The California Franchise Tax Board ("FTB") has officially put 1031 Exchange Qualified Intermediaries on notice that the FTB intends to assess failure to withhold penalties against Qualified Intermediaries when certain tax-deferred installment sale strategies are used to "save" failed 1031 Exchange transactions. The California FTB ruled that these installment sale structures drafted pursuant to Section 453 of the Internal Revenue Code ("Code") and used to "save" failed 1031 Exchanges will not qualify for tax-deferred treatment in California when used in this manner.
The FTB is aware of certain arrangements in which a 1031 Exchange investor and/or Qualified Intermediary attempt to convert proceeds from the sale of the investor's relinquished property that is part of a failed 1031 Exchange, or any unused proceeds from a partial 1031 Exchange, into an installment sale arrangement such as an installment note or other similar arrangement in which payments are to be paid out over two or more years in order to defer the taxes related to the failed 1031 Exchange transaction.
The California Franchise Tax Board made it abundantly clear that these installment sale arrangements will not qualify for tax-deferred recognition under Section 453 or Section 1031 of the Code since, among other reasons, these sections and the federal doctrine of constructive receipt do not support such a deferral of gain recognition.
These tax-deferred installment sale transaction structures have been promoted under various names over the years, including Private Annuity Trusts (PATs), Deferred Sales Trusts (DSTs), Monetized Installment Sales, Self-Directed Installment Notes, among others.
1031 Exchange Qualified Intermediaries ("QIs") must withhold and remit certain amounts to the California FTB when a 1031 Exchange either fully or partially fails. Qualified Intermediaries were put on notice by the California FTB through the issuance of California FTB Notice 2019-05 dated September 24, 2019.
This notice was issued specifically to let 1031 Exchange Qualified Intermediaries know that the California FTB will impose failure to withhold penalties against the Qualified Intermediaries who actively participate in these installment sale transactions where boot or proceeds from a failed 1031 Exchange are converted into an installment sale, installment note or other similar arrangement in which payments are to be paid out over two or more years in order to defer the taxes related to the failed 1031 Exchange.
It is critical that investors have both their legal and tax advisors review any real estate transaction structure before proceeding, especially in cases where there is no guidance from the Internal Revenue Service and/or state taxing authorities. Interest and penalties can be devastating, so it is important that the investor knows and understands the risks involved with such transaction structures. Qualified Intermediaries should be equally careful before voluntarily participating in tax-deferred structures or strategies that have no Federal or state guidance to rely upon.