- IRS Revenue Procedure Provides Guidance For Section 1031 Exchanges Involving Property Held In Tenancy-In-Common Form
- December 9, 2003 | Author: William Cornachio
- Law Firm: Rivkin Radler LLP - Uniondale Office
For more than 75 years, the Internal Revenue Code has contained Section 1031, which allows investors to defer taxes that otherwise would be payable on capital gains they incur in connection with certain transactions that involve the exchange of business or investment property from one party to another. In essence, Section 1031 provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment.
The Section 1031 tax-deferred exchange, and its flip side, the reverse exchange, continue to attract much investor attention. In large measure, this is due to the financial value that can be derived from tax-deferred transactions. It also results from recent revenue procedures issued by the Internal Revenue Service relating to Section 1031 transactions.
For example, Revenue Procedure 2000-37 provides a safe harbor under which the IRS will not challenge (1) the qualification of property as either "replacement property" or "relinquished property" for purposes of Section 1031 and the regulations thereunder or (2) the treatment of the "exchange accommodation titleholder" as the beneficial owner of such property for federal income tax purposes, if the property is held in a "qualified exchange accommodation arrangement."
More recently, in March 2002, the IRS issued Revenue Procedure 2002-22. This revenue procedure essentially explains when the IRS will consider a transfer of property held as a tenancy-in-common to be an investment in real estate for purposes of Section 1031 rather than an investment that falls outside the parameters of Section 1031. Revenue Procedure 2002-22 significantly expands the ability of real estate investors to engage in transactions involving tenancy-in-common properties, and makes this opportunity available to smaller investors as well as large institutional entities.
The difficult position in which tenancy-in-common interests had been placed stems from the exclusion of interests in a partnership from the benefits of Section 1031. The partnership exclusion under Section 1031(a)(2)(D) has been interpreted quite broadly by both the IRS and the courts, and has been held to include "a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and that is not a corporation or a trust or estate."1 Until the IRS issued Revenue Procedure 2002-22, transactions involving property held by tenants-in-common customarily failed to meet the requirements of Section 1031.
Technically, Revenue Procedure 2002-22 only specifies the conditions under which the IRS will consider a request for a ruling that an undivided fractional interest in rental real property is not a partnership interest in a business entity. However, as a practical matter, Revenue Procedure 2002-22 provides important guidance as to the types of transactions involving property held as a tenancy-in-common that will qualify for Section 1031 treatment.
Revenue Procedure 2002-22 indicates that it applies to co-ownership of rental real property (the "Property") in an arrangement classified under local law as a tenancy-in-common. This is a change from prior practice, under which the question of whether an organization was an entity separate from its owners for federal tax purposes was a matter of federal law. As provided in the Revenue Procedure, where multiple parcels of property owned by the co-owners2 are leased to a single tenant pursuant to a single lease agreement and any debt of one or more co-owners is secured by all of the parcels, the IRS generally will treat all of the parcels as a single Property. In such a case, the IRS generally will not consider a ruling request under this revenue procedure unless:
- Each co-owner's percentage interest in each parcel is identical to that co-owner's percentage interest in every other parcel,
- Each co-owner's percentage interests in the parcels cannot be separated and traded independently, and
- The parcels of property are properly viewed as a single business unit.
The IRS generally will treat contiguous parcels as comprising a single business unit. Even if the parcels are not contiguous, however, the IRS may treat multiple parcels as comprising a single business unit where there is a close connection between the business use of one parcel and the business use of another parcel. For example, an office building and a garage that services the tenants of the office building may be treated as a single business unit even if the office building and the garage are not contiguous.
Information To Be Submitted
Generally, the following information and copies of documents and materials must be submitted with a ruling request:
- The name, taxpayer identification number, and percentage fractional interest in the Property of each co-owner;
- The name, taxpayer identification number, ownership of, and any relationship among, all persons involved in the acquisition, sale, lease and other use of the Property, including the sponsor, lessee, manager, and lender;
- A full description of the Property;
- A representation that each of the co-owners holds title to the Property (including each of multiple parcels of property treated as a single Property under this revenue procedure) as a tenant in common under local law;
- All promotional documents relating to the sale of fractional interests in the Property;
- All lending agreements relating to the Property;
- All agreements among the co-owners relating to the Property;
- Any lease agreement relating to the Property;
- Any purchase and sale agreement relating to the Property;
- Any property management or brokerage agreement relating to the Property; and
- Any other agreement relating to the Property not specified in this section, including agreements relating to any debt secured by the Property (such as guarantees or indemnity agreements) and any call and put options relating to the Property.
There are 15 requirements set forth in the Revenue Procedure that parties must meet before the IRS will issue a favorable ruling under this Revenue Procedure, finding that it qualifies as a tax-free exchange. In essence, the IRS indicated that the "central characteristic" of a tenancy-in-common that will qualify under Section 1031 rather than fall within the partnership exclusion is that each owner is deemed to own individually a physically undivided part of the entire parcel of property. Thus, 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. These rights, the IRS continued, generally provide a tenant in common the benefits of ownership of the property within the constraint that no rights may be exercised to the detriment of the other tenants in common.
- Tenancy in Common Ownership. Each of the co-owners must hold title to the Property (either directly or through a disregarded entity) as a tenant in common under local law. Thus, title to the Property as a whole may not be held by an entity recognized under local law.
- Number of Co-Owners. In an apparent borrowing from federal securities act rules and regulations, the number of co-owners must be limited to no more than 35 persons. For this purpose, a husband and wife are treated as a single person and all persons who acquire interests from a co-owner by inheritance are treated as a single person.
- 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 (nor may the co-owners hold themselves out as partners, shareholders, or members of a business entity). The IRS generally will not issue a ruling under this Revenue Procedure if the co-owners held interests in the Property through a partnership or corporation immediately prior to the formation of the co-ownership.
- Co-Ownership Agreement. The co-owners may enter into a limited co-ownership agreement that may run with the land. It is essential to draft this document carefully, to assure that it is not treated as a partnership agreement. For example, a co-ownership agreement may provide that a co-owner must 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; or that certain actions on behalf of the co-ownership require the vote of co-owners holding more than 50 percent of the undivided interests in the Property.
- Voting. The 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 re-lease 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 by unanimous approval of the co-owners. For all other actions on behalf of the co-ownership, 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.
- Restrictions on Alienation. In general, each co-owner must have the rights to transfer, partition, and encumber the co-owner's undivided interest in the Property without the agreement or approval of any person. However, 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. Moreover, as noted, the co-owners, the sponsor, or the lessee may have a right of first offer (the right to have the first opportunity to offer to purchase the co-ownership interest) with respect to any co-owner's exercise of the right to transfer the co-ownership 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 to the co-owner's undivided interest in the Property. Neither the other co-owners, nor the sponsor, nor the manager 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 owner of the co-owner) and is not for a period exceeding 31 days.
- Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.
- Options. A co-owner may issue an option to purchase the co-owner's undivided interest (a "call option"), provided that the exercise price for the call option reflects the fair market value of the Property determined as of 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 the co-owner's undivided interest (a "put option") to the sponsor, the lessee, another co-owner, or the lender, or any person related to the sponsor, the lessee, another co-owner, or the lender.
- No Business Activities. The co-owners' activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property (customary activities). Activities will be treated as customary activities for this purpose if the activities would not prevent an amount received by an organization described in IRC Section 511(a)(2) from qualifying as rent under IRC Section 512(b)(3)(A) and the regulations thereunder. In determining the co-owners' activities, 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, whether or not those activities are performed by the co-owners in their capacities as co-owners. 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. The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually, with an agent, who may be the sponsor or a co-owner (or any person related to the sponsor or a co-owner), but who 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 three 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, and to negotiate modifications of the terms of any lease or any indebtedness encumbering the Property, subject to the 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. Again, careful drafting is vital to avoid against the possibility that the manager is characterized as the managing partner of a partnership.
- 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. 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). 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 with respect to any debt 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.
- Payments to Sponsor. Except as otherwise provided in this revenue procedure, 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.
The IRS envisions a tenancy-in-common within the parameters of Section 1031 for which the property owners have active co-ownership rights and responsibilities. Attorneys and advisors can structure transactions to help to meet these requirements by using a variety of tools, ranging from master lease structures to common managing members. It is clear that Revenue Procedure 2002-22 is an important step toward encouraging a broader use of tenancy-in-common transactions in Section 1031 exchanges.
1 See IRC Section 761(a).
2 For purposes of the Revenue Procedure, the term "co-owner" means any person that owns an interest in the Property as a tenant in common.