A section 1031 proximate exchange occurs when partners desire to transfer partnership property, separate, and separately complete section 1031 exchanges with their respective individual shares of sale proceeds. A section 1031 proximate exchange also occurs when an exchanger desires to acquire property as part of an intended section 1031 exchange and contribute it to a partnership. These transactions are often referred to as “drop-and-swaps” or “swap-and-drops.” The United States Tax Court has established the proximate-exchange principle: “[A] trade of property A for property B, both of like kind, may be preceded by the tax-free acquisition of Property A at the front end, or succeeded by a tax-free transfer of property B on the back end.” Despite this well-established principle, some commentators and advisors still hesitate to rely upon it when advising property owners with respect to proximate exchanges. More troubling, is the disregard of the principle by states that adopt federal income tax rules as their state law. Such disregard by states has many negative tax consequences.

California has most blatantly disregarded the proximate-exchange principle with predictable results. The California Franchise Tax Board (California FTB), the state’s tax enforcement agency, flouts the proximate-exchange principle, and the California Office of Tax Appeals (California OTA), an independent body created by the California legislature to hear taxpayer appeals from positions taken by the California FTB. The California OTA applied the proximate-exchange principle in some cases but more recently failed to apply it in other cases. The result of the different results published by the California OTA is guidance that lacks internal consistency and is inconsistent with the federal proximate-exchange principle. This lack of uniformity creates many undesirable results, including taxpayer confusion, high-cost alternative structures, inequitable tax-planning opportunities that favor high-value transactions, structured transactions that introduce serious non-tax risks into ownership that would not otherwise be present, and sends a horrible message to taxpayers regarding state tax enforcement.

This Article reviews the federal law regarding section 1031 proximate exchanges, showing that federal law overwhelmingly supports granting section 1031 nonrecognition to proximate exchanges. Federal courts present both sound technical and policy reasons for granting section 1031 nonrecognition to such transactions. By contrast, California deviates from federal law in this area with blatant technical and policy deficiencies. This Article reviews the California rulings, showing their inconsistent treatment of section 1031 proximate exchanges and further revealing their technical deficiencies. That analysis shows that California (1) does not apply federal tax law to its detriment; (2) presents a substance-over-form analysis that collapses on itself by elevating formal aspects of proximate-exchange structures over substance when convenient to its desired outcome and otherwise applying the principle haphazardly; (3) commits blatant technical errors in its opinions; and (4) and disregards the purposes of nonrecognition provisions that federal courts rely upon. After showing the shortcomings of California rulings, the Article considers other state decisions and presents suggestions for fixing the problems caused by the California rulings.