For California personal income tax purposes, taxpayers were not entitled to nonrecognition of gain from an exchange of property because the taxpayers erroneously included replacement property value in gain calculation. Under California law, an exchange of property qualifies for nonrecognition of gain treatment if (1) the transaction is an exchange; (2) the exchange involves like-kind properties; and (3) both the property transferred and the property received are held for productive use in a trade or business or held for investment.

In this matter, the taxpayers sold the property and reported it as a taxable sale. However, in calculating taxable gain, they used the sales price that was the fair market value of the replacement property instead of the sales price listed in the asset purchase agreement. Upon audit, the Franchise Tax Board (FTB) determined the calculation was incorrect and proposed assessments and imposed accuracy-related penalties. Taxpayers appealed.

Upon review, the Office of Tax Appeals noted that taxpayers failed to show that the exchange was not structured to avoid related party restrictions, Section 1031 and its safe harbor provisions did not apply. Accordingly, the partnership was required to include the sale price of the sold property in the calculation. Thus, the taxpayers’ protest was denied. Lovinck Investments, California Office of Tax Appeals, OTA Case Nos. 19095228, 19095246, September 28, 2021, released November 2021