California’s Office of Tax Appeals Approves Drop and Swap Transaction In Important Decision for California Real Estate Investors by Robert S. Horwitz
When a partnership wants to sell real property it sometimes has a problem: some of the partners want to cash out while others want to do a like-kind exchange and remain invested in real property. The “drop and swap” transaction was designed to address this problem. Prior to the sale, the partnership distributes, in exchange for their partnership interests, tenancy-in-common (TIC) interests to partners who want to do a like-kind exchange. At the close of escrow, the partners will get cash distributed to them. The former partners will do a like-kind exchange through a qualified intermediary. To ensure that those partners who want to do a like-kind exchange do not prolong or disrupt a sale by not agreeing to terms the partnership finds acceptable, these transactions are normally structured so that the TIC interests are distributed after the partnership and the buyer have entered into a contract.
For several years, the Franchise Tax Board has scrutinized “drop and swap” transactions and, in late 2016, in In re Giurbino, a non-precedential decision, the Board of Equalization upheld the FTB’s determinations that such a transaction did not qualify as a like-kind exchange and that the taxpayers were liable for an accuracy penalty.
The newly-constituted Office of Tax Appeals has done an about face and held for the taxpayer in a drop and swap transaction in Appeal of Mitchell (8/2/2018). The facts in the case are similar to those in In re Giurbino. The partnership, Con-Med, owned rental property. It began negotiations with the lessee, which offered to buy the property for $6 million. Con-Med and the lessee entered into a contract for the sale of the property. Because two of the partners, the taxpayer and her mother, wanted to do a 1031 exchange, shortly before the close of escrow Con Med redeemed the taxpayer’s and her mother’s partnership interests and issued grant deeds transferring TIC interests in the property to them. The partnership, the taxpayer and her mother signed grant deeds transferring their respective partnership interests to the buyer. The escrow company transferred to a qualified intermediary the taxpayer’s and her mother’s aliquot share of sale proceeds. Subsequently, replacement property was identified and purchased for the taxpayer and her mother.
The OTA held an evidentiary hearing before a panel of three administrative law judges. The FTB argued that the transaction did not satisfy the exchange requirement because the partnership rather than the taxpayer sold the property. It argued substance over form, that the taxpayer was merely a conduit for passing title and that she never had any of the benefits or burdens of ownership. Finally it argued that the partnership made an anticipatory assignment of income. The OTA rejected the FTB’s arguments and ruled for the taxpayer.
The two judge majority held that the taxpayer “continuously held” an interest in the property for investment purposes and that she intended to exchange it for like-kind property. That the taxpayer’s ownership changed from holding through a partnership to direct ownership of a TIC interest was viewed as immaterial. Since she transferred her interest to a qualified intermediary she met the requirements of §1031.
The majority rejected the substance over form and step transaction arguments on the ground that for a number of years prior to the sale the partners had been discussing a sale that allowed some of the partners to do a like-kind exchange. A drop and swap was the only way to accommodate the wishes of the partners to either cash out or do a like-kind exchange.
With respect to the conduit argument, the majority held that since the grant deed to the taxpayer was valid on its face and Con Med negotiated on behalf of all its 17 partners, “that only Con Med’s name appears on counteroffers is simply a reflection of the state of the title to the Property at the time.”
In Court Holding, 324 US 331, the Court held that a corporation that negotiated a sale of property was in substance the seller taxable on the gain even though, prior to the close of the transaction, it had deeded the property to its shareholders, who signed the sales agreement, completed the transaction and reported the gain on their tax returns. The majority viewed Court Holding as inapplicable since it involved a corporation and was based on its facts. The case before it did not involve an attempt to avoid taxes, merely to defer them through a 1031 exchange. The majority also rejected the assignment of income argument on the ground that the partnership, as a pass-through entity, was not taxable on gain from the sale.
The dissent pointed out that the taxpayer was not involved in negotiations, was not mentioned in any of the counteroffers or the signed agreement and the redemption agreement recited that Con Med (not the taxpayer) was under contract to sell the property. Con Med handled the negotiations and sold the property. Additionally, rents were paid to Con Med during the entire period up to the sale date and Con Med paid all expenses associated with the property, not the taxpayer. Based on the notarized dates and filing dates, the deeds transferring TIC interests to the taxpayer and her mother were signed and filed one day before the deeds transferring the property to the buyer.
The dissent criticized the majority’s rejection of Court Holding, noting that it had been applied by both federal courts and the Board of Equalization to cases involving 1031 exchanges. It also pointed out that the facts in Court Holding were more favorable to the taxpayer since the shareholders were the only ones who signed any sales contract whereas here the partnership, not the partner, signed all sales documents. Thus, the dissent would have found that there was an assignment of income.
The dissent would also have found that in substance the transaction was a sale by the partnership, rejecting the taxpayer’s argument that the partnership negotiated the sale as her agent. Further, contrary to the majority, there was no evidence that the taxpayer’s mother negotiated a sale on behalf of the taxpayer. The dissent would have found that the partnership, not the taxpayer, negotiated and sold the property, and, therefore, the transaction was not a like-kind exchange.
The FTB has filed a petition for rehearing, which is currently pending. Because of the petition for rehearing, the opinion has not become final. Whether the OTA will deny the petition or issue a new opinion remains to be seen. If the OTA ultimately reaffirms its initial opinion and designates it as precedential, the FTB’s challenges to drop and swap transactions will finally be over and application of the like kind exchange provisions in California will be consistent with the more liberal federal interpretations.
For more information please contact Robert S. Horwitz – firstname.lastname@example.org or 310.281.3200 Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., former Chair of the Taxation Section, California Lawyers’ Association, a former Assistant United States Attorney and a formed Trial Attorney, United States Department of Justice Tax Division. He represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com