If you are attempting a 1031 exchange you need to keep your tax records squeaky clean because one of the top audit issues continues to be like kind exchanges, also known as 1031 exchanges. Under IRC Section 1031 and conforming California laws, if certain conditions are met, taxpayers may defer gain from the sale of property, either in part or full.
There are three general requirements:
- There must be an exchange, as opposed to a separate sale and reinvestment, by the same taxpayer.
- The relinquished property and replacement property must be “like kind.”
- Both the property given up and the replacement property must be held for investment or for productive use in a trade or business. Property held for personal use or primarily for sale is generally not eligible for nonrecognition treatment.
If at any time during the exchange, the taxpayer or his agent has receipt or control of any portion of the sales proceeds, this will generally result in gain recognition. Along similar lines, if the taxpayer does not reinvest the full amount of proceeds into eligible replacement property, or obtains other property in the exchange (referred to as “boot”), this may also result in gain recognition. If the transaction is done in accordance with IRC Section 1031 regulations, a qualified intermediary will not be considered the taxpayer’s agent.
The source of the original deferred gain on California property will remain with California, regardless of the location of the replacement property. When the replacement property is ultimately sold in a taxable transaction, the gain originally deferred on the California property will have its source in and be taxable by California.
Common Audit Issues
- Sourcing of gains to California upon disposition of replacement property received in a California deferred exchange.
- Taxpayer receives other property (boot) in the exchange but does not report the boot on their return.
- Taxpayers do not meet identification or other technical requirements of IRC Section 1031.
- Relinquished and/or replacement property are not held for investment or for productive use in a trade or business (i.e. property is used for personal purposes or is held primarily for sale).
- The taxpayer who transfers relinquished property is a different taxpayer than the party who acquires replacement property.
We also continue to review certain “drop and swap” or “swap and drop” transactions. Not all of these transactions are ineligible due to varying facts and circumstances; however, where the form does not support the economic realities or substance of the transaction, we will recharacterize the taxpayer’s transaction as appropriate.
Recently, the Board of Equalization decided several notable, although noncitable, like kind exchange cases. The three cases are:
- Appeal of Frank and Mary Lou Aries, Appeal No. 464475 (swap and drop).
- Appeal of Gerald J. and Carol L. Marcil, Appeal No. 458832 (different taxpayer acquired replacement property, rehearing granted).
- Appeal of Howard Brief, Appeal No. 530872 (deemed contribution to a partnership).
The significance of these cases is that we are sustaining a taxable position where we have recharacterized the taxpayer’s transaction to reflect the realities of the transaction.