For several years, the California Franchise Tax Board has had a project to identify and challenge certain exchanges of real property for which taxpayers have sought treatment under IRC Section 1031 as tax-free exchanges. The particular types of exchanges in the sights of the FTB are referred to as “drop and swap” and “swap and drop” exchanges.

In a drop-and-swap exchange, real property is held by a partnership or limited liability company. At the time the property is to be sold, some partners wish to sell for cash, while others wish to complete a 1031 exchange. To accommodate these competing interests, the partnership might first distribute undivided interests in the property to retire the interests of the partners who want to complete like-kind exchanges. These partners would hold the distributed interests as tenants in common with the partnership, which would continue to hold the interests for the partners who want to sell for cash. The partnership and each partner holding a tenancy-in-common interest all enter into an agreement to sell the property to a buyer. Upon the closing of the sale, the partnership receives cash, and the proceeds that would be due to the individual sellers are paid by the buyer to a qualified exchange intermediary so those sellers can purchase qualified replacement property and complete a 1031 exchange. In a swap-and-drop exchange, a taxpayer exchanges real property under IRC Section 1031 and shortly after obtaining the replacement property contributes it to an entity, such as a partnership or limited liability company.

The IRS challenged both types of exchanges many years ago on the basis that the short holding period between the taxpayer’s receipt of the property from a legal entity and the its sale, or acquisition of replacement property and the transfer of it to a legal entity, precluded the taxpayer from having held the property for investment, a requirement of IRC Section 1031. (The taxpayer must hold both the property he sells and the replacement property for investment.) After losing a series of court cases, the IRS abandoned its position for the most part.  

The federal cases favoring taxpayers have not deterred the FTB, however. The Board has disallowed like-kind-exchange treatment in numerous drop-and-swap and swap-and-drop exchange transactions. In the recent case of Rago Development Corporation (June 23, 2015), the California State Board of Equalization unanimously found in favor of the taxpayer on a swap-and-drop exchange. Two different groups had each sold property and jointly acquired a property referred to as Sand Creek Crossing to complete their like-kind exchanges. The Sand Creek Crossing property was purchased on June 30, 2003, and held by the two groups as tenants in common. The two groups arranged to obtain financing on this property, but the lender required that it be owned by a single-purpose limited liability company, and the property was transferred by both groups to Sand Creek Crossing LLC on Jan. 31, 2004, some seven months later. 

The Franchise Tax Board challenged the exchange on two grounds: (1)  the taxpayers did not hold the property for investment prior to transferring it to Sand Creek Crossing LLC, and (2) the step transaction doctrine should be applied to recast the exchange as one of real property for a membership interest in Sand Creek Crossing LLC, which would not be a like-kind asset under IRC Section 1031.

Relying heavily on the federal cases and a case from the Oregon Tax Court that it found persuasive and well-reasoned, the SBE first determined that the taxpayers did hold the Sand Creek Crossing property for investment. Under the analysis of the federal cases, their interests in Sand Creek Crossing LLC were merely a continuation of their investment in the real property under a different form of ownership, not a cashing out of the investment. 

The SBE then turned its attention to the step transaction doctrine, which holds that where a taxpayer engages in a series of transactions or transaction steps, any meaningless step can be ignored by the taxing authority, and the transaction can be recast as though the meaningless step had not occurred. The FTB viewed the taxpayers’ seven-month holding of the replacement property as a transitory and needless step, and proposed to reconfigure the transaction as an exchange of real property for an interest in a limited liability company, which is not considered like-kind under IRC Section 1031.

In finding for the taxpayers on both positions raised by the FTB, the SBE emphasized the fact that the taxpayers held the property for seven months before transferring to a legal entity, and a lot can happen in seven months. The SBE also pointed out that the transfer to the legal entity was as a result of a requirement imposed by a third party, in this case the lender. Whether the SBE would come to the same conclusion in a case in which the taxpayer completes a like-kind exchange and then transfers the property to a legal entity the same day or the next day remains unclear, and caution dictates holding replacement property for at least several months prior to any transfer of the property to a legal entity.

We will also have to wait for another case to see whether the SBE will find in favor of the taxpayer in a drop-and-swap exchange. If it continues to follow the federal cases, it should find for the taxpayer, but only time will tell.