The appeal of Sharon Mitchel vs. California is a CA Drop and Swap tax case we are watching closely. The case has potential national impact. The language of the 1031 law says you can exchange property that is held for investment or business purpose for replacement investment or business property also to be held. The only way to defer taxes is to own the real property and exchange for new real property. The “Drop and Swap” strategy is to drop out of the LLC/partnership ownership into a percentage ownership interest in the real property.
The terms “held” and “hold” in the law do not define a time period but define intent. A taxpayer doing an exchange must have had the intent to hold the property for investment for business purpose. Time is one of many ways to prove intent.
A general partnership owned a relinquished property. The partnership signed an agreement to sell the property. Sharon Mitchell dropped her 10% ownership in the general partnership to a tenant in common ownership two days before the settlement. Sharon “held” the property herself for two days. The California Franchise Tax Board (FTB) argued that the general partnership was the seller of the property and not Sharon Mitchel due to substance over form and step transaction principles. In a two to one decision, the Office of Tax Appeals (OTA) found for Sharon Mitchell because she was continuing investment in real property and not cashing out. The last-minute change in ownership form did not matter. We think it is unusual for CA to lose a case like this, and CA is appealing – the decision isn’t final.