Since starting this blog, I’ve written a number of posts about various issues involved in the use of Section 1031 tax-deferred exchanges for commercial real estate. I’ve previously discussed the stumbling blocks that can emerge when record title is held in a partnership or LLC, and the partners/members disagree about how to proceed with a proposed exchange—the so-called “drop and swap” scenario, where the partners/members “drop” the property out of the partnership or LLC before moving forward with a “swap” (exchange) to sell the property and acquire replacement property .
If the exchange involves commercial property located in California, another consideration that can add to these complications is the fact that the Franchise Tax Board (“FTB”) has demonstrated its willingness over the years to challenge the use of this tax deferral method. The FTB has pursued this goal in two different ways: (1) Rigorously enforcing the relevant provisions of the Internal Revenue Code, and (2) adopting regulations for these transactions that are, in some instances, even more stringent than the Code.
In the matter of In Re Giurbino, a ruling issued in November 2016 by the state Board of Equalization (“BOE”) dealing with a protest by a married couple of a tax and penalty assessment arising out of a “drop and swap” exchange of commercial real estate, the FTB’s antipathy towards this practice was on full display. In that case, the LLC holding title to the property (a) listed it for sale, (b) entered into a sale agreement, and (c) opened escrow for the sale, not in the names of the married taxpayers, but rather in its own name, all in the space of three months; only then, mere days before close of escrow, did the couple take title to the real property. Remarking on these events, the BOE noted: “At that time, the sale of the property was practically certain to be completed.”
The FTB disputed the couple’s claim of deferred gain from the disposition of the property on the ground that the timing of the “drop and swap” failed to satisfy the requirements for such treatment under existing case law. In its decision upholding the FTB’s assessment, the BOE concluded that the couple’s intentions, as demonstrated by the circumstances surrounding the manner in which title had been held, pointed to the LLC as being the actual owner and seller of the real estate, rather than the taxpayers.
As such, the BOE determined that the couple was instead acting as the agents of the LLC, and not as the owners of the property, based on the brief period of time that the asset was in their names. The BOE thus held that the sale did not qualify for Section 1031 tax-deferred treatment, and affirmed the FTB’s assessment of nearly $500,000 in tax. In addition, due to a variety of irregularities in the handling of these tax issues by the couple, the BOE also sustained the FTB’s assessment of an “accuracy-related penalty” of nearly $100,000.
If you are an investor who utilizes LLCs or partnerships as vehicles for the co-ownership of California commercial real estate, and you are concerned about the outcome in this case, keep in mind that this case presented unusually egregious positions being taken by the taxpayers—a roadmap of what not to do, as it were. Your key takeaway should be this: Discuss with your co-owners your respective plans for entering into an exchange as far in advance of a contemplated sale as possible. That way, if some of you wish to cash out while others want to acquire other investment property with the proceeds in order to take advantage of Section 1031 tax treatment, there will be enough time prior to the sale (1-2 years) to transfer title to the real estate out of the name of the LLC or partnership and into the names of the co-owners as tenants in common. Taking such action will allow the owners who wish to enter into an exchange the ability to prove that they are in fact holding the property for investment and not for sale.
The BOE’s decision in this case can be found here.