ARE 1031 DROP & SWAP REAL ESTATE EXCHANGES IN JEOPARDY IN CALIFORNIA?

By Tenzing N. Tunden¹

Given the current state of the real estate market, more and more taxpayers find themselves with real properties that are either vacant or facing difficulty in filling leases, that they would like to sell, and they may desire to roll their sale proceeds into new real estate in a tax-deferred, like-kind exchange under Internal Revenue Code ("IRC") Section 1031. Section 1031 provides that no gain or loss is recognized on an exchange of like-kind property that is used in a trade or business or held for investment.² However, Section 1031 does not apply to "stocks, bonds . . . notes, [or] other securities or evidences of indebtedness or interest."³ Since 2018, Section 1031 has only applied to real property. Before that, people swapped planes, radio and TV stations, artwork, and crypto.⁴ But now, Section 1031 has returned to its roots, just swaps of real estate.

Most states conform to this storied provision, even California, although California has special rules where California property is exchanged for non-California property.⁵ Most swaps are not simultaneous, of course, since you usually do not find two parties who want exactly what the other has. Most exchanges are delayed, with at least three parties, and a qualified intermediary who holds the funds. There are stringent timing requirements for deferred exchanges with respect to identification of the replacement property and the closing date for the replacement property.⁶ The replacement property, for deferred forward exchange, must be identified within 45 days and received by earlier of: (1) 180 days following the sale or (2) the due date of the transferor’s return for the year in which the property is relinquished.⁷ There are also holding purpose requirements and qualified use requirements that the Taxpayer must comply with to have a valid 1031 exchange.⁸

This article provides a broad survey of the recent developments for 1031 Drop and Swap exchanges within California. The article discusses common audit issues for Drop and Swap exchanges, a selection of seminal caselaw, and recent precedential decisions. In particular, the article examines the impact of these recent cases on the utility of a Drop and Swap exchanges. This article discusses several steps that taxpayers can take to minimize the audit risk for their Drop and Swap exchange. The article also briefly discusses alternatives to the Drop and Swap structure that taxpayers can utilize to exchange their property.