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Great news for business owners in California: As of January 28, 2020, the Franchise Tax Board’s Office of Tax Appeals (OTA) denied the appeal of Sharon Mitchell case that would prevent “drop and swap” exchanges. The decision is now final and California taxpayers, partnerships, and LLCs now will have some tax authority to structure a sale of real estate by having some partners engage in a Section 1031 tax deferred exchange into one property, while other partners are able to cash out their partnership investment or exchange into a different property.

Sharon Mitchell Recap

In Sharon Mitchell vs. California, the OTA approved for Section 1031 exchange purposes a general partnership first distributing out a tenancy-in-common interest in a real property to one of its partners, immediately followed by the sale of that entire real property by the distributee partner and the partnership.  Those partners remaining in the partnership desired to receive cash as part of the real property’s sale, while the distributee partner wanted to do a 1031 tax-deferred exchange with its share of the real property’s sales proceeds.

To accomplish these two goals, the distributee partner first received as a distribution from the partnership an 18% tenancy-in-common interest in the real property immediately prior to the sale of that real property.  This tenancy-in-common interest was then sold by the former partner to a third party and was followed immediately by this former partner doing a qualified 1031 tax deferred exchange of that tenancy-in-common interest.

The OTA held in this case that the taxpayer (the former partner who became a tenant-in-common) met the 1031 exchange requirements and that neither “step-transaction” principals nor “substance over form” principals would deny the taxpayer 1031 tax treatment.

Drop and Swap Refresher

Owners of a real estate business frequently own interests in multiple partnerships or LLCs with each entity owning one or more rental or investment properties. When owners decide to go their separate ways, the properties must be divided up. One approach is to divide these properties in a drop and swap transaction. To execute a drop and swap, the entities distribute fractional interests in the properties to the owners and then the owners exchange interests with the end goal of one or more owners owning all of the interest in some of the properties, but no interests in other properties.

1031 Exchange Refresher

A 1031 Exchange is found in section 1031 of the Internal Revenue Code (IRC). It is a transaction in which investor and owners can sell rental, business, or investment properties and defer the taxes that would otherwise be due as a part of the sale, including the capital gains tax, the depreciation recapture tax, and state income tax.

The Fine Print

The Mitchell decision applies only to California taxes. IRS is not required to follow the case for federal income taxes, however, this case could have an ancillary impact on future Federal tax court cases.

The timing of the drop and the swap is critical, so the exchange should be 1) planned ahead of time, and 2) done with the help of qualified professionals—intermediaries, attorneys and accountants—to avoid unnecessary tax mistakes.

Additionally, prudent clients should comply with the formalities of the partnership’s operations and of the partnership’s liquidation and distributions, such as notifying (and receiving applicable consents on liquidation) of lenders, insurance companies, utilities, tenants and vendors, and also by entering into formalized tenancy-in-common agreements.

If you would like more information on how this case might affect you or assistance with planning for a drop and swap exchange, the team at Sousa & Weber is happy to help. Get in touch with us today.