California Office of Tax Appeals Upholds Taxpayer Friendly "Drop and Swap" Case

On January 28, 2020, the California Office of Tax Appeals (OTA) denied the California Franchise Tax Board’s (FTB) request to rehear In the Matter of the Appeal of Sharon Mitchell (OTA Case No. 18011715). This decision may allow California taxpayers to have more flexibility in structuring Section 1031 exchanges where a partnership is involved and some partners wish to cash out their investment, while others desire to continue their investment in other like kind real estate. In such instances, the parties often attempt to engage what is commonly referred to as a "drop and swap" transaction. As many tax advisors and owners of real property are aware, the FTB has aggressively scrutinized and challenged "drop and swap" transactions over the last decade, and proven successful in many of its challenges.   

What is a "drop and swap"?

When a partnership owns real property, it is not uncommon for some partners to want to cash out their investment, while other partners want to remain invested in real property. Often the partners who want to remain invested in real property are desirous of engaging in a 1031 exchange to avoid gain recognition on any sale. Unfortunately, section 1031 prohibits the exchange of partnership interests, and so a partner is not able to unilaterally exchange its indirect interest in real property on a tax-deferred basis. A “drop and swap” aims to address that problem by transforming a partnership interest into an interest in real property prior to a tax-deferred exchange.

A “drop and swap” has two parts: the “drop” and the “swap.” The “drop” ordinarily refers to a partnership (or limited liability company) that owns real property and distributes undivided interests of such real property to one or more of its partners. Thereafter, the real property is held not by a single entity, but by multiple persons as tenants in common. The “swap” refers to the ultimate disposition of the real property whereby one or more of the tenants in common engage in a 1031 exchange. If the “drop” occurs too closely in time and/or is interconnected to the “swap,” tax authorities have utilized a number of legal theories with varying success to challenge the validity of a purported 1031 exchange. As a result, poorly structured "drop and swap" transactions can create a substantial tax risk for the taxpayer. 

The Sharon Mitchell case

In Sharon Mitchell, the taxpayer was a partner in a general partnership that owned real property. The partnership wanted to sell the real property and most of the partners wanted to be cashed out of their investment upon the sale. The taxpayer, however, wanted to engage in a 1031 exchange of its interest and continue its investment in real property. To meet the conflicting needs of the partners, the partnership adopted a "drop and swap" structure for the transaction. Given the concern that the taxpayer in Sharon Mitchell may hold up the sale, only the partnership negotiated and entered into the sale agreement with the buyer, and the partnership distributed an undivided interest in the property to the taxpayer only one day before the closing of the sale. The FTB argued that the partnership was the seller of the property and not the taxpayer (which, if true, would invalidate taxpayer’s exchange) due to substance over form and step transaction principles. However, in a 2-1 decision on August 2, 2018, the OTA found that the taxpayer was the true owner and seller of its undivided interest in the property. The OTA opined that the last-minute nature of the change in the form of ownership did not invalidate such change in form, and rejected the FTB's substance over form and step transaction arguments. Given that the decision went against the longstanding FTB view regarding “drop and swaps”, the FTB petitioned the OTA for a rehearing arguing, among other things, the OTA erred in applying the law. In the January 28, 2020, opinion denying the FTB’s request for a rehearing, the OTA was not persuaded that its original opinion contained an erroneous application of the law.

Implications for California taxpayers

Sharon Mitchell may provide California taxpayers helpful guidance and authority should they find themselves exploring a "drop and swap" transaction. The OTA is still considering whether to publish its decision, which would make it binding on future proceedings with the FTB. It should also be noted that OTA decisions are not binding authority for federal income tax purposes and would likely not affect any proceedings with the Internal Revenue Service.