Those of us in California who give advice regarding the structuring of IRC Section 1031 like-kind tax-deferred exchanges of real property are well aware that the California Franchise Tax Board (FTB) has an active program of auditing these transactions. There seems to be no rhyme or reason as to how the FTB's audit algorithm works. In some instances, exchange transactions of more than $100,000,000 are not audited, while others involving $3,000,000 are audited.
While we will never know how the FTB's algorithm works, we do know that the FTB has a list of hot-button transactions that bear extra scrutiny. We know about these hot-button items in part from speaking to FTB personnel who oversee the FTB's 1031 exchange audit program and in part from discussions with other advisors in this area.
This article explores two of the FTB's hot-button items: Drops and Swaps and Post-Closing Refinancing. As it turns out, the FTB's positions on these hot-button issues may not always comport with current legal precedents.
Drops and Swaps:
Among other requirements for tax deferral under IRC Section 1031 is the requirement that the taxpayer have held the Relinquished Property (i.e., the "downleg") for use in its trade or business or for investment. This requirement is usually referred to as the "held for" requirement. As an example, if a limited liability company acquires and holds an apartment building for 5 years and then structures the sale of the building as a Section 1031 exchange, all things being equal, the LLC should be eligible for IRC Section 1031 tax-deferral treatment.
However, what if each of the LLC members wants to do their own separate Section 1031 exchange and, to accomplish this result, on the eve of closing, the LLC distributes a tenancy-in-common interest to each of the members and then the members complete the transaction and undertake separate Section 1031 exchanges? This is a classic drop and swap transaction and, if the transaction is audited, in all likelihood the FTB will challenge whether the members are eligible for IRC Section 1031 treatment. The position that the FTB is likely to take is that the LLC, and not the members, held the property for use in it trade or business of renting the apartments and that the members held the property only for purposes of sale. Alternatively, the FTB could assert that the LLC made the sale and only the LLC, and not its members, could acquire the Replacement Property (i.e., the "upleg").
While there are defenses to the FTB's position, the best approach is to avoid the drop and swap scenario in the first place. Our Office has developed a number of alternates to this classic drop and swap structure which the FTB (as well as the IRS) have approved.
Post-Closing Refinancing:
Even if the other requirements for tax deferral under IRC Section 1031 are met, if all of the cash from the sale of the Relinquished Property is not invested in the Replacement Property, the amount of uninvested cash (i.e., the "boot"), is taxable. As a simple example, if a Relinquished Property is sold and the cash proceeds are $1,000,000, but only $800,000 is invested in the Replacement Property, there will be $200,000 of taxable gain.
But what if the same Relinquished Property is sold for $1,000,000, a Replacement Property is acquired for $1,000,000, and a week after the Replacement Property is acquired, a loan for $500,000, secured by the Replacement Property, is obtained? The FTB's position is that if the arrangements for the loan began prior to the acquisition of the Replacement Property, then there is $500,000 of taxable gain.
We believe that the FTB's view is an incorrect interpretation of the law. Nevertheless, to avoid the issue, we recommend a number of structures to counter any FTB challenge*.
This article was originally published in Genesis Bank's "Insights" newsletter.
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