I Fought the Law, and I Won

1031 “Drop and Swap”

A like-kind exchange pursuant to Internal Revenue Code (IRC) §1031 permits a taxpayer to exchange like-kind property and defer the recognition of gain on the transfer of said property. This allows a taxpayer to continue their investment until such time as their investment is eventually cashed out, i.e., sold. There are strict requirements under the Code and Regulations with respect to properly completing a like-kind exchange.

Things become more complicated when, prior to exchanging real property, the property is first transferred out of a partnership or other business entity and exchanged – the property is dropped, then swapped. The state of California has historically pursued these types of transactions aggressively to prevent the deferral of gain when property is exchanged.

The Franchise Tax Board (FTB) has been able to successfully challenge these drop and swap exchanges by alleging that the taxpayer did not “hold the property for investment.” The FTB has applied a one year holding period in a blanket fashion to nearly all drop and swap 1031 exchange cases without any statute or case law as support. Remarkably, the taxpayer in the following case held the property in issue as a tenant in common for approximately ten days.

In the Appeal of Sharon Mitchell,1 Sharon was a partner of Con-Med, a general partnership, since 1991. Sharon’s mother, Caroline Mitchell, was a partner of Con-Med long before Sharon became a partner. Con-Med owned a single piece of commercial property in Walnut Creek, California. As early as 1990, the tenant of the property indicated interest in potentially purchasing the property.

Early on in the negotiations, several partners expressed an interest in doing a 1031 exchange of their interest in the underlying property. Con-Med ultimately decided it wanted to sell the property, but it also wanted to allow some of its partners to do 1031 exchanges of their interests in the underlying property if possible.

In December of 2006, the tenant offered to buy the property from Con-Med. Con-Med made a counteroffer, and the parties entered into a purchase agreement. All throughout this process, Con-Med continued to assure the partners who wanted to do a 1031 exchange that it wanted to permit them to be able to do so if possible. After the purchase agreement was entered into, the sale did not close for eight months. Ten days prior to closing, Con-Med redeemed the partnership interests of the partners who wanted to do the 1031 exchange, and each of these partners received an undivided interest as a tenant in common. One week later, Sharon entered into a 1031 exchange agreement with a qualified intermediary. In the next four days, the tenancy in common deeds (from the partnership to the partner) were recorded, the sale closed, and the proceeds from Sharon’s 10% tenancy in common interest went to the qualified intermediary.

I am familiar with IRC §1031, and the regulations promulgated thereunder, as well as the case law surrounding this statute, because I have argued, and fought, many like-kind exchange cases in the past. Consequently, I am also very familiar with the FTB’s historical treatment, and arbitrary disallowance, of like-kind exchanges that the FTB deems to have been held for less than one year.

However, I have always argued that the Congressional intent behind the enactment of IRC §1031 is to alleviate taxpayers from the unfair burden of paying taxes on theoretical gains that have not yet been liquidated.2 To require a taxpayer to pay tax on an investment that had not yet been cashed out would create a substantial burden on taxpayers. The case law at the 9th Circuit level is very clear that a taxpayer’s intent when participating in a 1031 exchange is substantially relevant, if not controlling.3
Despite my opinion that the law is on the taxpayer’s side in these drop and swap transactions, not very many taxpayers want to, or are able to, take on the FTB and see these cases through. In fact, this case did not go to hearing before the Office of Tax Appeals (OTA) until April of 2018, even though the tax year in issue was 2007, so the taxpayer fought this matter for many years.

Throughout briefing, and at the hearing, the FTB proposed to deny the taxpayer like-kind exchange treatment. The FTB asserted that the partnership was the true seller, not the taxpayer Sharon Mitchell. The FTB also asserted that the step transaction doctrine applied to bar the taxpayer from being able to complete a 1031 exchange because of the last-minute nature in which the redemption of her interest and the exchange occurred.

Finally, my long-held convictions regarding like-kind exchanges paid off, and the taxpayer ultimately prevailed. The opinion was issued by a panel of three administrative law judges in a 2-1 split decision. The opinion included a strong dissent. The opinion went final on or around January 28, 2020.4

The OTA made 23 separate findings of fact in its opinion. The OTA completely rejected the FTB’s position and held that the taxpayer completed a 1031 exchange of her interest in the underlying property following the partnership’s redemption of her interest.

While this is great news for taxpayers everywhere, taxpayers should still be cautious. There is a strong dissent in this case, and there is a conflicting opinion5 that came out around the same time as the Mitchell case.

The takeaway from Mitchell seems to be, at least in part, that if intent to exchange is evidenced early and often, a taxpayer may be able to successfully complete a like-kind exchange even if the exchange occurs fairly soon after the property was redeemed by the partnership or other business entity. Or, at least, this would be one important factor in the taxpayer’s favor.

This case was labeled as non-precedential, similar to a memorandum opinion in U.S. Tax Court verusa reviewed opinion. However, this case finally got the law correct. This was a huge win for taxpayers all over California, and our hope would be that other taxpayers would be able to benefit from it. We ask that you consider writing to the OTA and requesting that this case be labeled “precedential.” You can submit these requests to the OTA here: precedential@ota.ca.gov.

[1] OTA Case No. 18011715.
[2] Jordan Marsh Co. v. Commissioner, 269 F.2d 453, 456 (2d Cir. 1959); 61 Cong. Rec 5201 (1921); H.R. Rep. No. 67-350 at 10 (1921), reprinted in 1939-1 (part 2) CB 168, 175-76, see also S. Rep. No. 67-275, at 11 (1921).
[3] Bolker v. Commissioner, 81 T.C. 782, aff’d 760 F.2d 1039 (9th Cir. 1985); Magneson v. Commissioner, 81 T.C. 767 (1983), aff’d 753 F.2d 1490 (9th Cir. 1985).
[4] The opinion was initially issued on August 2, 2018, but the FTB petitioned for rehearing. The OTA issued an opinion denying the rehearing on January 28, 2020.
[5] See Appeal of Peter & Susanne Pau, SBE Case 959931, OTA Case 18011375. In this case, the OTA ultimately denied the taxpayers like-kind exchange treatment where in the first like-kind exchange (the second failed for other reasons) the taxpayer’s interests in the LLC was redeemed approximately two days before recording deeds to the individual. Thereafter a new LLC was established to acquire replacement property. The OTA ultimately disallowed the exchange on a substance over form principle.