denver area, said he, like Lapin and Wiener, has seen investment shifts out of California's big cities or out of the state altogether.

"We’re definitely seeing people maybe come out of metropolitan type areas, and maybe they're relocating to the suburbs," he said. "Or we’re even seeing some capital move out of the West Coast, let’s say California, Oregon and Washington, and people exchange into markets like Texas, Florida, Arizona and Tennessee: some of those areas with either no state tax or a little bit more business-friendly environment."