1031 Exchange Review: Trouble in Wine Country

The California Office of Tax Appeals (OTA) recently posted a nonprecedential opinion regarding a like-kind exchange under Internal Revenue Code Section 1031. Silverado Lodging Co., LLC, et al.[1] involved the sale of a Napa Valley hotel, and the attempted 1031 exchanges by the two members of Silverado Lodging Co., LLC (Silverado) following the transfer of the hotel to the members by Silverado prior to the closing of the sale.

This was another "drop & swap" case, with the California Franchise Tax Board (FTB) challenging the validity of the resulting 1031 exchanges by the members of the LLC (Members), to whom the property was "dropped." The OTA held in favor of the FTB, and the OTA's analysis is consistent with recent cases. For a California taxpayer doing a 1031 exchange as part of a "drop & swap" transaction, it is important to review and understand the position of the FTB and the OTA, as illustrated in the Silverado case.

The Facts

Silverado owned a hotel (the Property) in Calistoga, in the heart of the Napa Valley. In May of 2014 Silverado listed the hotel for sale. On September 10, 2014, Silverado entered into an agreement to sell the hotel (Sale Agreement) with a third party purchaser.

On October 31, 2014, Silverado entered into a dissolution agreement pursuant to which Silverado agreed to distribute the Property in equal undivided interests to its two Members. On November 30, Silverado assigned its rights under the Sale Agreement to the two Members, and on December 2 the Sale Agreement was amended to refer to the two Members as the "New Sellers," and expressed the intent of each of the Members to each engage in a 1031 exchange with their respective undivided interests in the Property.

On December 30, 2014, Silverado recorded the deed transferring the Property to its two Members. On January 9, 2015, the sale of the Property closed. Each of the Members engaged in a 1031 exchange with their respective portion of the proceeds from the sale, and each claimed the gain deferral under Section 1031 on their 2015 tax return.

In December of 2019, following an audit, the FTB issued Notices of Proposed Assessment requiring Silverado to recognize $7,530,388 of gain on the sale of the Property, along with a California LLC gross receipts fee in the amount of $11,790, and to allocate those amounts to the two Members. The Members appealed the matter to the OTA.

The Analysis

Section 1031 allows a taxpayer to avoid gain recognition when "real property held for productive use in a trade or business or for investment" is exchanged for like-kind real property. In a "drop & swap" transaction, an entity which is taxed as a partnership (e.g., a multi-member LLC) distributes real property to its partners (or members of an LLC), with the partners (members) then completing a 1031 exchange with the distributed property.

Prior to Appeal of Rago Development, et al.[2], the FTB could challenge drop & swap transactions based a "qualified use" argument-i.e., the property received by the partner in distribution was not acquired to be held for investment, but to be sold as relinquished property in a 1031 exchange. In Rago, the State Board of Equalization (predecessor of the OTA), in a precedential opinion, expressly applied a line of taxpayer-friendly cases from the federal courts (i.e., Bolker[3], Magneson[4], Maloney[5], and Mason[6]), to effectively negate the "qualified use" argument for the FTB.

Post-Rago, the line of reasoning typically used by the FTB to contest drop & swaps, and the line of reasoning described by the OTA in finding for the FTB in Silverado, is based on the U.S. Supreme Court case Court Holding,[7]and its progeny.

Court Holding involved a corporation that entered into an oral agreement to sell an apartment building, its sole asset, and accepted a down payment from the purchasers. Prior to the sale, and prior to entering into a written agreement, the shareholders discovered that the corporation would incur a large tax liability if it completed the sale. To avoid the tax at the corporate level, the corporation distributed the asset to its shareholders, with the shareholders then completing the sale. The Supreme Court disallowed the characterization of the transaction as a sale by the shareholders, finding that, in substance, the sale was by the corporation, and therefore the corporation must recognize the gain associated with the sale.

The OTA in Silverado cited Court Holding in support of its "substance over form" argument that the sale of the Property had actually been by the LLC and not the Members. The OTA pointed out that the LLC had negotiated the terms of the sale, and had entered into the Sale Agreement as the "Seller." Only later, just prior to closing, did the LLC transfer the Property, and assign its rights under the Sale Agreement, to the Members.

A companion case to Court Holding cited by the OTA is Cumberland Public Service.[8] Cumberland involved a power generating corporation seeking to sell out to a competing cooperative. The corporation first offered to sell its stock to the cooperative. The cooperative rejected that offer, but offered to purchase the assets of the corporation. The corporation rejected that offer because of the corporate tax liability associated with that sale. The shareholders then offered to acquire the assets from the corporation, and sell them to the cooperative, and that transaction was completed. The IRS attempted to use Court Holding to argue that the sale had actually been completed by the corporation. This time, however, the Supreme Court held for the taxpayer, and distinguished Court Holding by finding that, in Cumberland, at no point did the corporation intend to sell the assets, and the sale was intended to be completed by shareholders from its inception.

The OTA in Silverado distinguished Cumberland by finding that the LLC, and not the Members, intended to be the seller of the hotel from the outset since the LLC negotiated the terms of the transaction and entered into the Sale Agreement. Only later, just prior to closing, did the LLC transfer the Property, and assign its rights under the Sale Agreement, to the Members. Therefore the sale was not intended to be completed by the Members from its inception.

The Bottom Line

The takeaway from Silverado is that, if the members of an LLC intend to do a drop & swap and to withstand a challenge by the FTB, they need to complete the distribution to the members very early, certainly before entering into any agreement with a purchaser, and preferably even before listing the property for sale. If this cannot be accomplished, there may be other methods of achieving the ultimate goals of the members, but those methods become more complicated than a simple distribution of the property to the members.

[1] OTA Case Nos. 21047599, 21047600, 21047601 (2024).

[2]In the Matter of the Consolidated Appeals of Rago Development Corp., et al., Formal Opinion 2015-SBE-001 (June 23, 2015).

[3]Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985).

[4]Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985).

[5]Maloney v. Commissioner, 93 T.C. 89 (1989).

[6]Mason v. Commissioner, 55 T.C.M.1134 (1988).

[7]Commissioner v. Court Holding Co., 324 U.S. 331 (1945).

[8]United States v. Cumberland Public Service Co., 338 U.S. 451 (1950).

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