It is well known that the state of California does not like “drop and swap” 1031 exchanges. A typical drop and swap scenario involves a partnership (or limited liability company) that owns real property it wishes to sell. Some partners would like to receive cash but others would like to defer their tax by engaging in an IRC Section 1031 exchange. To satisfy everyone, before the property is sold the partnership distributes it to the partners as tenants in common. This enables partners who wish to sell for cash to do so, and those who wish to do 1031 exchanges can engage a qualified intermediary for those exchanges.

The main issue presented by these exchanges is whether the partners who do exchanges ever held the property sold for “investment,” which is a requirement of IRC Section 1031. The issue is most likely to arise when the property is sold very soon after the partnership distributes it to the partners. A very brief holding period could be considered inconsistent with the notion of holding property for investment purposes. The IRS originally attacked these types of transactions but eventually gave up after losing the Magneson and Bolker cases. The California Franchise Tax Board, however, was not so easily deterred. It launched a major project to identify and challenge drop and swap exchanges.

Very recently, the California State Board of Equalization (“SBE”) heard a drop and swap case, In re Giurbino. A partnership entity, Aim LLC, entered into an agreement to sell its real property and an escrow was opened in the name of Aim LLC. Subsequently, the property was deeded to the members of the LLC and they completed the sale days later. Aim LLC originally filed its tax return reporting the gain recognized from the sale of the property. Some members reported their share of the gain on their income tax returns; however, the Giurbinos reported inconsistently and took the position they had completed a 1031 exchange. More than four years after the sale, and likely while the audit was ongoing, the Aim LLC tax returns were amended to reflect that the property had been distributed before the sale to the members of Aim LLC.

On this terrible set of facts, it was not a surprise that the SBE held in favor of the FTB, and determined that no 1031 exchange had occurred. However, the basis of the SBE holding is important for future cases. The SBE did not hold in favor of the FTB on the basis that the members of Aim LLC did not hold the property for investment. Rather, the SBE determined that, in substance, Aim LLC was the seller of the property rather than the LLC members. The key statement by the SBE is that by the time the property was deeded to the members of Aim LLC “the sale of the property was practically certain to be completed.”

This holding will not prevent the SBE from finding for the taxpayer in a future case with a better set of facts. Clearly, the property should be transferred to the partners or members well in advance of any documents being signed related to the sale of the property. All such documents should list the partners as the sellers and the partnership should not be a party to any of them. The property should also be transferred to the partners or members as far in advance of the sale as possible in order to provide the partners with a good position that they held the property for investment, should the FTB rely on that argument to challenge the transaction.