California’s Office of Tax Appeals Gives Hope to Drop and Swaps (in California)
On January 28, 2020 the California Office of Tax Appeals (OTA) delivered its opinion denying a Petition for Rehearing of the appeal of Sharon Mitchell, OTA Case No. 18011715. This opinion let stand the OTA’s decision of August 2, 2018 that allowed a partner to redeem her partnership shares for a tenancy in common (TIC) interest in real estate and shortly thereafter exchange that TIC interest in a Section 1031 like-kind exchange.
Sharon Mitchell was a 10% partner in the partnership that owned a parcel of real property. The partnership negotiated and entered into a contract to sell that real property. A few days before closing, the partnership deeded a 10% TIC interest in the real estate (which was the sole asset of the partnership) to Sharon Mitchell so that she could accomplish a Section 1031 like-kind exchange. At closing, Mitchell and the partnership each delivered deeds for their respective interests to the buyer.
The California Franchise Tax Board (FTB) denied exchange treatment on the basis that the partnership was the real seller of the property and that its conveyance of the TIC interest to Mitchell was simply a step transaction that lacked economic substance, as the conveyance was only done so that Mitchell could accomplish a Section1031 exchange. Originally, the FTB argued that Mitchell did not meet the holding requirement, that the partnership had been the holder of the real estate, and that she acquired the TIC interest with the intent of almost immediately transferring it to a third party (the buyer). The FTB did not raise the holding argument on appeal.
The OTA ruled on August 2, 2018 in favor of Mitchell, holding that she completed a 1031 exchange of her 10% TIC interest and stating:
“…a 1031 exchange can be preceded by a tax-free acquisition of the relinquished property or followed by a tax-free transfer of the replacement property. Here, appellant’s 1031 exchange was preceded by a tax-free acquisition of the relinquished property. The redemption of her partnership interest in exchange for the TIC interest was not taxable. (IRC sec, 731(a)(1).) Allowing the integration of the steps as a 1031 exchange serves section 1031’s purpose of promoting continuity of investment.”
The FTB filed a Petition for Rehearing, and on Jan 28, 2020, the OTA denied the Petition and affirmed the decision in favor of Sharon Mitchell. The OTA ruled that the previous Opinion was not contrary to law. The OTA reiterated their prior findings that Mitchell was the seller of her 10% of the property and that the parties to the transaction “did what they thought was required to accomplish their diverse objectives.” The OTA further explained that Mitchell had followed the plan set out by the partnership’s managing partner and attorney to transfer a partnership interest to direct ownership of real estate in order to accomplish a valid Section 1031 exchange.
The OTA did not accept FTB’s argument that Ms. Mitchell’s transaction lacked substance. Rather, the OTA responded that there was no other way for Ms. Mitchell to structure the transaction. The OTA summarized its finding on that matter by stating,
“The exchange was not a sham. The parties engaged in a series of reasonable, necessary, and integrated transactions to accomplish a 1031 exchange. There was no last-minute decision to change the parties to the sale.”
This is certainly a taxpayer friendly decision by the OTA. However, the OTA’s decision is not binding on the Internal Revenue Service nor is it any guarantee that the FTB won’t continue to challenge drop and swap transactions. The FTB’s position is that the exiting partner doing the exchange hasn’t held the property for investment, the partnership has, and moreover, that the taxpayer acquired the TIC interest with the express intent to sell it, thus making it inventory (disqualified property). Additionally the FTB believes that the seller of the relinquished property is a party other than the taxpayer.
We encourage our clients to be cautious and to consult with competent tax counsel, especially when engaging in a drop and swap transaction. There is still considerable risk of exchange treatment being denied at both the Federal and state level, including California.