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Tenancy in Common Interests as Replacement Property
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
Undivided fractional interests (UFIs) also known as tenancy-in-common
interests (TICs) have become a favored and highly promoted form of ownership
because of the ability to exchange into and out of such interests under
Section 1031. See, e.g., Rev. Rul. 73-476; Rev. Rul. 79-44; PLRs 200019014-200019019
(allowing the exchange of TIC interests under Section 1031). In contrast
to bona fide TIC interests, stock, partnership and LLC interests, and
other interests in entities (including interests in a REIT) cannot be
exchanged tax-free under Section 1031. Section 1031(a)(2) specifically
excludes interests in corporations and partnerships (as well as notes,
securities and dealer property) from tax-free treatment under Section
1031.
UFI ownership can be very attractive when faced with the time pressures
of a delayed exchange (45 days to identify and 180 days to receive new property).
Many TIC properties are sponsored and come prepackaged with financing, due
diligence, title commitments and other necessary items in place. TIC ownership
offers many of the same legal and investment advantages as group ownership
through a separate entity, including centralized management, pooling of
capital, leverage, monthly cash flow, low minimum equity requirements, quality
properties and diversification. Limited liability can also be obtained by
owning the TIC interest through an entity that is recognized for legal purposes
but disregarded for tax purposes, such as a single-member LLC. Thus, Section
1031 and UFIs have become a hot new pairing on the tax menu because owners
can exchange tax-free into and out of UFIs (unlike interests in corporations,
partnerships and LLCs) while enjoying the legal and investment benefits
of group ownership. However, an investment in a TIC property should be a
sound and suitable investment standing alone and free of income tax considerations.
A fine wine should not be paired with substandard food. But if the cake
itself is good, the “frosting” of the tax benefits of Section
1031 may make it irresistible.
A UFI is a direct co-ownership interest in property. The transfer of a
UFI conveys an interest in the property itself, not merely an intangible
interest in an entity that owns the property. A UFI is separately alienable
(capable of being transferred or encumbered) and descendible (capable of
being passed by inheritance). Under state law, the owner of a UFI typically
has the right to partition and force a sale of the entire property. UFIs
need not be equal (e.g., the UFIs could be 65%, 30% and 5% co-ownership
interests). As noted above, a direct co-ownership interest in property may
be exchanged just like a 100% fee interest under Section 1031. A joint tenancy
interest is a special and limited kind of UFI. A joint tenancy interest
must be equal (e.g., three joint tenants each own an equal 1/3 interest)
and passes by right of survivorship upon death to the surviving joint tenants.
Owners of UFIs, especially if they are unrelated, usually want varying percentages
of ownership and do not want their interests to pass upon death by right
of survivorship to the surviving owners.
A legal co-ownership may be treated as a tax partnership if the co-owners
engage in sufficient business activity, file partnership returns or otherwise
hold themselves out as a partnership. This “trap for the unwary” greatly
complicates the issue of exchanges into or out of such interests under Section
1031. An owner will be unexpectedly taxed if, in an otherwise qualified
exchange, the owner transfers or receives a legal co-ownership interest
that is treated as an interest in a tax partnership. The very thorny issue
of a tax partnership versus a valid TIC arrangement is analyzed below. To
mitigate this concern, the IRS provided advance ruling guidelines for certain
sponsored TIC programs in Rev. Proc. 2002-22, 2002-14 I.R.B. 733. If the
TIC program obtains a ruling, owners will be assured that the interest qualifies
as a valid co-ownership interest for Section 1031 and other tax purposes.
A fundamental distinction between a co-ownership interest and an interest
in a separate entity is the ability of co-owners to partition the property.
Practitioners often confuse the tax treatment of a partition of one property
(not a “realization event” for tax purposes) with the sale or
exchange of interests in different parcels (a “realization event”).
The IRS recently issued further guidance on the issue of non-taxable partitions.
See PLRs 200328034 and 200303023.
If a tax partnership was created (even though legal co-ownership interests
are owned), what can the owners do? The techniques involve “drop and
swap” transactions (distributions out of a partnership, subsequently
followed by separate exchanges by one or more of the co-owners/former partners)
and “swap and drop” transactions (exchanges at the partnership
level, subsequently followed by distributions of the new properties to the
partners). Another difficult issue is how to handle cash-out partners if
the partnership does a Section 1031 exchange. These transactions are discussed
below in connection with partnership terminations, mergers and divisions.
Section 1031 allows for the exchange of an interest in a partnership if
a valid election out of all of Subchapter K (the partnership tax rules)
is in effect. See Section 1031(a)(2) (flush language). The exchange of such
an interest is treated as an exchange of an interest in the underlying assets
of the partnership. However, it remains unclear when a partnership can make
a valid election out of Subchapter K under the Section 761 regulations.
The IRS recently issued Notice 2004-53, 2004-33 I.R.B. 209, requesting comments
on whether, and under what circumstances, individuals who own property through
state law entities, including a limited partnership or LLC, should be able
to make an election out of Subchapter K.
Tax Partnership Versus Valid Co-ownership Arrangement
Authorities. Reg. Section 301.7701-1(a)(2) provides that a joint undertaking
or other contractual arrangement may create a separate entity for federal
tax purposes if the participants carry on a trade, business, financial operation
or venture and divide the profits therefrom. “For example, a separate
entity exists for federal tax purposes if co-owners of an apartment building
lease space and in addition provide services to the occupants either directly
or through an agent” under this regulation. But “mere co-ownership
of property that is maintained, kept in repair, and rented or leased does
not constitute a separate entity for federal tax purposes.” This determination
is made as a matter of federal tax law and does not depend on whether the
arrangement is recognized as an entity under local law. If the arrangement
creates a business entity with two or more members, the entity will be classified
as a partnership or corporation. See also Reg. Section 1.761-1(a) broadly
defining a tax partnership by reference to these regulations. An exchange
into or out of an interest in such a tax entity does not qualify under Section
1031. Section 1031(a)(2) specifically excludes stock, securities and partnership
interests from nonrecognition treatment under Section 1031.
Under common law, the central characteristic of a tenancy in common is
that each owner is deemed to own individually a physically undivided part
of the entire parcel of property. Each tenant in common is entitled to share
with the other tenants the possession of the whole parcel and has the associated
rights to a proportionate share of rents or profits from the property, to
transfer the interest, and to demand a partition of the property. A tenant
in common has the benefits of direct ownership of the property within the
constraint that no rights may be exercised to the detriment of the other
tenants in common.
Rev. Rul. 75-374, 1975-2 C.B. 261, held that a two-person co-ownership
of an apartment building did not constitute a partnership for federal tax
purposes. In the revenue ruling, the co-owners employed an agent to manage
the apartments on their behalf. The agent collected rents, paid property
taxes, insurance premiums, repair and maintenance expenses, and provided
the tenants with customary services, such as heat, air conditioning, trash
removal, unattended parking, and maintenance of public areas. The ruling
concluded that the agent’s activities in providing customary services
to the tenants, although imputed to the co-owners, were not sufficiently
extensive to cause the co-ownership to be characterized as a partnership.
Similarly, in Rev. Rul. 79-77, 1979-1 C.B. 448, the IRS held that a business
entity was not formed where three individuals transferred ownership of a
commercial building subject to a net lease to a trust with the three individuals
as beneficiaries.
Certain cases specifically address sponsored UFI arrangements. Where
a sponsor packages co-ownership interests for sale by acquiring property,
negotiating a master lease on the property, and arranging for financing,
the courts have looked at the relationships not only among the co-owners,
but also between the sponsor and the co-owners in determining whether the
co-ownership gives rise to a partnership. In Bergford v. Commissioner, 12
F.3d 166 (9th Cir. 1993), seventy-eight investors purchased “co-ownership” interests
in computer equipment that was subject to a 7-year net lease. The co-owners
authorized the manager to arrange financing and refinancing, purchase and
lease the equipment, collect rents and apply those rents to the notes used
to finance the equipment, prepare statements, and advance funds to participants
on an interest-free basis to meet cash flow. The agreement allowed the co-owners
to decide by majority vote whether to sell or lease the equipment at the
end of the lease. Absent a majority vote, the manager could make that decision.
In addition, the manager was entitled to a remarketing fee of 10 percent
of the equipment’s selling price or lease rental whether or not a
co-owner terminated the agreement or the manager performed any remarketing.
A co-owner could assign an interest in the co-ownership only after fulfilling
numerous conditions and obtaining the manager’s consent.
The court held that the co-ownership arrangement constituted a partnership
for federal tax purposes. Among the factors that influenced the court’s
decision were the limitations on the co-owners’ ability to sell, lease,
or encumber either the co-ownership interest or the underlying property,
and the manager’s effective participation in both profits (through
the remarketing fee) and losses (through the advances). Bergford, 12 F.3d
at 169-180. See also Bussing v. Commissioner, 88 T.C. 449 (1987), aff’d
on reh’g, 89 T.C. 1050 (1987); Alhouse v. Commissioner, T.C. Memo
1991-652.
Under Reg. Sections 1.761-1(a) and 301.7701-1 through 301-7701-3, a federal
tax partnership does not include mere co-ownership of property where the
owners’ activities are limited to maintaining, repairing, and renting
or leasing the property. However, “a partnership for federal tax purposes
in broader in scope than the common law meaning of partnership and may include
groups not classified by state law as partnerships.” Bergford, 12
F.3d at 169. Where the parties to a venture join together capital or services
with the intent of conducting a business or enterprise and of sharing the
profits and losses from the venture, a partnership (or other business entity)
is created. Bussing, 88 T.C. at 460. Furthermore, where the economic benefits
to the individual participants are not derivative of their co-ownership,
but rather come from their joint relationship toward a common goal, the
co-ownership arrangement may be characterized as a partnership (or other
business entity) for federal tax purposes. Bergford, 12 F.2d at 169. But
these statements do not provide “bright line” tests and the
dividing line between co-ownerships and partnerships remains unclear.
As a matter of federal tax law, and without an advance ruling from the
IRS, no one can say with great assurance that a sponsored UFI arrangement
is not a tax partnership. The answer may depend upon the exact terms of
the arrangement. Is there a trade, business, financial operation or venture?
If so, who carries it on? Should the activities of the sponsor, manager
or lessee be attributed to the holders of the UFIs? Are any “additional
services” provided to tenants? Is there a sharing of profits and losses
or other shared economic interest between the lessors and lessee or owners
and manager? See, e.g., Bergford, supra; Bussing, supra; PLR 8330093; PLR
8046064. Simply because they are sponsored, should sponsored UFI arrangements
be treated differently than traditional co-ownership of property that has
long been recognized as not creating a separate entity for tax purposes?
See Estate of Appleby v. Commissioner, 41 B.T.A. 18 (1940), affd 123 F.2d
700 (2d Cir. 1941); Gilford v. Commissioner, 210 F.2d 735 (2d Cir. 1953);
Powell v. Commissioner, T.C. Memo 1967-32; McShain v. Commissioner, 68 T.C.
154 (1977).
Allowable Services. Rev. Rul. 75-374, 1975-2 C.B. 261, limits the type
of services that give rise to an active business and partnership status.
Under this ruling, co-owners or their agent may provide "customary
tenant services" in connection with the maintenance and repair of an
apartment building, such as heat, air conditioning, hot and cold water,
normal repairs, trash removal, unattended parking, and common area cleaning
and maintenance. The ruling states that furnishing such customary services
will not create an active business and render a co-ownership a partnership.
Similarly, co-owners or their agent may collect rent and other payments
from tenants, and pay taxes, insurance and normal operating expenses without
creating a partnership. See also PLR 200019014 (2/10/00) (corporate general
partner of six partnerships that will own apartment complexes as tenants
in common will manager the apartment complexes but furnish only customary
services to tenants). In PLR 200019014, the IRS ruled that a new partnership
will not be formed as a result of the six partnerships owning the apartment
complexes as tenants in common, and that the exchange of mobile home parks
for TIC interests in the apartment complexes qualified under Section 1031.
However, Rev. Rul. 75-374 states that furnishing additional services, such
as attendant parking, other utilities for a separate charge, restaurants,
cabanas, recreational facilities, maid service and similar hotel-like services
imply the active conduct of a business. In Rev. Rul. 75-374, an unrelated
company provided additional services for which tenants paid a separate charge
to the company. The company determined the time and manner of performing
these services, paid the expenses, and kept all of the income from these
services. None of the profits arising from additional services were divided
between the co-owners. The ruling holds that the separate provision of additional
services did not taint the co-ownership and create a partnership because
the company alone furnished the services and kept the profits.
In a number of private letter rulings, the Service has followed Rev. Rul.
75-374 in respecting co-ownership arrangements that limit themselves to
customary tenant services. See PLRs 20019014, 8330093, 8048064, 8117040,
7832007, and 7826012. Co-owners may own rental property, including apartment
and office buildings, without creating a tax partnership by following the
arrangements described in the above rulings. Co-owners or their agents must
not furnish additional services to tenants or other persons. If additional
services are to be furnished, they must be provided by an unrelated and
independent operator who will be responsible for the services, pay the expenses
and keep the income. In most small rental properties, such additional services
are usually not provided. Thus, co-ownership of such properties may not
be reclassified as a tax partnership as long as Rev. Rul. 75-374 applies.
Additional Services. The line separating customary and additional services
to tenants is not clear. The provision of gas, electricity and unspecified
other utilities for a separate charge was listed as an “additional
service” in Rev. Rul. 75-374. Presumably, the problem may be avoided
by having separate meters with tenants paying such utilities, or by including
a standard utility charge in the basic rent and making adjustments thereto.
However, utilities such as gas and electricity are usually and customarily
provided by a lessor of an apartment building. Separate charges or reimbursements
for such utilities, without other “additional services,” should
not render a co-ownership a partnership. On the other end of the spectrum,
it is clear that services furnished in connection with a hotel are additional
services that create an active business. See, e.g., Reg. Sections 1.512(b)-1(c)(5)
and 1.1402(a)-1(c)(1)(iii); Rev. Rul. 57-108, 1957-1, C.B. 273 (maid service,
instruction in swimming, boating and fishing, delivering messages and mail).
Additional services may also include laundry facilities, vending machines,
special security, recreational facilities and similar services that are
furnished primarily for the convenience and comfort of tenants. In other
words, such services are unlikely to be “customary” services
relating to the maintenance and repair of the property. See, e.g., G.C.M.
36251 (recreational facilities may be an additional service depending on
facts); PLR 8117040 (laundry facilities “may constitute additional
service”).
The factors used to distinguish between customary and additional services
include: (1) whether the service is furnished primarily for the personal
convenience and comfort of tenants and their guests (additional service);
(2) whether the service is usually and customarily rendered by a lesser
of property (customary service); (3) whether the service relates to the
maintenance and repair of the property (customary service); (4) whether
a service or a facility is an integral part of the property (customary service);
(5) whether the activity itself constitutes a trade of business under other
Code provisions (additional service); (6) whether the service or facility
requires significant time, effort, personnel or capital (additional services);
and (7) whether a separate charge is imposed or a profit is earned (additional
service). If co-owners are in doubt about whether a service is customary
or additional and they desire to avoid partnership status, such services
either should not be provided to tenants or should be contracted out to
an independent firm. If additional services are contracted out, the co-owners
may be able to receive payments from the operator for the privilege of conducting
business on the property that are not based on the operator’s net
profits. See PLR 8117040 (co-owners received a percentage of gross receipts
from the operator of laundry facilities that were installed and maintained
by the operator).
Improvements. Capital improvements made to a property, beyond deductible
maintenance and repair expenses, may imply the active conduct of a business,
depending on the nature, extent and purpose of the improvements. Under the
rules above, such improvements may constitute an additional service to tenants
or other persons that is not customarily performed by a lessor. In the case
of new rental units, the construction itself may involve active conduct
of a business. However, at least one case holds that improvements made merely
to make a property more productive should not render a co-ownership a partnership
for tax purposes. See Estate of Appleby, 14 B.T.A. 18 (1940), aff’d
123 F.2d 700 (2d Cir. 1941). In Estate of Appleby, a building on land was
demolished to construct a garage at a cost of over $143,000 (1917 dollars).
The garage was constructed to pay taxes and produce income at the suggestion
of two auto dealers who became the first tenants, and was later improved
with an inside mezzanine floor at a cost of over $8,000 (1925 dollars).
The court stated that the co-owners did not “operate” the garage
and “were merely the owners of the property, which was improved and
rented primarily to defray the taxes.”
Uncertain Case Law. A plethora of cases have addressed the question of
whether a partnership exists in connection with jointly-owned real estate.
The cases differ somewhat on the level of business activity necessary to
create a tax partnership. The deciding factor in most of theses cases is
whether the parties intended to create a partnership, as evidenced by their
agreement, actions, use of a common name, holding of title, partnership
bank accounts, filing of partnership tax returns, level of business activity,
manner of operation, pooling of income and expenses, degree of individual
or joint control, and continuation of a business enterprise in another form.
The courts find that if a co-ownership has operated like a partnership,
it is a partnership. In these cases, the fact that title to property was
taken as tenants in common is not determinative and “may be considered
neutral evidence.” McManus v. Commissioner, 583 F.2d 443, 447 (9th
Cir. 1978).
The filing of Forms 1065, and the reporting of a partner’s distributive
share on his own tax return, may conclusively establish partnership status
against claims by a co-owner to the contrary. See McManus, supra at 447
(“A taxpayer is estopped from later denying the [partner] status he
claimed on his tax returns”); PLR 8916034 (filing a partnership tax
return and opening a partnership bank account evidenced an intent by co-owners
to form a partnership, despite no significant services to tenants and prior
co-ownership status). However, earlier cases have held that filing a partnership
return is not determinative of partnership status. Needless to say, co-ownerships
desiring to avoid partnership status should not file Form 1065, unless they
are required to do so in order to make an election out of Subchapter K.
See Madison Gas and Electric Company v. Commissioner, 72 T.C. 521, 558,
aff’d 633 F.2d 512 (7th Cir. 1980) (the filing of a partnership return
and election-out under Section 761(a) are not “admissions” of
partnership status).
With the significant exception of Rev. Rul. 75-374 and some private letter
rulings that followed it, the trend of the cases and rulings is to find
a tax partnership in co-ownership cases upon a showing of minimal business
activity and joint conduct. See, Cusick v. Commissioner, T.C.M. 1998-286;
Estate of Aaron Levine v. Commissioner, 72 T.C. 780 (1979). See also Baker
v. Commissioner, T.C. Memo 1997-442; Winkler v. Commissioner, T.C. Memo
1997-4; Marinos v. Commissioner, T.C. Memo 1989-492; Bergford, supra. Compare
Gabriel v. Commissioner, T.C. Memo 1993-524; Lattin v. Commissioner, T.C.
Memo 1995-233; Clifton v. Commissioner, T.C. Memo 1995-528.
The recent case of Cusick is a case of “man bites dog.” The
IRS argued that the rental property was owned by co-owners, while the taxpayer
claimed to be partners in a tax partnership in order to deduct expenses
that had accrued and were unpaid or paid by others. The court held that
despite the lack of any formalities evidencing a partnership, the co-owners
met the definition of a tax partnership because they were engaged in a business
activity and shared profits and losses. At different times, each co-owner
managed a commercial property where office space was rented to a variety
of month-to-month tenants. The management of the property “was difficult
and required a significant amount of time.” The co-owners “not
only maintained books and records and collected rent, but also performed
maintenance tasks such as fixing backed-up toilets and assisting tenants
who were locked out of their offices.” The court held that the “degree
of business activity” exhibited by the co-owners in conducting their
rental real estate activities caused the relationship to be characterized
as a tax partnership.
Cases that have upheld co-ownership arrangements are older cases or usually
involve property inherited by family members (persons who had co-ownership “thrust
upon them”). Moreover, the courts have literally applied a very broad
statute, and found co-owners to be partners if they or their agents carry
on the requisite “degree of business activities,” regardless
of whether or not they intended to form a partnership. In Madison Gas and
Electric Company, supra, 633 F.2d at 514-15, the court stated: “At
bottom MGE’s position is that it is not sound policy to treat the
[co-ownership] entity here as a partnership. But we are not free to rewrite
the tax laws, whatever the merits of MGE’s position.” In the
absence of a ruling under Rev. Proc. 2002-22, the issue of whether a UFI
may be exchanged under Section 1031 may depend on uncertain case law determining
whether or not a co-ownership is a partnership for tax purposes. The burden
of proof will be on co-owners of rental real estate to prove that they are
not partners. See Rothenberg v. Commissioner, 48 T.C. 369 (1967).
Trap for the Unwary. The inadvertent creation of a tax partnership by a
co-ownership remains a huge trap for the unwary under Section 1031, and
the Service is well aware of it. See, e.g., TAM 199907029 (co-ownership
was tax partnership and had to exchange as a partnership); FSA 199951004
(substance of transaction was exchange of partnership interest); PLR 9818003
(replacement properties conveyed directly to partners in liquidation of
their interests disqualified partnership’s exchange); PLR 9741017
(exchange of interests in rental properties did not qualify under Section
1031 because the interests were deemed to be interests in a tax partnership);
PLR 9645005 (partner cannot individually defer gain on property distributed
one day before closing of condemnation sale; replacement property had to
be purchased by joint venture under Section 1033). Compare PLR 9022037 (partnership
conveyed property to partners as tenants in common, 18 days later partners
sold property under threat of condemnation, and partners individually were
eligible to purchase replacement property under Section 1033 since they
were tenants in common at the time of the sale).
Analysis of Rev. Proc. 2002-22
Conditions for Ruling. Section 5 of the revenue procedure outlines the
information required as part of a ruling request. The request must contain
a complete statement of all facts relating to the UFI arrangements, including
those relating to promoting, financing, and managing the property. The information
must include all promotional documents relating to the sale of the UFI,
and all agreements relating to the property, including lending, co-ownership,
lease, purchase and sale, management, brokerage, indemnity, guaranty and
option agreements. All items of information and the conditions set forth
in Section 6 must be accounted for. When multiple parcels of property owned
by the co-owners are leased to a single tenant pursuant to a single lease
agreement and any debt is secured by all of the parcels, the IRS will generally
treat all of the parcels as a single property. In such a case, the IRS will
generally not consider a ruling request unless (1) each co-owner’s
percentage interest is the same in all parcels, (2) each co-owner’s
interest cannot be separated and traded independently, and (3) the parcels
are properly viewed a single business unit.
Section 6 of the revenue procedure details 15 conditions for obtaining
a favorable ruling, and states that “ordinarily” the IRS will
not consider a ruling request unless each one of these 15 conditions is
satisfied.
TIC Ownership. Each of the co-owners must hold title, either directly or
indirectly or through a disregarded entity, as a tenant in common under
local law. Title may not be held by an entity recognized under local law
(other than a disregarded entity). This title requirement also presumably
applies for purposes of electing out of Subchapter K as an “investing
partnership.” See Reg. Section 1.761-2(a)(2) (investment property
must be “owned as co-owners”). So far, so good. Almost all UFI
arrangements, by definition, should meet this requirement.
Number of Co-Owners. The number of co-owners must be limited to no more
than 35 persons (as defined in Section 7701(a)(1)). Under Section 7701(a)(1),
a person includes an individual, trust, estate, partnership, association,
company or corporation. A husband and wife are treated as a single person
and all heirs are treated as a single person. This requirement, on its face,
might be circumvented by using an entity to consolidate an unlimited number
of cash purchasers as one co-owner. Up to 34 exchangers could then directly
own the remaining interests in the property. But for purposes of a ruling
request, the IRS may decide to “look through” the entity in
determining the number of persons.
No Treatment as Entity. The co-ownership may not file a partnership or
corporate tax return. The co-ownership may not 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 business entity. A common bank
account is permitted but the co-ownership should be careful about how it
titles the account. The IRS generally will not issue a ruling if the co-owners
held interests in the property through a partnership or corporation immediately
prior to the formation of the co-ownership. This rules out many situations
in which a ruling would be the most useful, including liquidation of a tax
partnership and holding property as co-owners before an exchange.
Limited Co-Ownership Agreement. The co-owners may enter into a limited
co-ownership agreement that runs with the land. The agreement may provide
that a co-owner must offer the interest for sale to the other owners, the
sponsor or the lessee at fair market value before exercising any right to
partition. The agreement may provide certain voting rights. These are the
only two examples given of what may be included in a co-ownership agreement.
Presumably, the agreement may contain other provisions that are not in conflict
with any of the other conditions of Section 6.
Voting. Each co-owner must retain the right to approve the hiring of any
manager, the sale or other disposition of the property, any leases, or the
creation or modification of a blanket lien, including the negotiation, renegotiation,
extension, or renewal of such agreements or re-leasing of the property (“major
actions”). These major actions must be decided by unanimous approval
of the co-owners. For all other actions, the co-owners may agree to be bound
by the vote of a majority-in-interest. A co-owner who has consented to an
action may provide a power of attorney to execute documents for that action
but may not give a global power of attorney. The requirement of unanimous
approval for major actions may create practical problems and allows a small
dissenting owner to block and stalemate the co-ownership. This is the problem
of “the squeaky wheel running the train.” A co-owner is allowed
to issue an option to purchase his interest (call option). If minority owners
dissent, it is not clear whether the call option could be triggered in the
case of deadlock. Would such a provision be consistent with each co-owner
retaining the right to approve major actions, or would it make such rights
illusory? Compare PLR 8117040 (1/27/81) (no tax partnership where co-owners
could approve management decisions by majority vote, but any decision to
sell or mortgage the property required approval of 75% of the owners in
interest and would be binding on all co-owners); PLR 8048064 (decisions
made by co-owners of a majority-in-interest); PLR 8002011 (10/22/79) (co-ownership
was tax partnership where co-owners agreed to jointly sell the property
by majority vote, could not transfer their interest to third parties with
the prior written consent of all other owners and waived right to partition
during term of agreement).
Alienation. In general, each co-owner must have the rights to transfer,
partition, and encumber the co-owner’s interest in the property without
the agreement or approval of any person. Restrictions are not prohibited
if they are required by a third-party lender (as provided in Section 6.14)
and are consistent with customary commercial lending practices. Further,
the other co-owners, the sponsor, or the lessee may have a right of first
offer to purchase the interest with respect to any co-owner’s exercise
of the right to transfer his interest, and a co-owner may agree to offer
his interest for sale before exercising any right to partition as provided
above. These allowable restrictions may be sufficient to address most concerns
over the right to transfer, partition, or encumber a co-owner’s interest.
If a judgment or other lien attached to a co-owner’s interest and
the creditor attempted to foreclose on the property, the right of first
offer may be triggered with respect to the co-owner’s or his creditor’s
attempt to transfer the interest. Compare PLR 8048064 (grant of right of
first refusal to other co-owners and limited waiver of right of partition
were allowed); PLR 7832007 (similar to PLR 8048064 and right of first refusal
granted to manager if property is sold).
Sharing Net Proceeds. 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. This is straightforward and distinguishes a co-ownership
from, for example, a limited partnership where the general partner may decide
to reinvest the proceeds rather than distribute them to the partners.
Proportionate Sharing of Profits and Losses. Each co-owner must share in
all revenues and costs in proportion to his undivided interest. The other
co-owners, the sponsor and the manager may not advance funds to a co-owner
to meet expenses unless the advance is recourse to the co-owner and not
for a period exceeding 31 days. See Bergford, supra (manager’s advances
to co-owners was a form of sharing in losses).
Proportionate Sharing of Debts. The co-owners must share in any debt secured
by a blanket lien in proportion to their undivided interests. Compare PLR
20019014 (2/10/00) (allowing disproportionate sharing of debt among co-owners
in accordance with the terms of their debt-sharing agreement).
Options. A co-owner may issue a call option provided that the exercise
price reflects the fair market value of the property at the time the option
is exercised (without any discount for a fractional interest). A co-owner
may not acquire an option to sell the co-owner’s interest (put option)
to the sponsor, the lessee, another co-owner, the lender, or any person
related to them. The rationale behind the prohibition of put options is
not entirely clear since such an option enhances the free alienability of
the interest, a distinguishing feature of TIC ownership. The IRS may have
been concerned that put options make the interests akin to marketable securities.
No Business Activities. The co-owner’s activities must be limited
to those customarily performed in connection with the maintenance and repair
of rental real property (customary activities) as described in Rev. Rul.
75-374, supra. Activities will be treated as customary activities if they
would not prevent an amount received by a tax-exempt organization from qualifying
as rent under Section 512 (b)(3)(A) and the regulations thereunder. All
activities of the co-owners, their agents and any persons related to the
co-owners are taken into account, whether or not the activities are performed
in their capacities as co-owners (e.g., all activities of a sponsor or lessee
are taken into account if the sponsor or lessee is a co-owner). However,
activities of a co-owner or related person are not taken into account if
the co-owner owns an interest in the property for less than 6 months.
Management and Brokerage Accounts. The co-owners may enter into management
or brokerage agreements, which must be renewable no less frequently than
annually. The manager 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
against any revenues before disbursing each co-owner’s share of net
revenues. In all events, however, the manager must disburse to the co-owners
their shares of net revenues within 3 months from the date of receipt of
those revenues. The management agreement may also authorize the manager
to prepare statements for the co-owners showing their shares of revenue
and costs from the property. In addition, the management agreement may authorize
the manager to obtain or modify insurance on the property. The manager may
negotiate modifications of the terms of any lease or any indebtedness encumbering
the property, subject to the unanimous approval of the co-owners. The determination
of any fees paid by the co-ownership to the manager must 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 brokers for similar services.
Leasing Agreements. All leasing arrangements must be bona fide for federal
tax purposes. Rents paid by a lessee must reflect the fair market value
for the use of the property. The determination of the amount of the rent
must 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). The rules for REITs under
Section 856(d)(2)(A) and the regulations there under apply for this purpose.
Thus, for example, 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 with respect to any debt that encumbers the
property or that is incurred to acquire an undivided interest in the property
may not be a related person to any co-owner, the sponsor, the manager, or
any lessee of the property. A related person is defined by reference to
Sections 267(b) and 707(b)(1) as if the co-ownership were a partnership
and each co-owner was a partner.
Payments to Sponsor. The amount of any payment to the sponsor for the acquisition
of the co-ownership interest (and the amount of any fees paid to the 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.
Recent Private Letter Ruling. In PLR 200327003, the IRS ruled that an undivided
fractional interest (UFI) in rental real property will not be an interest
in a partnership or other business entity and the UFI will qualify as eligible
replacement property under Section 1031. The sponsor of the UFI program
received a favorable ruling under Rev. Proc. 2002-22, even though it could
not comply with all of the information requirements of the revenue procedure,
the management agreement provided for automatic annual renewals (absent
written notice of termination by any co-owner), and the sponsor would own
some interests in the property and the sales of the interests may take 18
months or longer to complete. PLR 200327003 indicates that the IRS may take
a practical and flexible approach in granting rulings under Rev. Proc. 2002-22
as long as there is substantial compliance with the substantive requirements
of the revenue procedure.
Interest in DST. The IRS recently ruled that a beneficial interest in a
Delaware statutory trust (DST) may be considered an interest in the real
property held by the DST and therefore eligible as relinquished property
or replacement property in an exchange. In Rev. Rul. 2004-86, the DST held
real property, and multiple persons held beneficial interests in the DST.
The trustee’s duties were limited to the collection and distribution
of income to the beneficial owners. The beneficial interests in the DST
represented interests in a grantor trust and thus the beneficial owners
were considered to own undivided fractional interests in the real property
for federal tax and Section 1031 purposes. The trustee could not exchange
the property for other property, purchase assets other than short-term investment
assets, or accept additional contributions of assets, renegotiate the terms
of the debt used to acquire the property, renegotiate the lease with the
tenant of the property or enter into new leases, except in the case of bankruptcy.
Further, the trustee could make only minor nonstructural modifications to
the property. If the trustee had any of these additional powers, then the
ruling holds that the DST would be a business entity classified as a partnership
or corporation and the beneficial interests would not be valid relinquished
property or replacement property in an exchange.
Conclusion. Most of the conditions set forth in Section 6 of Rev. Proc.
2002-22 are not surprising and are consistent with prior authorities addressing
the co-ownership versus tax partnership issue. Sponsored UFI arrangements
that are “vanilla programs” should be able to meet these conditions.
For example, if the co-owners enter into a net lease of their property to
a third party lessee, who in turn re-leases the property to tenants, the
UFI arrangement should satisfy the conditions for a ruling provided that
(1) the number of co-owners does not exceed 35 persons; (2) the lessee is
not the taxpayer’s agent, a co-owner or a person related to a co-owner
(so that the activities of the lessee are not attributed to the co-owners);
(3) the lease meets the requirements of Section 6 and there is no sharing
of profits and losses or other “shared economic interest” between
the co-owners and the lessee; and (4) a sponsor’s compensation does
not exceed fair market value or depend, in whole or in part, on the income
or profits of any person in the property. In these arrangements, the co-owners
may not even enter into any type of co-ownership or management agreement
involving the property, although limited agreements are allowed under the
revenue procedure. Instead, the rights of the co-owners concerning the property
are set forth in the lease with the lessee. These arrangements are the most
likely to qualify as “RETICs” (or ruling-eligible tenancy-in-common
interests).
These arrangements may be contrasted with situations in which the co-owners
enter into both a co-ownership agreement and hire a manager to actively
manage the property on their behalf. Even if the property generates only
rental income, there is a risk that such an arrangement would be treated
as a tax partnership depending on the activities of the manager and whether
any additional services are provided to tenants. Similarly, many sponsored
UFI arrangements that provide for enhanced returns to sponsors, including
any type of cash flow or equity participation, will not eligible to obtain
a ruling under Section 6.15 of the revenue procedure.
Rev. Proc. 2002-22 also may have implications for traditional co-ownerships
that do not involve any sponsors. Traditional co-ownerships can use the
conditions set forth in Section 6 (most of which are consistent with prior
authorities) to avoid reclassification as a partnership. While the revenue
procedure states that these conditions “are not intended to be substantive
rules and are not to be used for audit purposes,” an arrangement that
satisfies these conditions (and thus is “ruling eligible”) is
very unlikely to be treated by the IRS as a tax partnership. At least in
this respect, the conditions in the revenue procedure are like having a
pink elephant in the room that everyone sees but is told to ignore.
The advantages of TIC programs cited by sponsors include the following:
1. Fractional ownership allows an investor to diversify into more than
one property and to participate in potentially larger, institutional quality
properties. Thus, small investors in one area of the country may participate
in large industrial, commercial, and residential property investments
all around the country with professional management.
2. TIC investments provide simplicity by eliminating active property
management headaches. Individuals who are tired of the day-to-day burdens
of being a landlord or who own land and would like an income-producing property
may appreciate the benefits of a TIC investment. A TIC program may provide
a "coupon clipper" or "mailbox management" investment
that can save time and money.
3. Cash flow is generally paid monthly and is tax-sheltered via depreciation
deductions. Owners also share in the appreciation of the property when sold.
4. Minimum equity requirements may be as low as $50,000 and allow the
owner to invest in high quality, institutional grade properties. Otherwise,
it may be prohibitive to acquire property with a billion-dollar credit-worthy
tenant guaranteeing a long-term lease. These low minimums also allow an
owner to investments in different locations, with various property types,
tenants, industries, etc.
5. National real estate companies structure these TIC programs. They
acquire (identify and locate, evaluate, arrange financing, etc.), manage
(maintain, lease, collect rent, service mortgage), and sell the TIC properties.
They have a vested interest in the performance of the property. These companies
may have strong track records extensive experience in all sectors, types,
and locations of real estate.
6. TICs may enable the owner to replace the required debt on the exchange.
Accredited investors assume non-recourse (no personal guarantee) financing
existing on the property. Owners can invest in properties that have no debt
or in ones with very high leverage.
7. TICs may provide the flexibility to avoid the taxable boot if other
real estate does not allow the owner to meet the full debt and equity requirements.
8. A ready inventory of TIC properties allows individuals to easily identify
properties within the 45-day identification period, acquire the property
within the 180 days, or have a "back-up" property in case their
preferred real estate falls through.
Each party to a TIC transaction should consider a variety of factors.
Does the transaction satisfy all provisions of Revenue Procedure 2002-22
and if not which of the requirements does the transaction fail? Further,
is the sponsor interested in obtaining a private letter ruling? Often the
structure and the leverage ratios in a TIC deal are dictated by lenders
and underwriting criteria, and most TIC deals have lower leverage ratios
than most real estate transactions. Further, lenders often require that
the sponsor either guarantee all the non-recourse carve-outs or guarantee
the performance of property managers or other affiliates. All parties should
consider how non-recourse carve-outs are treated in the loan documents.
The sponsor must consider whether or not they will serve as the master tenant
in the transaction. A master lease structure allows the sponsor to particulate
in the upside appreciation of the property but requires a level of financial
commitment in the event that the property fails to perform. Typically the
sponsor has to purchase the property at one price, increase it by the sponsor’s
expenses (“load”) and sell it at a price that will be supported
by an appraisal that can be used to finance the property. This generally
limits the sponsor’s ability to mark up the property when being syndicated.
Most TIC transactions are designed for accredited investors only. Investors
should consider whether the provisions of Rev. Proc. 2002-22 are satisfied;
whether there are any legal opinions supporting the tax treatment of the
arrangement; load and leverage ratios; the reputation of the sponsor and
the major tenants; the existence and adequacy of reserves; exit strategies
including when will the property be sold, when will the debt be due, and
is there any secondary market for the interest?); the structure of the debt,
including any balloon payment and whether the interest rate is fixed or
variable; whether the investor is diversified in the type of property being
held, geographical location and other investments; and the overall economics,
risks and expected return on the deal, taking into account what the sponsor,
master lessee or manager will receive.
In conclusion, TIC investments are usually offered by professional sponsors
that purchase or already own attractive, high quality, commercial properties.
The sponsor puts the owner into a TIC ownership structure, which allows
for up to 35 investors. The property is then re-sold at a marked-up, retail
price to TIC investors. Once the available equity is sold out, the sponsor
usually stays in place as the asset and/or property manager. Since an owner
can invest in several TICs simultaneously, the owner can obtain the benefits
of diversification. Some TIC sponsors offer several property types, such
as retail, office, industrial and multi-family in various and diverse locations.
Such programs can act like a real estate stock mutual fund for the conservative
or passive investor. Both for tax and investment reasons, TIC ownership
structures have become very popular and highly promoted. Combined with Section
1031 exchanges, these TIC ownership structures have become a hot new pairing
on the tax menu.
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