Here’s some great news for California owners of real estate investment properties: As of September 1, 2018, the California Office of Tax Appeals (OTA) has issued a new position regarding “drop and swap” real estate transactions (defined below). The OTA ruled that drop and swap is an accepted business practice for changing ownership of real property and the drop can be followed with an immediate 1031 Exchange (also called a like-kind exchange, a tax-deferred exchange, or a Starker exchange) for a replacement property without an immediate tax effect. Here’s why: based on the rules of the 1031, the tax is deferred, and TAX DEFERMENT is the REALLY GOOD NEWS.
What is a drop and swap?
Summary definition of a drop: When the deed to an investment or business property held in a Partnership or LLC is converted to (dropped into) a Tenancy in Common (TIC), it is called a drop.
Summary definition of a swap: The subsequent trade after the drop is called the “swap.”
An example follows.
Three brothers, Andrew, Brad, and Charles, own equal shares of a Partnership, as well as the building in which their business operates. All three brothers want to sell the business but disagree on how to handle the building, valued at $15 million. Andrew and Brad want to cash out. Charles wants to continue owning real estate. The brothers ‘drop’ the building into a Tenancy in Common, and it is now held equally in the names of each brother, who separately own a third valued at $5 million apiece. Andrew and Brad would pay tax on the gain for the property value when the building is sold because they are not reinvesting in real property. If Charles does a 1031 Exchange, he swaps out of the TIC for his share of the building, and the other brothers swap theirs for cash. Since Charles reinvests in the building, he will defer paying tax on the gain.
At closing, Charles will want to direct his portion of the net proceeds to a qualified intermediary3 for proper handling, just to make sure it’s done correctly.
Here’s the bottom line: As real estate investors, the brothers can enact a 1031 Exchange—or can simply ‘1031’ the building or real property. However, 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—attorneys and accountants—to avoid unnecessary tax mistakes. Again, the brothers that are cashing out without reinvesting would not be able to defer the taxes, which can create a huge tax bill!
Important note: The Franchise Tax Board and IRS interpretations aren’t necessarily the same.
The IRS requires you to hold the property for investment. If you are in a Partnership, you need to trade “like” property meaning you need to be an investor or long term owner of the property, and trade “like” properties. Like properties as of this writing are pretty loose.
LSL’s Position
The tricky part for many of our clients here in California is that they file both California and Federal taxes. Also, they can own property in more than one state. Even though the California FTB allows Drop and Swap (similar to the IRS), other states may have conflicting laws. Bottom line: we advise strict compliance with both state (any state) and federal laws and urge our clients to get legal and tax advice before handling and real property transactions.
Real estate transactions can be complicated, so please CONTACT US to schedule a discovery call. We’ll make sure your property and your situation are good fits for a 1031 Exchange, help you plan for your real estate transactions, and spread the high-fives around. The enhanced tax deferment possibilities provided by the recently approved Drop and Swap ruling in California is cause for celebration. We’ll bring the noisemakers.
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Refresher: What is a 1031 Exchange?
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 1 tax, the depreciation recapture 2 tax, and state income tax.
1 Capital gains tax applies to the difference between your “cost basis” in a piece of real estate and the sale price you receive for that property. Cost basis is what you paid for the property plus any money you’ve spent to improve it.
2 ‘Depreciation recapture’ is the gain received from the sale of depreciable capital property that must be reported as income. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is “recaptured” by reporting it as income.
3 A qualified intermediary is “an independent entity, person, or company that enters a written agreement with an exchanger to expedite the transfer of proceeds from the purchaser of the relinquished property to the exchanger and from the exchanger to the seller of the replacement property to effect a tax-deferred exchange under Internal Revenue Code (IRC) Section 1031. Qualified intermediary services are typically provided on a fee basis by third parties and function much like escrow agents.
