California FTB Scrutinizes Section 1031 Exchanges but Allows Some Too

Section 1031 exchanges of California property can be accomplished.

There is a greater risk of disallowance by the California Franchise Tax Board than by the United States Internal Revenue Service, and, therefore, you really need to know a good California lawyer and meticulous care should be given to compliance. In terms of applying California's Revenue and Taxation Code, the California statutory analog of the U.S. Internal Revenue Code, the California Franchise Tax Board is applying the same provisions of federal statutes and regulations as the U.S. Internal Revenue Service does. However, in pursuit of incremental tax revenues, the California FTB independently and energetically interprets the Internal Revenue Service's exacting requirements in an even stricter manner, sometimes taking scrutiny to another level entirely.

Some of the possible ways that the California's Franchise Tax Board has defeated taxpayers' positions in a 1031 situations include those below, which are primarily random examples, and definitely do NOT present the full scope of the FTB's past, present or future regulatory and audit activities in this area.


Be Aware How Property Identification Can Trip Up an Otherwise-perfect Section 1031 Exchange.

Any inconsequential variance between the property identified by the 45th day and the property acquired by the 180th day is heavily scrutinized. For instance, assume that a taxpayer sells a property for $100,000 and identifies an undivided 10% co-tenancy interest in a known property as replacement property (Note: he has not identified the property in terms of a known dollar amount and an unknown percentage). If the price for the replacement property goes down after the time when the property had been identified, then the value of 10% goes down. A person with a fixed number of dollars to exchange should acquire a larger-percentage co-tenancy interest than expected, except that, if the taxpayer identifies a percentage ownership and then increases that percentage in the actual transaction, then the difference in percentage is deemed in the FTB's playbook to be unidentified and therefore taxed. The Franchise Tax Board considers the difference between the originally identified percentage and the actual percentage as unidentified excess and therefore, to that extent, not qualifying as replacement property.

Be Aware How the Step-Transaction Doctrine Disqualifies an Otherwise-perfect Section 1031 Exchange.

In a step transaction, at each step a different person or entity could own the property, and pass the property one to the other, and the step-transaction doctrine is a legal supposition that asks whether the law would permit the first person or entity in that chain to do that deal, beginning to end, or not. While the actual owner at each step may change, under this legal fiction, whoever or whatever began as the owner or controlling person before the supposed "first-step" transaction is required to justify an ability under Section 1031 to itself directly exchange its original property for the property ultimately received by a different taxpayer in the "final step" of a supposed "step transaction".

Step Transaction Examples:

#1. Entity Negotiates Sale then Distributes Property to Owners who then Complete Sale Intended to Begin 1031 Exchange Process ("Drop and Swap").

The Franchise Tax Board applies the step-transaction doctrine and disqualifies this transaction because the entity participated in the sale process, which makes it, so the Franchise Tax Board considers, an additional participant in the 1031 transaction. The legitimate grounds for disqualification of the Section 1031 exchange are premised entirely upon a fiction, conjured to result in failing under Section 1031.

#2. Owner Conducts 1031 Exchange and Then Contributes the Replacement Property to An Entity ("Swap and Drop").

An exchange followed by a capital contribution of the replacement property to an entity in return for an ownership interest in the entity is considered a "step transaction" by our FTB. In the first step of this scenario, the taxpayer has given up real property and in the last step the taxpayer has received intangible personal property (a membership or partnership interest), which is not a "like-kind" exchange.

#3. Exchange and then Borrow.

If post-closing borrowing is planned before the exchange, the Franchise Tax Board considers the taxpayer's borrowing to be part of a step transaction and in a Section 1031 exchange all of the un-reinvested cash is considered to be boot.

Be Aware How Real Estate Options Can Taint a Section 1031 Exchange.

The Franchise Tax Board bases some disqualifications on a finding that a contract or option was intrinsically related to the transaction and exchange of this option or other contract actually took place. The FTB's position is that the option or contract is personal property, and a real estate option is not real estate. Unless real estate is exchanged for real estate, it cannot be a Section 1031 "like-kind" exchange.

Know and Comply with California's Reporting Rules.

The position of the California Franchise Tax Board is that gain or loss from the exchange of property located in California is California-sourced income that must be reported to the FTB when the gain or loss is ultimately recognized (i.e., when the replacement property is subsequently sold). The Franchise Tax Board recently indicated that one of its top auditing issues involves taxpayers not sourcing gains to California upon disposition of Section 1031 replacement property. To further the FTB's efforts to raise tax revenues, the FTB tracks deferred gains or losses on Section 1031 Exchanges for taxpayers or replacement properties outside California and requires taxpayers to file annual reports.