California FTB Denies Exchange Based on Cash Out at Closing:
Analysis and Response
It’s no secret that the California Franchise Tax Board (“FTB”) has become very aggressive in challenging 1031 exchanges. In a recent audit, the FTB held that an exchange failed based on a practice which has become commonplace: the distribution of a portion of the relinquished property sales proceeds to the taxpayer, as boot, at the close of escrow. The FTB’s analysis suggests that a change in practice may be required to avoid running afoul of this new basis for challenging exchanges.
In the Audit, the taxpayer entered into an exchange agreement where the taxpayer relinquished her right to all cash proceeds from the sale of the relinquished property. Prior to the close of escrow, the taxpayer sent an e-mail to the escrow agent instructing the escrow agent to release $150,000.00 of the proceeds from the sale to the taxpayer. There was no reference to any document allowing the taxpayer to take the money, and no communication to or from the QI.
The FTB held that the ability of the taxpayer to direct the closer to distribute a portion of the sales proceeds to her constituted “constructive receipt” of all of the sale proceeds, disqualifying the transaction from 1031 exchange treatment. The FTB found that the ability of the taxpayer to instruct the escrow company by simple notice showed that there were no restrictions on the taxpayer’s access to the sales proceeds, and this constituted constructive receipt. The FTB also held that, since the taxpayer had expressly assigned all of the cash proceeds to the QI in the exchange agreement, the taxpayer had relinquished her right to receive any cash proceeds in the transaction.
APPLICATION: Given the position of the FTB regarding the receipt of cash at closing, how should the arrangement among the taxpayer, QI and escrow agent be structured? The approach being used by Asset Preservation, Inc. involves: (i) the taxpayer expressly excluding the amount they want to receive from the sales proceeds assigned to the QI in the exchange agreement; and (ii) the instructions to the closer acknowledging the exclusion of this amount, and the right of the taxpayer to receive this amount at the closing.
California FTB Allows Only Partial Exchange
Due to Violation of the Identification Rules
In another recent audit, the FTB partially disallowed a taxpayer’s exchange because the taxpayer did not properly identify replacement property as required by Section 1031. The audit presented a textbook case of the application by the FTB of the following 1031 basic identification rules:
- During the 45-day identification period (“Identification Period”), a taxpayer can identify up to three properties, regardless of value.
- A taxpayer can identify more than three properties as long as the total value of the identified properties does not exceed 200% of the value of the property sold.
- If both of these rules are violated, the taxpayer will be treated as having failed to identify any properties, except:
- Any properties actually acquired by the taxpayer during the Identification Period will be considered properly identified; and
- All properties identified during the Identification Period will be treated as properly identified if the taxpayer actually acquires properties with a total value equal to 95% of the total value of the properties identified.
In the FTB audit, the taxpayer identified five properties during the Identification Period. The FTB found that the total value of the identified properties was 267% of the value of the property sold, and the taxpayer did not provide evidence to refute this valuation. The taxpayer actually acquired two properties during the Identification Period. The taxpayer acquired one other identified property, after the expiration of the Identification Period. The total value of the properties acquired by the taxpayer was less than 95% of the value of the properties identified.
Applying the above rules, the FTB held that the two properties acquired during the Identification Period were properly identified like-kind properties, but the property acquired outside of the Identification Period was not like-kind property since it was not properly identified. The proceeds applied toward the purchase of the third property, therefore, were treated as boot and not included in the exchange.
APPLICATION: The identification rules are fairly easy to understand, but must be meticulously applied. For example, if a taxpayer chooses to use the 200% rule, the taxpayer should make sure the combined fair market value of all identified properties does not exceed 200% of the fair market value of the relinquished property. For a more thorough review of the identification rules, Read More…
Proposed Repeal of Section 1031 Would Hurt Taxpayers
Three separate tax reform proposals have been advanced by the House Ways and Means Committee, the Senate Finance Committee and the Treasury Department to either repeal or restrict tax deferral of gain from Section 1031 exchanges of like-kind property.
Like-kind exchanges benefit millions of American investors and businesses every year. Section 1031 exchanges encourage businesses to expand and help keep dollars moving in the U.S. economy. Without the tax-deferral benefit that 1031 exchanges provide, small and medium sized businesses would not be as equipped to reinvest in their businesses, real estate values would decline, the U.S. economy would suffer, and businesses of all sizes would lose the opportunity to expand. The repeal of Section 1031 will cause a decline in real estate values as investors will be motivated to hold on to properties and to invest in more liquid, non-real estate investments with faster returns. The proposals effectively impose punitive and targeted tax increases on economically sound commercial real estate investment, the likely unintended consequence of which will be similar to implementation of 1986 tax reform modifications that resulted in a recession.
Send a strong message to lawmakers that 1031 exchanges are a powerful economic tool. Learn more and voice your opposition to these proposals with these critical actions at www.1031taxreform.com.