The California State Board of Equalization (Board) recently issued a favorable decision in an important Section 1031 exchange case. As an elected body of five members, the Board hears appeals in California tax cases where the taxpayer has not been able to agree or settle with the California Franchise Tax Board (FTB). A hearing before the Board is the last stop in the administrative appeal process. The only recourse a taxpayer has after a Board decision is to pay the tax and go to court to sue for a refund. Generally viewed as an unfriendly venue for taxpayers, it is significant that the Board unanimously held in favor of a group of taxpayers who appealed the disallowance of their Section 1031 exchanges by the FTB.

The FTB has been very aggressive in auditing Section 1031 exchanges and disallowing exchanges involving a "drop and swap" or a "swap and drop." The new Board decision should put the brakes on the FTB's aggressive positions which are not consistent with established federal case law in the 1031 exchange area.

This new decision involved a swap and drop. A group of taxpayers sold properties and exchanged into tenancy-in-common interests in a replacement property (the "swap"). As required by their lender, they contributed their individual co-tenancy interests into a single purpose limited liability company seven months after the exchange (the "drop"). The FTB argued that the drop—this planned roll-up into an LLC—disqualified the 1031 exchange.

Rejecting the arguments of the FTB, the Board held that there was independent significance to the taxpayers' holding the property as co-tenants for seven months. The roll-up of the co-tenancy interests into an LLC was merely a change in the form of ownership which did not disqualify the exchange as the FTB argued.

This decision affects a number of California cases that are currently on appeal. It gives taxpayers and their advisors reason to cheer and will hopefully bring California more in line with the approach which the IRS and federal courts have taken on 1031 exchanges.