During the last several years, the California Franchise Tax Board (“FTB”) has been closely scrutinizing section 1031 exchanges, and finding section 1031 exchanges to be a fruitful area for state tax audits. While California law is equivalent to Federal law with respect to the qualification of an exchange under section 1031, the FTB interprets the tax cases more restrictively than the IRS. More of the same is in store as California is also the first state to enact a reporting requirement on non-residents to enforce the "clawback" of gain on later sales when exchanges are made into out-of-state property.

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While FTB examinations of section 1031 exchanges generally cover all requirements for an exchange, there are certain areas where the FTB has focused its efforts:

Drop and swap. A distribution of property by an entity followed by a previously planned exchange is commonly referred to as a "drop and swap." The FTB takes a dim view of many if not most of these transactions. The FTB considers the participation of the entity in the sale process prior to the entity's distribution of the property as grounds for disqualification of the exchange under certain tax principles.

Swap and drop. An exchange followed by a capital contribution of the replacement property to an entity in return for an ownership interest in the entity is commonly referred to as a "swap and drop." The FTB's position is that if these transaction are related, at the end of the transactions the taxpayer has given up real property and received intangible personal property (the membership or partnership interest), with the result that the taxpayer did not conduct a "like-kind" exchange.

California's new clawback reporting rule. Stretching its reach across the country, California now requires on-going reporting by out-of-state residents of deferred gain from section 1031 exchanges of California property.

Exchange of Option for Real Estate. The FTB views exchanges where one leg of the exchange relies on a contract right such as an option agreement as not being "like kind" and thus disqualified.

Co-tenancy property identification. A taxpayer can acquire an undivided co-tenancy interest as replacement property. If a larger percentage co-tenancy interest is acquired than was identified, the FTB considers the excess as not having been identified and therefore not qualifying replacement property.

Borrowing after an exchange. If borrowing is part of a step transaction that is planned ahead of the exchange, the FTB considers the net proceeds from the borrowing received by the taxpayer to be boot.

Most section 1031 exchanges of California property can be accomplished expeditiously with little risk of disallowance by the FTB, provided careful attention is paid to complying with the requirements of section 1031. A large number of California exchanges, however, have run afoul of the FTB's heightened scrutiny and tighter strictures on exchanges. Relying on the more liberal IRS approach when exchanging California property is not wise in light of the tougher enforcement standards of the FTB.