Good News for Drop and Swaps

Over my 39‑year career advising real estate clients on Section 1031 exchanges, I have never encountered a more common (nor more frustrating) question than the following:  

“How long do we need to hold a property (either before or after an exchange) to qualify for tax-deferred treatment?”  

While I was well-schooled on the issue, I was never really satisfied with the answer I was giving, which went something like this – 

“Well, you should wait at least one filing period, preferably two, to age the transaction, but you still run the risk that, on audit, the agent (most likely from the FTB) will argue that you did not meet the held for the requirement.”  (1) PLR 8429039 – Two years of business or investment use is sufficient to meet the requirement that the property was held for the requisite intent.

Not very comforting advice for a client-facing a potential six-figure gain.  

Well, thanks to 2 administrative law judges serving in the Office of Tax Appeals (OTA) for the State of California, practitioners are emboldened to now give a little more definitive advice in this area  (2) Appeal of Mitchell, 2018-OTA-210.

The most common of techniques for which the question mentioned above is relevant is the Drop and Swap. For those of you who are already familiar with this technique, feel free to skip ahead.

Here is the scenario.  A real estate partnership owning a property it desires to dispose of is faced with a dilemma.  Several of its partners would like to cash out their investments, while others wish to do an exchange ala Section 1031 and defer their tax by rolling their gain into the replacement property. What’s a General Partner to do?  Because it’s possible to distribute tax-free an undivided tenancy in common interest to the partners in the soon-to-be relinquished property, wouldn’t the partners be free to do what they want with their interest? 

Maybe, maybe not.  It depends on whether the transaction before the sale of the property can be structured in a way that will satisfy the taxing authorities that a) the pre-exchange transaction is, in fact, qualified for tax deferral and b) the property now in the hands of the individual partners meets the “held for requirement.” For decades, the State of California has argued (mostly successfully, sometimes not) that a partner can’t receive an undivided interest in partnership property and then immediately exchange it. Their argument is, he or she hasn’t held the property long enough to establish it was either held for investment or use in a trade or business.  

Hence, the reason for the question posed earlier – “How long is long enough?”

Sharon Mitchell and her mother both held an interest in a partnership that owned real property in Walnut Creek, CA.  Most of the partners wanted to cash out their investment, but Sharon and her mother wanted to roll their share of the equity into a Section 1031 exchange. To accommodate this, the partnership distributed to them undivided tenant-in-common (TIC) interests in the property. Since the point of this article is to try and discern a period necessary to satisfy the held-for requirement, it is essential to present a summary of the timing of the critical events occurring in this case: 

March 2, 2007 – Partnership accepts an offer to sell property, contingent on approval of the partners by March 21, 2007, and a projected closing date of August 31, 2007, which buyer agreed to extend to accommodate the seller’s Section 1031 exchange.

November 17, 2007 – A redemption agreement executed between Sharon and her mother, with the partnership agreeing to distribute to each of them their pro‑rata share in the partnership’s property.

November 20, 2007 – Partnership executes a Grant Deed to transfer title to Sharon and her mother as tenants in common. Their Grant Deeds recorded on November 29, 2007.

November 28, 2007 – Sharon and her mother transfer (and Exchange Accommodator accepts) their TIC interests to begin the process of facilitating an exchange.  That same day, the partnership, along with Sharon and her mother, execute a Grant Deed to buyers, thus signaling the close of escrow.  This Deed recorded on November 30, 2007.

As you might guess, the FTB did not take kindly to a distribution occurring just ten days (eight if you count from the date the Grant Deed was executed) as meeting the definition of qualified property.  However, the FTB was unsuccessful in convincing at least two judges (the OTA assigns a panel of 3 Administrative Law Judges to each case, one of which here dissented from the majority opinion) that the exchange did not qualify. 

Using largely long-standing federal cases as precedent,  (3) Magneson v. Commissioner (9^th Cir. 1985) 753 F 2d 1490 (Mageneson), the attorneys for the appellant successfully argued that not only did timing of the TIC transfers not matter, but that the FTB’s assertion that these pre-exchange transfers “lacked substance” was without merit.

 We could spend time reviewing arguments made in favor of the taxpayer.  However, candidly, these arguments are the same we practitioners have been making for years.  Therefore, it may behoove us to examine the comments of the dissenting judge lest we overlook opposing arguments we may fail to plan for. Informally, the FTB has already taken the position that it will not follow Mitchell).

Oddly enough, the main objection of the dissent is not one of the usual suspects (e.g., held-for requirement, benefits, and burdens of ownership, ban against the exchange of partnership interests), but one of assignment of income (4) Court Holding v. Commissioner (1943) 2 TC 531. In fact, according to Judge Rosas, before reaching an analysis on the holding requirement, the “first question we must consider is who made the exchange …”

Judge Rosas contended that the facts in the case showed that the Partnership was the seller of the property, not the appellant.  He dismissed testimony that a February 26, 2007 counteroffer was evidence that the buyers knew the appellant was going to do a Section 1031 exchange.  He points out that the counteroffer only names the Partnership and “is silent about appellant holding a 10-percent partnership interest, about her holding a 10-percent TIC interest in the Property, about her being one of the sellers, or about her wanting to undertake a Section 1031 exchange.”  He adds further that documentary evidence and testimony suggest that the day escrow closed “was the earliest date the buyers were even made aware of the appellant’s ownership interest and intentions.”

It is hard to argue with this assertion, although it is not clear why the buyer’s knowledge has any relevance to the seller’s intent. Further, there was, in fact, evidence that Sharon and her mother had always made clear their intention to do an exchange and therefore needed to have their partnership interests redeemed before any sale. While this case provides much‑needed support for a drop and swap to qualify under Section 1031, partnerships anticipating following in the footsteps of Mitchell will still be well-advised to “drop early” and name the TIC owners in the listing agreement (if possible) and the purchase documents to reduce the risk of a challenge to the reported exchange.

If you are anticipating a Drop and Swap and would like guidance on the period necessary to “hold the property,” the answer appears to be “zero,” according to the arguments in Mitchell.  However, if you wish to overcome an assignment of income issue, I’m not sure I would follow this advice. Mitchell has been designated “Non‑precedential” by the OTA. Thus, at present, the FTB is not bound to follow its result. Requests to re-designate the opinion to “Precedential,” thereby bringing more clarity and certainty in this area, have already been made, with more to follow.

It is clear from the Mitchell case (and the OTA’s refusal to grant a rehearing) that the FTB may have lost its final battle on this front.  The question is, will the IRS come to a similar taxpayer-friendly conclusion?  Posing this question to my good friend and SF tax attorney Ed Kaplan of Greene Radovsky (Ed was the lead attorney on the Rago Development case (5) Appeal of Rago Development, et al. 2015-SBE-001, June 23, 2015), one of the taxpayer-friendly cases cited in Mitchell):

“Standing in a field of sheep, yes, I’m still bullish.  As for the IRS National Office, they’ve been sitting on their hands for years, allowing California to try to create new ‘federal’ law in the 1031 arena.  I haven’t seen a single exchange challenged by the IRS for years; it’s always the FTB.  It will continue to be the FTB, even after the opinion is re-designated “precedential,” which I believe will happen sooner rather than later.  

Magneson either means what it says, or it doesn’t.  If you change the form of how you hold your property interest, nothing else changes.  Your intent in holding your property investment remains the same, as it looks to the beneficial owner to determine intent.  I think we’re safe here in the 9^th Circuit and have always believed that the IRS’s choice to not pursue a split in the Circuits was its acknowledgment that it was correctly decided.  

Let the FTB continue to wave red capes.  I’m bullish.” Thanks, Ed.  I guess we’ll just need to be careful where we step.