California's Changing Approach to Like-Kind Exchanges

Internal Revenue Code (IRC) Section 1031 allows nonrecognition of gain or loss where property held for investment or for productive use in a trade or business is exchanged for like-kind property held for the same purpose. An issue arising under Section 1031 involves multiple owners of a real estate business entity holding one or more investment properties, where some owners want to maintain their investment while others want to cash out their investment. One common technique when the owners want to go their separate ways with investments is for the entity to redeem the interest of the member in exchange for an undivided interest in the property (a so-called “drop-and-swap”). Thereafter, the entity and the former owner join in the sale of the property to a buyer. Following the sale, the former owner can direct its share of the sale proceeds to a qualified intermediary to be reinvested in like-kind property without recognizing gain.

While California law conforms to Section 1031, the California Franchise Tax Board (FTB) has historically taken a much more restrictive approach than the IRS. Particularly in the area of drop-and-swaps, the FTB has disqualified attempted 1031 exchanges by asserting the step transaction doctrine and examining a series of integrated transactions as a whole. But in 2015, the California State Board of Equalization (BOE) departed from the FTB’s narrow interpretation of the rules, unanimously overruling the FTB’s disallowance of like-kind exchange treatment under Section 1031. The BOE does not often issue formal guidance that may be cited as precedent. However, the 2015 decision—In re Rago Development Corp., 2015-DBR-001— was issued as a formal opinion. The decision involved a “swap-and-drop,” which is an exchange followed by a capital contribution of the replacement property to an entity in return for an ownership interest in the entity. In that opinion, the BOE rejected the FTB’s assertion that the step transaction doctrine should treat it as though the taxpayer had exchanged real property interests for interests in an LLC.

More recently, in August 2018, the new California Office of Tax Appeals (OTA) (which replaced the BOE as an administrative board) issued an opinion rejecting the FTB’s disqualification of Section 1031 like-kind treatment based on the step transaction doctrine. In Appeal of Mitchell, the taxpayer held an interest in a general partnership owning a single property as its sole asset. The majority of the other partners sought to cash out their interest, but the taxpayer wanted to maintain her investment in real estate through a 1031 exchange. A sale of the property was arranged and the partnership redeemed the taxpayer’s partnership interest for a TIC interest in the property. Thereafter, through a qualified intermediary, the taxpayer’s proceeds from the sale were reinvested in qualified property outside of California.

The FTB issued a Notice of Proposed Assessment to the taxpayer in Mitchell, asserting that the transaction did not qualify as a 1031 exchange and that she must recognize gain from the sale of the property. Asserting the step transaction doctrine, the FTB argued that the taxpayer failed to meet the “exchange” requirement of Section 1031 because the partnership, rather than the taxpayer, made the sale of the property and the taxpayer was only a conduit for the sale.. On this point, the FTB stressed the fact that the partnership, and not the taxpayer, negotiated the sale of the property with the buyer. Additionally, the FTB asserted that the taxpayer did not satisfy the holding requirement for a Section 1031 property because she only held her TIC interest in the property for two days—the days between the redemption of her partnership interest and the sale of her TIC interest in the property to the buyer. The OTA disagreed.

As to FTB’s argument that the step transaction doctrine applied, the OTA referred to the Tax Court and Ninth Circuit decisions in Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985) and Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985) to ignore the series of integrated transactions accomplishing the exchange. In Magneson, the court acknowledged that combining the steps of a transaction may not be appropriate if the transaction could not have been achieved directly. In Mitchell, the fact that some of the partners sought to cash out their investment while others sought to continue their investment presented such a situation. The OTA also rejected the FTB’s support for the argument that the transaction failed because the taxpayer did not negotiate directly for the sale, since the taxpayer worked directly with the managing partner and the partnership’s attorney in structuring the multiple steps leading up to the sale. Further, in response to the FTB’s argument that the taxpayer did not “hold” the property for investment, the OTA explained that Section 1031 does not require ownership of the relinquished property for any period of time. Moreover, citing Bolker, the OTA noted that courts have allowed simultaneous or immediate transfers of replacement property following an exchange.

A potential distinction between the facts of Mitchell and Magneson is the nature of the interests held by the taxpayers. While both cases involved general partnership interests, Magneson involved a limited partnership and Mitchell involved a general partnership. While the court in Magneson did focus a significant portion of its opinion on the nature of a general partnership interest, it did not make any distinction based on which type of partnership the general partner held its interest in. Rather, the opinion explained the similarities between holding property via a general partnership interest and through a TIC interest. This portion of the decision, however, was mostly aimed at distinguishing partnership interests from corporate shares. Ultimately, the court in Magneson focused much more on the underlying property, providing that the “critical basis for [the] decision is that the partnership, in this case, had as its underlying assets property of like kind to the Magnesons’ original property, and its purpose was to hold that property for investment.”

In both Magneson and Bolker, the court reasoned that the individual transactions in either series would not have triggered a tax, and therefore the combination of transactions should not have triggered a tax. Following this reasoning, the OTA found that the transaction involved “the use of a series of reasonable, necessary, and integrated transactions to delay, not avoid, the recognition of gain, which section 1031 allows.” These decisions by the BOE and the OTA are an indication that California may be finally aligning itself with the federal standards for qualifying 1031 exchanges (although the FTB has not yet decided whether it will request a rehearing).

For more information, contact Tax Partner Jeffry Bernstein at Research analysis provided by Jessica N. Wilson.