Section 1031 of the Internal Revenue Code allows for the deferral of gain on the disposal of business or investment property if the proceeds are re-invested in similar property and the transaction otherwise qualifies as a like-kind exchange. To qualify as a like-kind exchange, both the relinquished property and the replacement property must be held for use in a trade, business or for investment purposes. Determining what constitutes ‘held for use in a trade, business or for investment purposes’ has been a considerable source of contention between the Franchise Tax Board (FTB) and taxpayers over the last few years. This dispute has manifested in several cases involving like-kind exchanges structured as so-called “Swap and Drop” transactions.

In a typical “Swap and Drop” transaction, the taxpayer contributes the replacement property and/or proceeds from the sale of the relinquished property to a lower-tier LLC or partnership. This type of structure may be preferred when there are partners who would like to sell their shares of the relinquished property and other partners who would like to continue their tax-deferred investment in another property. Simply buying out the partners is generally not feasible because the partnership would likely have to refinance the original property to obtain the necessary cash for the buyout. Since like-kind exchanges require that the value of the replacement property be greater than or equal to the value of the relinquished property, the remaining partners would have to contribute additional cash or risk receiving a taxable boot in the exchange transaction, diminishing the benefits of entering into a tax-deferred exchange.

The FTB has previously taken the position that Section 1031 exchanges structured as a “Swap and Drop” transaction do not qualify for tax-deferred treatment because it views the transaction as an exchange of real property for intangible personal property (i.e. partnership interests, which are specifically excluded from the types of property eligible for tax deferral under Section 1031). The FTB has also argued that the “Swap and Drop” transaction precludes taxpayers from the requisite holding of the replacement property for use in a trade or business or for investment purposes because of the transitory nature of the replacement property’s ownership prior to its transfer to the lower-tier LLC or partnership.

However, the Board of Equalization (BOE) recently held that a Section 1031 exchange structured as a “Swap and Drop” transaction did, in fact, qualify for tax-deferred treatment*. In Appeal of Rago Development Corp., the corporation exchanged real property for TIC interests in replacement properties consisting of developed and undeveloped parcels. The taxpayer was required by its lender to consolidate its TIC interests in the developed parcels into a single purpose LLC within seven months of purchasing the properties. The FTB contended that the transaction did not qualify for tax-deferred treatment because the taxpayer failed to hold the replacement properties for use in a trade or business or for investment purposes and that the step transaction doctrine should be applied to recast the transaction as the taxpayers having received partnership interests in the LLC rather than real property as their replacement property. The BOE dismissed these arguments and held that the transaction was a bona fide continuation of the taxpayer’s investment in real property. Accordingly, the BOE held that the transaction was a valid exchange under Section 1031 and qualified for tax-deferred treatment.

The FTB has been aggressively auditing like-kind exchange transactions over the last few years. This decision, while not precedential, will impact several ongoing appeals under consideration. The BOE’s decision should provide some level of comfort for taxpayers engaging in “Swap and Drop” transactions. Please contact your SLD advisor for additional information at 415.397.4444.

* Appeal of Rago Development Corp., 2015-SBE-001, dated June 23, 2015.