Section 1031 tax-deferred exchanges and their intricacies have been a substantial aspect of my law practice for many years, and are a regular feature in my blog. Given the large number of commercial property transactions in the San Francisco Bay Area involving highly appreciated real estate, it is hardly a surprise that I have spent a significant portion of my legal career providing advice and counsel in connection with these matters. From my perspective, one important reason for this emphasis has been the fact that the restrictions imposed on these exchanges under the tax codes and regulations are so complex, exacting and unforgiving.
Successfully taking advantage of the benefits of tax deferral demands the careful planning, timing and execution of the purchase and sale of the relinquished property and the replacement property in order to comply with these mandates. This precision and attention to detail is frequently beyond the ken of even the most sophisticated commercial real estate investors. As the Rolling Stone Record Guide once sarcastically described the effects of Deep Purple’s catalog, Internal Revenue Code Section 1031 and its accompanying regulations and other authority can give one a painful headache, among other things.
As such, one of my motivations for writing on this subject is the fact that, for many property owners, trying to understand the rules for Section 1031 tax deferral can be daunting, so I want to help clarify these issues as much as I can. This is even more true when, despite one’s best efforts, the exchange fails, which can happen for a variety of reasons. For example, a taxpayer may be unable to identify suitable replacement property within the mandatory time limits after the sale of the relinquished property or may be unable to acquire the identified replacement property within those time limits. These situations make it clear that competent, expert advice and guidance are critical in dealing with problems of this sort.
Besides having skilled legal counsel, one of the most important decisions one can make in pursuing a Section 1031 exchange is the choice of the qualified intermediary. The qualified intermediary plays a key role in the exchange, stepping in the shoes of the owner participating in the exchange transaction to ensure that the owner does not take actual or constructive receipt of the sales proceeds, which would vitiate the exchange. While it is critical that the qualified intermediary know the requirements of tax deferred exchanges inside and out in order to competently handle the transaction, and be financially able to stand behind its obligations in these transactions, some intermediaries may step too close to the line in their efforts to help the owner salvage a failed exchange.
Recently, the California Franchise Tax Board issued guidance about practices that it has observed regarding failed exchanges and the efforts of taxpayers and qualified intermediaries to preserve some tax advantage in those situations. Specifically, the FTB noted that it has become aware of arrangements where either a taxpayer or a qualified intermediary engages in efforts to transform the “boot” (excess cash received) from an exchange or the proceeds of a failed exchange into an installment contract or some other similar transaction where payments are spread over a period of several tax years, in an effort to defer tax. Notwithstanding such endeavors, however, the FTB points that deferral of gain is not authorized in these arrangements; specifically, they note that Sections 1031 and 453, along with the federal tax doctrine of constructive receipt, do not support deferral of recognition of gain in those situations.
With regard to these above-described arrangements, starting with those exchanges where the sale of the relinquished property closes on or after March 24, 2020, the FTB will begin to impose failure to withhold penalties on qualified intermediaries that participate in these arrangements and did not withhold 3⅓% of the sales price as required under California law based on their asserted deferral of gain. The FTB has now taken the position that, if an exchange fails or otherwise does not satisfy all of the requirements of Section 1031, the qualified intermediary must withhold 3⅓% of the sales price or elect an alternative withholding calculation based on the gain required to be recognized. Unless the qualified intermediary can show that its failure to withhold was based on reasonable cause, the FTB will impose a failure to withhold penalty equal to the greater of $500 or 10% of the amount of tax that should have been withheld.
The Franchise Tax Board guidance may be read here.
Dan, another good article as always.
With regards to a failed exchange and withholding, would putting the capital gains into an Opportunity Zone fund still require the withholding? It would seem a reasonable solution to a failed exchange. Your thoughts?
Obviously, the client should do their due diligence to find the appropriate investment that meets their needs if this is a viable strategy.
Thanks for the kind words, Marty.
You pose an excellent question, which I was just discussing with Mary Kay Kennedy, an attorney with First American Title who used to work with First American Exchange. My thought is that the FTB guidance specifically called out IRC 453 and 1031 and constructive receipt as not supporting gain deferral, and did not mention OZ gain deferral. Thus, on the one hand, OZ rules provide a separate ground for gain deferral, but on the other hand, withholding is a separate CA tax law issue. My guess would be that the institutional qualified intermediaries will likely err on the side of caution and withhold, and leave it up to the taxpayer to deal with getting a refund if there is gain deferral; private intermediaries may be more flexible (which is part of the reason why the FTB issued this guidance).
From my own research, I agree that the withholding will still be required. I suspect there will still be ample funds to invest regardless if appropriate; and then the taxpayer will have to file the necessary paperwork to get their appropriate refunds.
Thanks for the response.
Dan,
What are your thoughts on a “Deferred Sales Trust”? Specifically when one can defer his capital gains beyond the $500,000 for a married couple? Please advise
Hi Ron, I’ve never had any direct experience with deferred sales trusts, so I can’t comment on them from my own knowledge. Since they sound more like an estate planning tool, I discussed your question with the estate and tax attorneys here at Ferrari Ottoboni. They have not handled deferred sales trusts here, but they have researched them on behalf of clients who were interested in alternative tax deferral strategies. Their take was that there are two difficulties with deferred sales trusts: (1) In order to avoid taking constructive receipt of the sales proceeds, which would render the sale immediately taxable, the taxpayer cannot have any control over those proceeds, which requires a great deal of trust on the taxpayer’s part towards the trustee of the deferred sales trust. (2) The fees charged by the trustees for its services are substantial. I also found a recent interesting article on deferred sales trust that you may find helpful: https://www.forbes.com/sites/peterjreilly/2019/06/18/deferred-sales-trust-a-tax-plan-or-a-product-a-bit-of-both/#60eb7719347c
Thank you. Very helpful
Dan,
I received this link some time ago regarding installment sales. It does not reflect favorably on them. Please read at the following link: https://www.ftb.ca.gov/tax-pros/law/ftb-notices/2019-05.pdf
I suspect you will be able to better comment on the PDF. In what was sent to me, the author’s comments were:
“Attached is FTB Notice 2019-05 in which the California FTB has officially put taxpayers and Qualified Intermediaries on notice of its position that the “fallback,” “1031 rescue,” “Deferred Sales Trusts,” “Monetized Installment Sales,” and other quasi 1031 / 453 conversions are invalid.
FTB withholding will be required (unless the taxpayer is otherwise exempt) whenever there is boot or a failed exchange involving California relinquished property, regardless of any attempt by the Exchanger to convert the exchange into an installment sale. If the QI does not withhold, it will be subject to a failure to withhold penalty. The FTB will not assess penalties for these exchange / installment transactions in which the relinquished property is sold prior to March 24, 2020.”
It appears that investors may be able to utilize the DST if the property is sold prior to 3/24/20. Again, I will leave the legal interpretations to you. Hope this helps.
Thanks for this information, Marty, it is very helpful.
You are welcome.