Tenancy-in-Common and §1031 Exchanges
Internal Revenue Service Revenue Procedure 2002–22 addresses the use of real property fractional ownership interests as replacement property in Internal Revenue Code §1031 tax-deferred exchanges. Commercial real estate professionals commonly refer to these fractional ownership opportunities as tenancy-in-common interests (TIC).
Tenancy-in-common interests offer increased opportunities to identify a replacement property within 45 days, the option to buy into institutional-grade product for less money, and the potential to diversify into multiple properties with fewer dollars.
In order to achieve 100% tax deferral, the cost of the replacement property must be equal to or greater than the net sales price of the property being sold, and all the proceeds must be used. Further, the seller must identify a suitable replacement property within 45 days of the relinquished property sale. Finally, the seller must take title to the property he ultimately buys in the same manner in which he gives title to the property he sells.
In the past, the IRS often considered an investor’s TIC interest in the new property to be a partnership, thereby invalidating the exchange. Along with partnerships, §1031 prohibits owners from exchanging out of real estate and into a corporation or limited liability company. However, tenancy-in-common interests can be used to complete §1031 exchanges and comply with the title requirements, if the investors receive a deed for a portion of the property, rather than a share of a partnership or corporation.
Proper structuring is a critical step in tenancy-in-common transactions. Pursuant to Revenue Procedure 2002-22, the Internal Revenue Service will consider issuing a private-letter ruling to an interested party if the following 15 conditions are met and/or are present in a proposed TIC transaction.
- Number of Co-Owners. The number of co-owners or investors is limited to no more than 35 persons. For this purpose, a person is defined by Internal Revenue Code 7701(a)(1); however, husbands and wives and all persons who acquire interests from co-owners by inheritance are treated as single persons
- TIC Ownership. Each of the co-owners must hold title to the property, either directly or through a disregarded entity, as tenants in common under local law. The title to the property as a whole may not be held by a single entity recognized under local law.
- No Treatment of Co-Ownership as an Entity. The co-ownership may not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying any or all of the co-owners as partners, shareholders, or members of a business entity, or otherwise hold itself out as a partnership or other form of business entity. The individual co-owners similarly may not hold themselves out as partners, shareholders, or members of a business entity.
- Co-Ownership Agreement. The co-owners may enter into a limited co-ownership agreement that runs with the land. Such an agreement may provide that a co-owner must offer its interest for sale to the other co-owners, the sponsor, or the lessee at fair-market value (determined as of the time the partition right is exercised) before exercising any right to partition. (See §6.06 of Rev. Proc. 2002-22 for conditions relating to restrictions on alienation.) Certain actions on behalf of the co-ownership may require the vote of co-owners holding more than 50 percent of the undivided interests in the property. (See §6.05 of Rev. Proc. 2002-22 for conditions relating to voting.)
- Voting Conditions. Co-owners must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any leases of a portion or all of the property, or the creation or modification of a blanket lien. Any sale, lease, or release of a portion or all of the property, any negotiation or renegotiation of indebtedness secured by a blanket lien, the hiring of any manager, or the negotiation of any management contract (or any extension or renewal of such contract) must be unanimously approved by the co-owners. For all other actions, the co-owners may agree to be bound by the vote of those holding more than 50 percent of the undivided interests in the property. A co-owner who has consented to an action in conformance with Rev. Proc. 2002-22 §6.05 may provide the manager or other person with a power of attorney to execute a specific document with respect to that action, but may not provide the manager or other person with an unlimited power of attorney.
- Restrictions on Alienation. Each co-owner must have the right to transfer, partition, and encumber their own undivided interest in the property without the agreement or approval of any person. Restrictions on the right to transfer, partition, or encumber interests in the property that are required by a lender and that are consistent with customary commercial lending practices are not prohibited. (See Rev. Proc. 2002-22 §6.14 for restrictions on who may be a lender.) Moreover, the co-owners, the sponsor, or the lessee may demand the right of first offer (the first opportunity to offer to purchase the co-ownership interest) before any co-owner may exercise their right to transfer their interest in the property. In addition, a co-owner may agree to offer the co-ownership interest for sale to the other co-owners, the sponsor, or the lessee at fair-market value (determined as of the time the partition right is exercised) before exercising any right to partition.
- Sharing Proceeds and Liabilities Upon Sale of Property. If the property is sold, any debt secured by a blanket lien must be satisfied and the remaining sales proceeds must be distributed to the co-owners.
- Proportionate Sharing of Profits and Losses. Each co-owner must share in all revenues generated by the property and all costs associated with the property in proportion with their undivided interest in the property. The other co-owners, sponsor, or manager of the property may advance funds to a co-owner to meet expenses associated with the co-ownership interest unless the advance is recourse to the co-owner (and, where the co-owner is a disregarded entity, the underlying member of the co-owned interest) and is for a period not to exceed 31 days.
- Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by the property by a blanket lien in proportion to their undivided interests.
- Options. A co-owner may issue an option to purchase its undivided interest, referred to as a call option, provided that the exercise price for the call option reflects the fair-market value of the property determined at the time the option is exercised. For this purpose, the fair-market value of an undivided interest in the property is equal to the co-owner’s percentage interest in the property multiplied by the fair-market value of the property as a whole. A co-owner may not acquire an option to sell an undivided interest, referred to as a put option, to the sponsor, the lessee, another co-owner, the lender, or any person related to any of the parties.
- No Business Activities. Co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property according to IRS Rev. Ruling 75-374, 1975-2 C.B. 261. Activities will be treated as customary for this purpose if they do not prevent an amount received by an organization described in 511(a)(2) from qualifying as rent under 512(b)(3)(A) and associated regulations. In determining what constitutes the activities of the co-owners, all activities of the co-owners, their agents, and any persons related to the co-owners with respect to the property will be taken into account, regardless of the capacity in which the activities were actually performed. For example, if the sponsor or a lessee is a co-owner, then all of the activities of the sponsor or lessee (or any person related to the sponsor or lessee) with respect to the property will be taken into account in determining whether the co-owners’ activities are customary activities. However, activities of a co-owner or a related person with respect to the property (other than in the co-owner’s capacity as a co-owner) will not be taken into account if the co-owner owns an undivided interest in the property for less than six months.
- Management and Brokerage Agreements. Co-owners may enter into management or brokerage agreements with an agent, which must be renewable at least once a year. The agent may be the sponsor or a co-owner (or any person related to the sponsor or a co-owner), but may not be a lessee. The management agreement may authorize the manager to maintain a common bank account for the collection and deposit of rents, and to offset expenses associated with the property and revenues before disbursing each co-owner’s share of net revenues. The manager must disburse to the co-owners their shares of net revenues within three months of the date of receipt of those revenues irrespective of circumstances. Further, the management agreement also may authorize the manager to prepare statements for the co-owners showing their shares of revenue and costs from the property, and to obtain or modify insurance on the property and to negotiate modifications of the terms of any lease or any indebtedness encumbering the property (subject to the approval of the co-owners). (See Rev. Proc. 2002-22 §6.05 for conditions relating to the approval of lease and debt modifications.) The determination of any fees paid by the co-ownership to the manager may not depend, in whole or in part, on the income or profits derived by any person from the property, and may not exceed the fair-market value of the manager’s services. Any fee paid by the co-ownership to a broker must be comparable to fees paid by unrelated parties to a broker for similar services.
- Leasing Agreements. All leasing arrangements must be bona fide leases for federal tax purposes. Rents paid by a lessee must reflect the fair-market value for the use of the property and may not depend, in whole or in part, on the income or profits derived by any person from the property leased (other than an amount based on a fixed percentage or percentages of receipts or sales). (See Rev. Proc. 2002-22 Section 856(d)(2)(A) and the regulations therein.) This means that the amount of rent paid by a lessee may not be based on a percentage of net income from the property, cash flow, increases in equity, or similar arrangements.
- Loan Agreements. The lender may not be a person related to any co-owner, the sponsor, the manager, or any lessee of the property for any debt that encumbers the property or any debt incurred to acquire an undivided interest in the property.
- Payments to Sponsor. Except as otherwise provided, the amount of any payment to a sponsor for the acquisition of the co-ownership interest (and the amount of any fees paid to a sponsor for services) must reflect the fair-market value of the acquired co-ownership interest (or the services rendered) and may not depend, in whole or in part, on the income or profits derived by any person from the property.
Investors should seek private-letter rulings on specific offerings for more concrete assurance that their fractional interest meets the specified qualifications.
The new guidelines also open the door for investors who want to structure fractional interests in a desirable replacement property on their own.
Proceed With Caution
Tenancy-in-common programs are in their infancy and commercial real estate professionals should review them carefully before advising clients to consider them as viable replacement property options. Because all programs are not created equal and may have been structured prior to the release of Rev. Proc. 2002-22, careful due diligence is essential. As more sponsors modify their programs to seek and receive private-letter rulings certifying compliance, less due diligence will be necessary.
Consult a tax professional for further information on individual cases.