For California purposes, could a taxpayer recognize Oregon real-property gain during a section 1031 exchange to increase the California replacement property's basis?

Plain-English summary

California Chief Counsel Ruling 99-0571 required a taxpayer to defer gain and use a carryover basis after exchanging Oregon real property for California real property in a transaction that qualified under IRC section 1031.

The taxpayer was an Oregon resident when the exchange occurred and became a California resident later in the same taxable year. Oregon required immediate recognition because the replacement property was outside Oregon and the taxpayer ended Oregon residency.

California did not permit the taxpayer to recognize that gain voluntarily and step up the replacement property's California basis.

FTB also concluded that when the California property was later sold, California would allow a credit for Oregon tax paid on the deferred Oregon-property gain unless Oregon allowed a credit.

The taxpayer's three alternatives

The request presented three possible California treatments:

1. Follow the federal section 1031 treatment, defer the gain, and retain the lower carryover basis.
2. Report the Oregon gain immediately in California, claim an Oregon tax credit, and increase the California property's basis.
3. Exclude the gain because the taxpayer was not a California resident and the relinquished property was not in California when the exchange occurred.

FTB selected the first treatment, paired with a California credit in the later year when the deferred gain became taxable.

California followed the section 1031 basis rule

Revenue and Taxation Code section 18031 conformed to IRC section 1031.

The ruling quoted section 1031(d), which generally carried the relinquished property's basis into replacement property, adjusted for money received and gain or loss recognized.

Because the transaction met section 1031 and California made no exception for replacement property acquired by exchanging out-of-state property, the California property's basis did not increase by the unrecognized Oregon gain.

No election to recognize the gain early

FTB expressly rejected the taxpayer's second alternative.

Once the section 1031 requirements were satisfied, the taxpayer could not choose to report the Oregon gain in California during the exchange year merely to obtain a stepped-up California basis.

California's conformity prescribed deferral and carryover-basis treatment.

Credit when the California property was sold

Revenue and Taxation Code section 18001 allowed California residents a credit for tax paid to another state on income sourced to that state when the other state did not allow the credit.

FTB said the statute did not require both states to impose tax in the same taxable year.

When the replacement property was later disposed of in a taxable event, the California gain would include both the replacement property's own gain or loss and the previously deferred Oregon-property gain.

Because the deferred gain was sourced to Oregon and Oregon had already taxed it, California would allow the credit in the later sale year unless Oregon allowed a credit.

Why the nonresident-accrual exclusion did not apply

The request also raised Revenue and Taxation Code section 17554, which generally addressed income recognized after a taxpayer became resident but accrued while the taxpayer was a nonresident.

The ruling cited Daks v. FTB for the proposition that section 17554 applied only when the tax code did not prescribe a particular reporting method for the income.

Because IRC section 1031 prescribed a method for like-kind exchanges, FTB concluded that section 17554 did not exclude the deferred Oregon gain.

Holding

California required section 1031 deferral and carryover basis for the California replacement property.

The taxpayer could not elect immediate California recognition of the Oregon gain to increase basis.

When the California property was later sold, California would allow a credit for Oregon tax paid on the deferred Oregon gain unless Oregon allowed a credit.

What this means for you

Property owners changing states

A move after an exchange did not erase the deferred out-of-state gain in this ruling. California followed the section 1031 basis rule when the replacement property was in California.

Real estate investors

Immediate tax paid to another state did not create an optional California basis increase. FTB kept the California basis tied to section 1031 deferral.

Tax preparers

Preserve the exchange documents, both states' returns and tax-payment records, residency dates, relinquished-property sourcing evidence, and replacement-property basis schedule through the later sale.

Common questions

Q: Could the taxpayer recognize the Oregon gain voluntarily in California during the exchange year?

A: No. FTB said the taxpayer could not elect out of section 1031 treatment for California after satisfying its requirements.

Q: Did the California replacement property receive a stepped-up basis?

A: No. California used the section 1031 carryover-basis rule and did not add the gain that remained unrecognized under California law.

Q: When was the California credit for Oregon tax available?

A: In the year the California property was sold and the deferred Oregon gain became taxable in California, unless Oregon allowed a credit.

Q: Did both states have to tax the gain in the same year?

A: No. FTB said section 18001 imposed no same-year requirement.

Q: Why was the deferred gain sourced to Oregon?

A: The ruling applied the regulation stating that the source of deferred gain was the location of the exchanged property.

Key source language

• California basis: “Because California conforms to the federal rule and makes no exception for property acquired by the exchange of out-of-state property, the basis of the California replacement property will not be increased by the gain not recognized under California law.”
• Credit timing: “There is no statutory requirement that the income be taxed by each state during the same taxable year.”
• Rejected election: “the taxpayer may not elect to report the Oregon gain for California purposes and receive a stepped-up basis in the replacement property.”

Citations and references

• Cal. Rev. & Tax. Code §§ 18031, 18001, 17554, and 21012(a)(1)
• I.R.C. § 1031(d)
• Cal. Code Regs., tit. 18, § 17951-3
• Daks v. FTB, Cal. Tax Rptr. Para 403-036 (June 24, 1999)

Source

• Landing page: Chief Counsel Ruling index
• Official ruling: Chief Counsel Ruling 99-0571

Original ruling text

STATE OF CALIFORNIA
KATHLEEN CONNELL
FRANCHISE TAX BOARD
Chair
Legal Branch
DEAN ANDAL
PO Box 1720
Member
Rancho Cordova, CA 95741-1720
(916) 845-5316 Fax (916) 845-3648
B. TIMOTHY GAGE
Member

July 17, 2000
Chief Counsel Ruling
99-0571

Re: ****

Dear ***,

In your correspondence dated **, you requested advice concerning the following transaction. ***, who was a resident of Oregon, exchanged real property in Oregon for property in California. At the time of the exchange, he was an Oregon resident. Subsequently, during the same taxable year, the taxpayer became a resident of California. The exchange met the requirements of Internal Revenue Code section 1031, and the taxpayer deferred a gain of **for federal purposes. For Oregon purposes, he was required to recognize the gain because the replacement property was located outside Oregon and he terminated Oregon residency.

You asked how the transaction should be reported for California purposes. You presented the following three alternatives for consideration:

1. Follow the federal treatment and defer the gain. This alternative would result in a
   low depreciable basis for California purposes. You observe, however, that this alternative results in the taxpayer ultimately paying tax to Oregon and to California on the gain from the Oregon property and opine that no tax credit would be available for the year of the exchange because the year would surely be closed to the statute of limitations by the time the California property is sold.

2. Report the gain on the California return and claim a credit for tax paid in Oregon for
   the year of the exchange. This alternative would result in a higher depreciable basis for California purposes. You question whether this alternative is available considering there may be no possibility of electing out of Internal Revenue Code section 1031 for California purposes.

3. Exclude the gain because the taxpayer was not a resident of California when the
   exchange occurred nor was the exchanged property located in California. This alternative would result in a higher depreciable basis for California purposes.

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***.
99-0571
July 17, 2000
Page 2

We conclude that the proper treatment of the transaction is to defer the gain for California purposes pursuant to California's conformity to the basis provisions of Internal Revenue Code section 1031. We also conclude that a California tax credit is available in the year the California property is sold for taxes paid to Oregon on the gain from the Oregon property unless Oregon allows a credit.

Revenue and Taxation Code section 18031 conforms to Internal Revenue Code section 1031, which states, in pertinent part:

(d) Basis
If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange.

You stated that the transaction met the requirements of Internal Revenue Code section 1031 and that the gain from the Oregon property was deferred for federal purposes. Because California conforms to the federal rule and makes no exception for property acquired by the exchange of out-of-state property, the basis of the California replacement property will not be increased by the gain not recognized under California law.

Revenue and Taxation Code section 18001 provides that California residents shall be allowed a credit for taxes paid to another state on income derived from sources within the other state if the other state does not allow the credit. There is no statutory requirement that the income be taxed by each state during the same taxable year. Revenue and Taxation Code section 18001 only requires that the income taxed by the other state be "taxable under this part."

In this case, the basis rules of Internal Revenue Code section 1031(d) operate to defer the realized gain on the exchanged property until the replacement property is disposed of in a recognized taxable event. When this occurs, the ultimate amount of income that becomes "taxable under this part" consists of two elements, a gain or loss from the replacement property and the deferred gain from the exchanged property. Since Oregon tax was paid on the deferred gain, the income qualifies under the statute.

The source of the deferred gain is the location of the exchanged property. (Cal. Code of Regs., tit. 18, §17951-3.)

Because the governing statute does not require taxes be imposed by two states in the same year before the credit is available and the deferred gain has a source in Oregon,

Page 3

***.
99-0571
July 17, 2000
Page 3

we conclude that a California tax credit is available in the year the California property is sold unless Oregon allows a credit.

We specifically reject your second alternative. Because you state that the requirements of Internal Revenue Code section 1031 have been satisfied, the taxpayer may not elect to report the Oregon gain for California purposes and receive a stepped-up basis in the replacement property.

The only conceivable statutory basis for excluding the Oregon portion of the gain when the California property is later disposed of is Revenue and Taxation Code section 17554. That section generally provides that income which is recognized after the taxpayer becomes a resident is not taxable if the income accrued when the taxpayer was a nonresident. A recent California appellate court interpreted Revenue and Taxation Code section 17554 to apply only when the code does not prescribe a particular method for reporting the type of income in question. (Daks v. FTB, Cal. Tax Rptr. Para 403-036 (June 24, 1999).) Internal Revenue Code section 1031 prescribes a particular method of accounting for like kind exchanges. Accordingly, Revenue and Taxation Code section 17554 does not apply to transactions governed by Internal Revenue Code section 1031.

Please be advised that the tax consequences expressed in this Chief Counsel Ruling are applicable only to the named taxpayer and are based upon and limited to the facts you have submitted. In the event of a change in relevant legislation, or judicial or administrative law, a change in federal interpretation of federal law in cases where our opinion is based upon such an interpretation, or a change in the material facts or circumstances relating to your request upon which this opinion is based, this opinion may no longer be applicable. It is your responsibility to be aware of these changes should they occur. This letter is a legal ruling by the Franchise Tax Board Chief Counsel within the meaning of Revenue and Taxation Code section 21012(a)(1). Please attach a copy of this letter and your request to the back of the appropriate return(s) (if any) when filed or any notices or inquiries which might be issued.

Sincerely,

Richard Gould
Tax Counsel