Madison Title Agency | Madison 1031 | LeaseProbe/Real Diligence | Madison SPECS

By Lee David Medinets, Esq., Chief Counsel, MCRES

California state taxes are determined and collected by the California Franchise Tax Board (the “FTB”).  Prior to 2018, taxpayers who disagreed with a determination of the FTB could take an appeal to the California Board of Equalization (the “BOE”).  Pursuant to the California Taxpayer Transparency and Fairness Act of 2017, the tax appeal functions of the BOE have been transferred to the new California Office of Tax Appeals (the “OTA”), which functions like an administrative law court, hearing cases in three-judge panels.  The BOE, on the other hand, is a political institution whose members are elected.  Nevertheless, while the BOE handled tax appeals, it proceeded in a quasi-judicial fashion, first at a staff review level, and then, when necessary, through a hearing before the full Board.  Decisions by the BOE did not result in judicial precedent, although its proceedings were publicly reported. 

One helpful aspect of the BOE’s procedure was that, prior to final argument, the attorney for the BOE issued a hearing summary that detailed the BOE’s understanding of the facts, the arguments of both the taxpayer and the FTB, the applicable law, the current understanding of the BOE’s staff, and the issues that it hopes will be addressed by the parties in their arguments.  The BOE issued such a hearing summary In the Matter of Emerson Properties, et al., Case number 871652, et al.  The original hearing summary is available at this link.

The case is not obviously groundbreaking.  However, the issue under discussion is of interest to Qualified Intermediaries (QIs), and the hearing summary provides a comprehensive view of the case, although the BOE’s final decision is too brief to be useful.

Emerson Properties is an S Corp with multiple members.  Both the company and its members were appellants in this consolidated tax appeal.  In 2006, the company entered into a contract to sell farmland it owned in Oakley, California for $21,000,000.  There was an initial deposit of $1,000,000.  The contract was amended to increase the deposit by an additional $1,000,000.  Initially, the deposit money was held by an escrow agent in an interest-bearing account, but the money was released unconditionally to Emerson well before closing, together with accrued interest, for a total of $2,006,874.93. 

In July 2008, Emerson entered into an exchange agreement with a QI.  The $2,006,874.93 of deposit money continued to be retained by Emerson and was not transferred to the QI.  There was a final contract amendment that reduced the purchase price from $21,000,000 to $13,000,000 and that called for a final deposit payment to be made in the amount of $500,000.  That $500,000 deposit was delivered directly to the QI and was held as exchange proceeds.  The Oakley property was sold on August 29, 2008 for $13,313,837.  The net proceeds of sale were paid to the QI (as the $500,000 deposit had been).  The $2,006,874.93 initial deposit money was retained by Emerson and was listed as a credit toward the sales price on the closing statement. 

Emerson identified replacement property in Arizona and closed on that purchase on November 4, 2008.  It used at least $1,000,000 of the relinquished property deposit money that it was holding to pay for part of the purchase price.  Nearly all of the balance of the purchase price appears to have come from Emerson’s exchange proceeds and from financing.

On its IRS form 8824 (the form used to report like-kind exchanges), Emerson recognized a gain of $808,712, and claimed that it had deferred a gain of $11,244,464.  On audit, the FTB determined that additional taxable boot was received by Emerson in the amount of $1,198,126 that should have been reported and taxed. 

In short, Emerson claimed that $1,198,126 of deposit money should not be recognized as boot because that money was eventually rolled over into the replacement property.  The FTB claimed that money was taxable boot because Emerson was in actual receipt of that money after the time that the relinquished property was sold, and the gain could not thereafter be sheltered by using the funds to buy replacement property.

It is worth mentioning that the FTB did not argue that the deposit money had to be held by a QI from the time that it was paid by the seller.  The FTB argued only that the funds should have been held by the QI from the time that the relinquished property was sold.  This is an issue that is sometimes difficult to explain to taxpayers and their advisors.  It is helpful to be able to show that the FTB did not argue that ordinary deposit money constitutes boot simply by having been held prior to sale by a taxpayer.

Emerson conceded that deposit money that is paid directly to a taxpayer at closing constitutes taxable boot.  However, Emerson argued that the $2,000,000 plus interest that it held directly was, in essence, an option payment (like most real estate purchase deposits), and that this money is not like proceeds paid to a seller at closing.  The law of an option payment is that it is not income when it is received.  If the option expires without being exercised, then the money is ordinary income.  If the option is exercised, then the money is part of the capital transaction.  (Usually, that means it is treated as capital gains.)  In the meantime, its character remains undetermined, and it does not constitute income of any sort.  Emerson argued that the “transaction” in this case was the entire 1031 exchange – not simply the sale of the relinquished property to a third-party purchaser.  Therefore, Emerson argued, the character of the option payment could not be determined until the exchange was completed or it failed.  Since the exchange was completed, and $1,168,126 of that money was reinvested, there should be no taxable boot on those funds. 

The flaw in Emerson’s argument is that the entire exchange is not a single transaction for purposes of determining the character of option/deposit money.  That money’s characterization is fixed as part of the capital transaction as soon as the relinquished property is sold.  The existence of an exchange agreement and subsequent purchase of replacement property cannot alter the nature of money that was already received by the taxpayer.  If that money was not handled according to the requirements of the Treas. Reg. 1.1031(k)-1(g) safe harbor rules, then the money becomes boot as soon as the relinquished property is sold. 

The FTB made the appropriate arguments and brought proofs that option payments are treated like other payments of the purchase price.  The FTB cited Rev. Rul. 84-121 for the proposition that option payments are treated like other boot.  Emerson argued that the revenue ruling is distinguishable because, in that case, the option payments were kept by the taxpayer and were not reinvested. 

Analysis by the BOE staff made it clear that they generally found the FTB arguments compelling and the taxpayer’s arguments unconvincing although no definitive conclusion was reached in their memo.  BOE staff expressed an opinion that seems to this writer to be technically an overstatement, that deferred exchanges are possible only through the safe harbors provided in Treas. Reg. 1.1031(k)-1(g).  The BOE asked the taxpayers to explain how funds could qualify for 1031 exchange treatment when they had not been handled in accordance with those regulations.  BOE staff acknowledged that they were willing to consider taxpayer’s arguments as to how the “open transaction doctrine” that applies to option transactions might be an exception to the Treas. Reg. 1.1031(k)-1(f)(2) rules concerning actual and constructive receipt of exchange proceeds. 

As it turns out, Emerson’s arguments were not convincing to the BOE, which ultimately affirmed imposition of taxes on the $1,168,126 of deposit money as originally found by the Franchise Tax Board.