California Decision Opens Door to Like-Kind Exchange Treatment For Drop and Swap Exchanges With Partnerships/LLCs

The California Office of Tax Appeals (OTA) has issued a decision that provides authority for California taxpayers to do drop and swap and similar swap and drop Sec. 1031 transactions. The decision gives California taxpayers flexibility in structuring Sec. 1031 tax-deferred exchanges from partnerships and LLCs. The decision applies only to California taxes, but the reasoning in the case may be persuasive to IRS.

Background

Owners of a closely held real estate business frequently own interests in multiple partnerships or LLCs, with each entity owning one or more rental or investment properties. When the owners decide to go their separate ways, the properties must be divided up. One approach is to divvy up these properties in a drop and swap transaction. To execute a drop and swap, the entities distribute fractional interests in the properties to the owners and then the owners exchange interests with the end goal of one or more owners owning all of the interest in some of the properties, but no interests in other properties. The California Franchise Tax Board (FTB) has taken an aggressive stance against drop and swap and similar swap and drop (where the exchange is followed by a tax-free transfer of replacement property into a partnership) for Sec. 1031 purposes. IRS has also challenged such transactions in connection with federal income tax.

Appeal of Sharon Mitchell

On August 2, 2018, the OTA decided in a 2-1 vote in Appeal of Sharon Mitchell (Mitchell) that a taxpayer received Sec. 1031 exchange treatment where immediately before the exchange the taxpayer received, by way of partnership redemption, distribution of relinquished property from a general partnership followed by a Sec. 1031 exchange into replacement property. While the Mitchell decision involves a general partnership, it is not limited to general partnership interests and the decision implies that it should also apply to limited partnership or LLC interests. According to the OTA’s opinion in Mitchell, Sec. 1031 does not require ownership of the relinquished property (or replacement property) for any period of time, which is actually a departure from prior law on this issue.

Significant to the OTA was the fact that there was a valid business purpose for doing the redemption of the real estate to the exchanging partners before the exchange. The redeemed partner’s motivation for doing a Sec. 1031 exchange of one investment property for another investment property was regarded as an adequate reason to first redeem the relinquished property from the partnership and then immediately perform a Sec. 1031 exchange into the replacement property.

The Mitchell decision applies only to California taxes. IRS is not required to follow the case for federal income taxes, but the precedent and the arguments from the decision may be persuasive for IRS.

FTB had until September 1, 2018 to request an OTA rehearing. We understand, as provided in the Rules for Tax Appeals, the decision was issued to the parties and a petition for rehearing was subsequently filed. As a result this decision will not be officially posted by the OTA (i.e., available for public inspection) until the petition for rehearing is resolved.

The Takeaway

The Mitchell decision provides that a taxpayer may receive Sec. 1031 treatment for California tax purposes where the exchange is preceded by a tax-free acquisition of the relinquished property from a partnership (i.e., drop and swap) or where the exchange is followed by a tax-free transfer of the replacement property into a partnership (i.e., swap and drop). The OTA asserts that allowing taxpayers to integrate these steps is in keeping with Sec. 1031’s goal of continuity of investment. Whether IRS will find the decision to be persuasive is uncertain, and the decision may be subject to rehearing for California purposes as well.