1031 Exchange Update: California FTB’s Failure to Withhold Penalties for 1031 Exchange Rescue Transactions/QIs are in Effect as of March 24, 2020

By: James T. Walther, Esq., LL.M., General Counsel
Legal 1031 Exchange Services, LLC

The California Franchise Tax Board (“FTB”) recently emphasized its position on installment note or installment trust structures used as rescue options for failed or partial 1031 exchanges. Qualified intermediaries (“QIs) and investors should take note of CA FTB Notice 2019-05, September 24, 2019, which recently went into effect as of March 24, 2020 (“the Notice”). In the Notice, the FTB takes the position that these structures are invalid under the §1031 rules and the doctrine of constructive receipt. The Notice further states that QIs may be assessed penalties for not properly withholding taxes on exchange funds transferred to a trust or installment Note.

1031 Exchanges: Investors utilizing an IRC §1031 tax deferred exchange (“Exchange”) can defer the recognition of capital gains taxes they would have recognized upon the sale of real estate by reinvesting sales proceeds into replacement business or investment properties. The Exchanger must reinvest in “like-kind” replacement business or investment real estate, within 180-days. In addition, the replacement properties must be identified within 45-days of the original sale. These timelines can present challenges if not managed properly and the investor utilizing the exchange “Exchanger”) will lose the opportunity to defer taxes if they cannot close on replacement property in time. Accordingly, when an exchange is likely not to complete, Exchangers look for alternatives like tax deferred installment sale strategies to mitigate the potential tax impact. These strategies are sometimes referred to as “rescue transactions” by industry professionals.

Installment Trusts: Structuring an installment sale or trust under IRC §453 allows the seller of real estate or appreciated property to receive sales proceeds in monthly/quarterly/yearly installments over multiple tax years. Variations of installment sale structures are commonly used as a tax deferral strategy, estate planning strategy, and are sometimes used to rescue failed Exchanges. The general concept is that a taxpayer sells an appreciated asset or transfers the asset to an irrevocable trust in consideration for an installment payment agreement or annuity, which is paid to a designated beneficiary. The benefit of converting proceeds from the sale of an asset into an installment note or structured annuity is that it provides the investor the ability to strategically structure a cash-flow investment, to control the timeframe in which they or a beneficiary receive and recognize the gains from the sale, and earn interest on the gross proceeds (untaxed), generating a higher yield because taxes are deferred until payments are received. In general, these structures (“installment trust structures”) have been used by taxpayers for decades; however, the IRS has not issued specific determinations on various aspects of the instalment sales trusts commonly used as 1031 rescue transactions.i

Utilizing a structured installment trust in conjunction with a 1031 Exchange

Installment trust structures are often used as a tax deferral alternative to an Exchange and as a backup option for Exchangers who started a 1031 exchange but were unable to identify or to close on identified replacement property or have purchased replacement property and have leftover exchange proceeds (partial exchanges). Normally, at the completion of a failed or partial exchange, the qualified intermediary transfers any remaining exchange funds in escrow to the Exchanger and the result is a receipt of taxable gain. Exchangers looking for a mechanism to continue deferral of gain often direct funds from the exchange account to an installment trust, which continues to defer taxes on the funds until the installment payments are received. The installments received from the trust are not taxed when the trust is formed, but as explained above.

QIs and Investors should take note: The FTB has made it clear that they will not recognize the validity of the tax deferral mechanism where a QI transfers funds from an exchange escrow to an installment trust. Per the Notice, their position is “that these arrangements do not allow for a deferral of gain recognition under Internal Revenue Code (“IRC”) sections 453 and 1031 since, among other reasons, these sections and the federal doctrine of constructive receipt do not support such a deferral of gain recognition.” In addition, the FTB will penalize QIs who do not withhold and remit the appropriate amount of taxes on the funds invested in an installment trust unless the taxpayer is exempt from withholding.ii

Per the Notice, for exchanges started on or after March 24, 2020, if the taxpayer conducts an exchange where boot or proceeds from an attempted exchange are converted into an installment note or a similar arrangement in which payments are to be paid out over two or more years, CA state withholding is required on the amount converted to an installment note, trust, annuity, or similar arrangement.

With advance planning, an investor can potentially explore numerous options that will maximize the benefits of tax deferral to achieve their investment goals. In the case that an investor starts, but does not complete a full 1031 exchange, a structured installment sale might be a potential option to meet these goals. However, the State of California takes the position that these 1031 exchange rescue transactions are not valid. Intermediaries conducting exchanges for California clients should be aware of these rules. In addition, California taxpayers contemplating a 1031 exchange should consult with their legal or tax advisors regarding the potential consequences of using an installment trust in connection with an exchange.


i Some tax professionals cite PLR 200944002 as non-precedential authority for the premise that certain aspects of the installment trust structure are valid; however, there is some debate regarding the applicability of this taxpayer specific private ruling. More specifically, the Ruling states: “We are specifically not ruling on whether Trustee’s discretion to distribute income and principal of Trust to Grantor combined with other facts (such as, but not limited to, an understanding or pre-existing arrangement between Grantor and trustee regarding the exercise of this discretion) may cause inclusion of Trust’s assets in Grantor’s gross estate for federal estate tax purposes under § 2036 [Transfers with retained life estates].”


ii See FTB Notice 2019-05 available at: https://www.ftb.ca.gov/tax-pros/law/ftb-notices/2019-05.pdf; see also FTB Form 593 instructions at: https://www.ftb.ca.gov/forms/2020/2020-593-instructions.html

Legal 1031 does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Copyright © 2020 Legal1031. All rights reserved.