Exchanging Thoughts

California Drop and Swap: Substance Over Form

Posted by Laura Markham, JD on Fri, Apr 24, 2020

The Internal Revenue Code (IRC) section 1031 requires that the same taxpayer who relinquished property also take ownership of replacement property in a like kind exchange. Partnerships, corporations, LLCs, and all their various structures (hereafter “structure/entity”) are considered an individual “taxpayer” in the eyes of the IRC; not the individual members, shareholders, partners, etc. (collectively “members/partners”).

This can cause actual individuals who are members/partners of these structures to easily run afoul of the IRC if they are not careful and do not fully understand this rule. In particular, some member/partners will often want out of these structures to be able to “cash out” on proceeds from the sale of the relinquished property while others wish to remain invested in real property and defer their income gain. Often, the member/partners of these structures will attempt to take ownership of the replacement property outside of the structure that was used to sell the relinquished property through shuffling of the member/partners roles and ownership. This is a risk; and could cause the Internal Revenue Service (IRS), and similar state agencies, to flag a like kind exchange for unwanted review and possible penalties. 

Common techniques to avoid this risk, while still upholding the needs of both the leaving and staying member/partners, are called Drop & Swap or Swap & Drop. A Drop & Swap is when a structure/entity will drop the ownership title of the relinquished property to the member/partners as Tenants in Common (TICs), then swap for a like kind exchange. After the drop, it is advised to wait for (ideally) the safe harbor periods to enter into a like kind exchange. This is desirable to member/partners because as TICs, each member/partner has his or her own flexibility to cash out or reinvest their own shares. However, the wait requirement can deter some member/partners who want to cash out quickly. For a Swap & Drop, structure/entity will follow the same mechanisms, but reversed. The structure/entity will purchase the replacement property (i.e. the swap), then (ideally) wait within the safe harbor periods, then drop the ownership title to the members/partners to TICs where they are free to keep or sell their ownership portions.

Both of these techniques have risk, and if audited, will be reviewed based on two investigative principles of the IRS-

(1) the investment principle: if the relinquished property and replacement property were held for a sufficient time period to be considered an actual investment; and

(2) the ownership principle: If the ownership structure was created solely to avoid capital gains.1

Two California cases, the Appeal of Pau2 and the Appeal of Mitchell3, have recently shown a substance over form investigation; given that the outcomes, on their face, seem contrary to one another. While California does not give nationwide legal precedent, it is legal guiding.

In Pau, a California tax case, with an appeal denied by the Office of Tax Appeals (OTA) in 2019, an individual partner of a tiered entity partnership role exchanged his partner’s partnership interest for TICs to the buyer just prior to the sale of relinquished property (i.e. a Drop & Swap). This left Pau, as the sole partner and owner, while the other partnership’s interests were exchanged as TIC percentage interests. Pau then purchased replacement property within an LLC, claiming it was a single member LLC and attempted to defer his capital gains. Upon review, Pau failed as tax deferred exchange for multiple reasons. Generally, those failures were:

    • The partnership negotiated the sale of the relinquished property, signed the purchase and sale agreement (PSA), made no indications of the plan to convert to TICs prior to the sale, and held the burdens of ownership of the relinquished property up until the very end.
      • It appeared that the last-minute change in ownership structure was designed to avoid capital gains, failing the ownership principle.
      • The length of time the other partners had been TICs (right before closing) failed under the investment principle, as well as Pau’s sole partnership that was then rolled into the replacement property purchasing LLC.
    • The purchase of the replacement property was not in Pau’s single member LLC upon review, there were in fact 3 members, which were reported on taxes, and the Operating Agreement showed 3 managing members, with additional members making contributions.
      • This failed due to the ownership principle and the structure of the LLC, it was created to defer gains, and was not the same taxpayer who sold the relinquished property.
      • The previous TICs from the sale of relinquished property cashed out and did not reinvest in the replacement property.

    Conversely, in Mitchell, the OTA also denied an appeal in 2020, but found a valid tax deferred exchange with a seemingly similar Drop & Swap. In Mitchell, the relinquished property was held by a partnership and days prior to closing two partnership interests were moved into TICs. But here, it was found that all parties knew ahead of time of the ownership interest changes, and the exchange was valid because it was performed by the 3 separate taxpayers- the partnership and the two transferred TICs, Mitchell along with her mother. And, importantly, none of the parties cashed out, the 3 taxpayers purchased the replacement property together.

    Due to the structure of the exchange, in that there were no structure/entity surprises, the tax deferred exchange was upheld. Interestingly, the OTA also noted there is no time requirement for length of ownership (contrary to the generally recommended two-year safe harbor) based on title (moving from partnership to TIC) while investigating under the investment principle, rather it is the full substance of ownership.

    While these two contrasting cases seemingly fail to give tax advisors and potential deferred tax exchangers a road map on how to avoid risk and an audit, they in fact are helpful. Mitchell shows that even a risky Drop & Swap can be successful if it is well documented and disclosed from the start. Moreover, it is important that no parties cash out, and all remain in the exchange. Because, Pau shows us that when there are last minute ownership changes, with parties cashing out and failing to reinvest in new replacement property, an exchange will most likely fail. In addition, Pau failed because the partnership held itself out as the sole party to the transaction and failed to document and disclose the anticipated structure/entity change.

    Particularly challenging can be when there are multiple layers of these structures/entities owning a property, such as when a partnership is the managing partner of an LP or LLC. These structures are common today and can cause problems for the poorly advised taxpayer. Should you or your clients need guidance in Drop & Swaps (and Swap & Drops), please contact 1031 CORP. Our Exchange Team would be happy to assist you.


    1 Foster, Mary. Tax-Free Exchanges Under Sec. 1031, 2017-2018 ed. § 9.6

    2 Appeal of Pau, petition for rehearing denied, 2019-OTA-119; Appeal of Pau (December 17, 2017), Call. St. Bd. of Equal., Case No. 959931

    3 Appeal of Mitchell, 2018-OTA-210, petition for rehearing denied, 2020-OTA-001

 

Topics: 1031 exchange rules, Drop & Swap, Partnerships