The California State Board of Equalization (Board), the last administrative option for appeals, has found for a taxpayer and against the Franchise Tax Board (FTB) in a case where a group of taxpayers exchanged into fractional interests in a common replacement property. Their lender required that they contribute the tenancy-in-common interests into a partnership (single purpose LLC) seven months after the exchange.

Commonly referred to as "swap and drops," on the federal level the government has widely accepted such transactions, noting they represent only a change in form of ownership, without any impact on the tax attributes of the property in terms of the taxpayer. Related transactions, called "drop and swaps," have the reverse of that structure, where property is "dropped" out of a partnership in anticipation of an eventual exchange. FTB has aggressively pursued such transactions in California on the basis that they violate the "held for business or investment use" rule due to the short holding term either after the "drop" or after the "swap." According to FTB, the property has not been held for a qualified use for a long enough period and is ineligible for state tax deferral under Section 1031.

In the income tax world, a common qualifier for any tax rule is "except in California," and nowhere is this more true than in like-kind exchanges. This ruling by the Board - a unanimous decision - provides welcome relief indeed in a state where the pursuit of ever more tax revenue has become a critical drag on economic activity. It will be interesting to see what the consequences of this decision will be going forward.   

 Warm regards,