New Life in California for Drop and Swaps

Commercial office building on a sunny day. Real estate transactions.



A popular method of tax deferral with respect to real estate transactions is the use of the tax deferred exchange as allowed under Internal Revenue Code Section 1031. This allows real property held for use in a trade or business or held for investment purposes to be exchanged for different real property and defer some or all the tax on any gain that would have been paid on the disposition of the first property.

One of the challenges of this Code section occurs when property is held by a partnership; the exchange must take place at the partnership level. This can be problematic if there are partners that would prefer to recognize the gain and receive the cash or if some partners wish to use their share of the sales proceeds to exchange into their own replacement property. A popular technique often used to address this challenge is referred to as a "Drop and Swap".  This technique requires that a property that is held in a partnership be distributed to the partners as a Tenancy in Common (TIC) interest. Once this is distributed (generally tax-free), the owners of the property may then decide whether they wish to participate in the exchange or receive the cash and report the gain (or even exchange for property on their own).

Historically, the problem with Drop and Swaps has been successfully meeting the "Held For" requirement under the Code. Since the length of time the TIC interest must be held to satisfy this requirement is not specified in the Code, the California Franchise Tax Board (FTB) has been challenging these transactions when there is not a significant time between the "drop" and the "swap".

On August 2, 2018, the Franchise Tax Board Office of Tax Appeals (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, which is a significant departure from the FTB's position on this issue. While the current case cannot be relied upon as precedent (the FTB has submitted a petition for rehearing) it does indicate a potential change in how the FTB will be viewing these transactions in the future.

If you would like more information on how the opinion in this case might affect you, please consult your tax advisor for more information and analysis.

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