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§1031 Exchanges and the California Franchise Tax Board A Light at the End of the Tunnel?

§1031 Exchanges and the California Franchise Tax Board

A Light at the End of the Tunnel?

Over the past several years, our office has seen a heightened interest by the FTB towards §1031 exchanges.  In comparison with the IRS, it appears as though the FTB is taking a more narrow approach to many aspects of like-kind exchanges and has established a pattern of disallowing transactions that don’t fit within their unique interpretations of federal law. Most notably, the FTB is scrutinizing drop & swap and swap & drop transactions as well as strict adherence to the identification of replacement property and required documents.

§1031 prevents partners from exchanging their partnership interest for a property in a tax deferred exchange. Consequently, partners who have differing objectives are faced with a dilemma when selling partnership property. Drop & swap transactions involve exchanges whereby a partner receives a distribution of a tenants-in-common (“TIC”) interest in property (drop) and then exchanges for a like-kind property (swap).  Conversely, swap & drop transactions occur when properties are exchanged (swap) and then contributed into a partnership (drop). For years, these transactions were undertaken using the decisions in two tax court cases, Bolker and Magneson, as precedent.  Both of these tax court cases were taxpayer favorable and provided the real estate community with a foot hold to support their tax-free exchanges.

More recently, the FTB has aggressively challenged both of these transactions.  In the case of the drop & swap (Bolker), the FTB has challenged the structure if the sale of the property is negotiated by the partnership prior to the distribution of property to the partner. The FTB’s position is that the partnership is the seller and not the partner owning a TIC interest.  Swap & drop transactions (Magneson) have been challenged by the FTB as lacking the intent to hold the replacement property for use in a trade or business, which is required under §1031.

So where is the light at the end of the tunnel, you might ask?  A recent Board of Equalization (“BOE”) decision held in favor of a group of taxpayers who exchanged properties into TIC interests in replacement property followed by a contribution of the property to a partnership seven months later pursuant to a lender requirement. In re Rago Development Corp., the California BOE has unanimously overruled the Franchise Tax Board's disallowance of a like-kind exchange by a group of investors, holding that the exchange was valid under IRC §1031.  While the BOE's decision in favor of the investors in Rago was unanimous, the vote to make it a precedential formal opinion was 3 to 2.  The BOE Chair, Jerome Horton, was against making the opinion guidance that can be cited as precedent.  "The Rago case was fact-intensive and I voted for the taxpayers because the transaction was arranged in concert with the law, court cases, and IRS rulings," Horton said in an e-mail to Tax Analysts. "I voted not to adopt the decision as precedential because the case was based on a unique set of intricate facts and might mislead taxpayers to believe that the board somehow changed the application of existing law." 

We believe that the decision in the Rago case represents a message from the BOE to the FTB to retreat from their narrow interpretation of §1031 and to return to the standards supported in federal courts.  Regardless, §1031 exchanges with partners and partnerships require careful advance planning to avoid costly audit and appeals.  Please contact our office for further guidance at (949) 260-1430.

Written by Jeff Olson