Like-Kind Exchanges under IRC §1031
a four part series
In recent years 1031 like-kind exchanges have fallen under the increased scrutiny of the California Franchise Tax Board (FTB). As noted in our previous blog posts on this topic, IRC §1031 allows a taxpayer to defer recognition of capital gains on the sale of a business or investment property if a qualifying like-kind replacement is identified and purchased within the prescribed time limit.
Like-Kind Exchange Taxation Issues in California
The FTB has identified the following common issues concerning 1031 exchanges in California:
Failure to meet the technical requirements of IRC §1031. If an exchange does not meet the requirements set forth in IRC §1031 for non-recognition of gains, it will also not qualify in California. Section 1031 non-recognition treatment for California tax purposes can be found in California Revenue and Taxation Code (R&TC) section 24941. Properties not held for investment or business purposes and replacement properties not being identified on time are noted as the main reasons for failure to meet the 1031 technical requirements.
Failure to report boot. The FTB is on the lookout for taxpayers who fail to report boot -- money or the fair market value of other property received or given in the exchange. Note that boot is taxable to the extent of gain realized at a normal capital gains rate.
Sourcing of gains. If the relinquished property in a 1031 exchange is located in California, the deferred gain is sourced to California – regardless of the taxpayer’s residence or the replacement property’s location. As a result of difficulties determining whether or not out-of-state replacement properties were later sold in taxable transactions (thus generating California tax liabilities), the FTB now requires that taxpayers who engage in like-kind exchanges file an information return to help keep track of their California source deferred gains. Form 3840 must be completed for all like-kind exchanges that have taken place since January 1, 2014.
“Drop and swap” and “swap and drop” transactions. Section 1031(2)(D) specifically excludes transactions completed by partnership interests from nonrecognition treatment. Working around this exclusion is challenging, but not impossible. For example, a partner can change ownership prior to, or immediately following, a like-kind exchange and still qualify under section 1031 if the transaction is structured property. For example, in a “drop and swap,” the title of property held by a partnership or LLC is changed to reflect the individual names of its members, followed by a 1031 exchange. In a “swap and drop,” individuals complete a 1031 exchange and then contribute the replacement property to a partnership.
It is crucial that all steps are properly executed and recorded. If the IRS or FTB finds that the form of the transaction does not reflect the true substance or economic reality of the situation, the change of ownership may be declared a fiction, the transaction will be re-characterized, and capital gains taxes will be assessed. See Chase v. Commissioner, 92 T.C. 874 (1989).
A law firm experienced in tax planning
The tax attorneys and accountants at Moskowitz LLP, have extensive experience handling 1031 Like-Kind Exchanges. We advise our firm’s individual and corporate clients worldwide in the full range of federal and state tax planning issues. Contact our office today for a consultation.