Advisory Board Analysis (rev proc 2002-22)
Rev Proc 2002-22 Introduction
With the publication of Rev. Proc. 2002-22 (1), many practitioners and government attorneys thought that the IRS would be deluged with ruling requests from promoters, syndicators, and individual taxpayers who wanted some assurance that undivided fractional interests (UFI) in real estate would be treated as eligible replacement property in a §1031 exchange, and not as an interest in a business entity, such as a partnership. The avalanche of rulings did not materialize; possibly because it was virtually impossible, as a practical matter, to meet all the literal conditions required under the revenue procedure to obtain a ruling and it was very unclear the extent to which the IRS would be flexible in moving away from any of its conditions. Promoters and syndicators may have been concerned that it would put them and their customers in a very awkward position if they were unsuccessful in obtaining a ruling. In addition, it was not clear how or whether promoters and syndicators could procedurally obtain such a ruling since their potential customers in a proposed transaction could not be (or would not agree to be) identified. In addition, promoters would want the ruling to be generic, i.e., not to apply only to one particular underlying property.
On March 7, 2003, the IRS issued the first ruling (and at least as of such time, apparently the only ruling pending) under Rev. Proc. 2002-22. Although the ruling dealt with a rather conservative structure, promoters, syndicators, and taxpayers, in general, should be gratified by the IRS’s willingness to be practical and take business considerations into account.
The IRS announced in Rev. Proc. 2000-46 (2) that it would no longer issue rulings in connection with UFI’s acquired as replacement property in §1031 exchanges. Instead, it began a study to determine under what circumstances undivided interests should be treated as partnership interests. This study culminated in Rev. Proc. 2002-22, in which guidelines (Guidelines) were issued under which an advance ruling could be obtained. In several ways, the Guidelines were very generous, and they may have permitted one to include provisions in documents that previously may have caused some concern. In other ways, the Guidelines were very conservative and, as explained below, most existing structures that were being offered by syndicators and promoters (3) could not fully comply with the revenue procedure.
Some of the Guidelines and conditions for obtaining a ruling, that are relevant to the ruling that was issued, are:
- The Guidelines only apply to “rental real estate.”
- The Guidelines “are not intended to be substantive rules and are not to be used for audit purposes.” [However, from a practical viewpoint, taxpayers and IRS agents will undoubtedly both be looking to these Guidelines.]
- Each of the co-owners must hold title to the property as co-owners under local law (either directly or through a disregarded entity).
- There cannot be more than 35 co-owners (for this purpose, a husband and wife, and all persons who acquire an interest by inheritance, are treated as one co-owner).
- The co-owners cannot “conduct business under a common name.” [One would have thought they could not “conduct business” at all, irrespective of the name. In any event, it is not clear whether this precludes utilizing a common name for the property (e.g., for advertising or other purposes), although IRS representatives have said, orally, that was not intended. The co-owners, cannot, of course, file a partnership return or hold themselves out as partners for any purpose.]
- The co-owners “must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any lease of a portion or all of the property, or the creation or modification of a blanket lien.”
- Any sale, lease, or release of the property, any negotiation or renegotiation of the indebtedness secured by a blanket mortgage, the hiring of any manager, and the negotiation (or renegotiation) of any management contract, must be “by unanimous approval of the co-owners.”
- For all other actions on behalf of the co-owners, the co-owners may agree to be bound by a vote of those holding more than 50% of the undivided interests in the property.
- Restrictions on the right to transfer, partition, or encumber the co-owners interest in the property “that are required by a lender and that are consistent with customary commercial lending practices are not prohibited.”
- “Customary” type services, (typically performed in connection with maintenance and repair of the property), including cleaning of public areas and the furnishing of heat and light, can be provided to the tenant by the co-owners or their agents. [This is a very significant development because it appears to reaffirm the applicability of Rev. Rul. 75-374 (4)(some practitioners were concerned that the ruling does not have relevance outside the REIT area, which is what was involved) and in effect renders unnecessary the need, in many cases, to have a master net lease to an entity created by the sponsor.]
The revenue procedure states that activities will be treated as "customary" if the activities would qualify as rent under §512(b)(3)(A). This would include heat, air conditioning (although not mentioned in the ruling, it is mentioned in the Preamble to the revenue procedure), trash removal, unattended parking, and maintenance of public areas.
- No business-type activities (except perhaps, as discussed above, for "customary services") can be conducted with respect to the property. For this purpose, all activities of the co-owners, their agents, and any person related to the co-owners "with respect to the property" will be taken into account and attributed to the other co-owners, (except to the extent that a particular co-owner holds his interest for less than six months).
[This raises the issue of whether the maintaining of a co-ownership interest by the sponsor should be a problem, where no services are provided with respect to the property or only customary services are provided. In other words, does the attribution of activities discussed in the prior paragraph mean that the business activities of the promoter in selling the co-ownership interests could somehow be attributed to the other co-owners?]
- Management agreements must be renewable no less frequently than annually. [When taken together with the requirement that management agreements must have unanimous approval, this requirement (which apparently was based on one of the conditions in the §1.761-2(a)(2) regulations) may, from a practical viewpoint, be impossible to meet in almost all situations. IRS representatives have said orally that neither an automatic renewal in the agreement nor merely giving the co-owners the right to "revoke" the appointment of the manager may be acceptable.]
March 7, 2003 IRS Private Letter Ruling
The following is a summary of the facts involved in the ruling:
A promoter, (Promoter) who is in the business of selling UFIs, will acquire the fee interest in commercial real estate (Property) that it will lease to a single-corporate tenant user (the Lessee). The rent will be at fair market value and will not depend, in whole or in part, on the income or profits derived by any person from the Property leased. The lease (Lease) will be a “triple net lease,” under which all costs and expenses related to the Property, including real estate taxes, maintenance, insurance and repairs will be the responsibility of the Lessee. Promoter will acquire the Property with its own cash from the Lessee (in a sale-leaseback transaction).
Following the acquisition of the Property and the execution of the Lease, Promoter will create and sell up to 35 undivided fractional interests (TIC Interests) in the Property to purchasers/co-owners (not more than 35 co-owners, including Promoter if it retains a TIC Interest), presumably all of whom intend to acquire such TIC Interests for cash to complete exchanges under §1031. Neither Promoter, nor any person related to Promoter, will finance any portion of the purchase price of a buyer’s TIC Interest. Each co-owner will hold legal title to the Property as a tenant in common under local law.
Promoter will continue to hold some TIC Interests until all interests are sold, which may take up to a period of 18 months or more to complete. It is anticipated that the only activities of the co-owners (or any person related to the co-owners) with respect to the Property will be activities that would not prevent an amount received by an organization described in §511(a)(2) from qualifying as rent under §512(b)(3)(A) and the regulations thereunder.
The co-owners will not hold themselves out as partners to third parties or conduct business under a common name and will not file a partnership income tax return. The purchase price paid by each co-tenant for its TIC Interest (and the fees paid to the property manager) will reflect the fair market value of the acquired ownership interest (or the services rendered) and will not depend in whole or in part on the income or profits derived by any person from the Property.
Each co-owner will enter into a document titled, "Co-Tenancy Ownership Covenants" (CTOC), upon purchasing his TIC Interest in a Property, which will govern the relationship among the co-owners. Among other things, the CTOC will provide:
- Any sale of the entire property, any lease or re-lease of a portion or all of the Property, any negotiation or renegotiation of any indebtedness secured by any blanket lien, and the appointment of any manager must be approved by unanimous vote of the co-owners. For all other actions, except as set forth below, only approval by the holders of more than 50% of the undivided TIC Interests is required.
- Income and expenses are allocated among the co-owners in proportion to their individual ownership interests in the Property.
- A co-owner may, at any time, sell, finance, or otherwise create a lien upon his own interest, subject to the terms of the CTOC, provided it does not create a lien on anyone else’s interest.
- Any co-owner is free to sell, assign, or transfer all or part of their interest in the Property, subject to the terms of the CTOC.
- The CTOC, by its terms, does not create a partnership or joint venture among or between the co-owners.
- There is no waiver of partition rights among the co-owners.
In addition, each co-owner may, but will not be required to, enter into a Co-Tenancy Management Agreement (CTMA), with Promoter Management Services, Inc. (Manager), an entity that is part of a controlled group of corporations, within the meaning of §1563(a), with Promoter, to provide accounting, insurance monitoring, and lease monitoring activities for the co-owners. The CTMA will provide, among other things:
- Each co-owner who enters into the CTMA retains Manager to act as the manager and oversee all administrative, operational, and management matters of the Property, which include the management of the Lease, the obtaining of various consents when required, monitoring and enforcing the terms of the Lease, re-leasing the Property, maintenance of the Property, receiving and monitoring the rental revenue and the paying of certain expenses, distributing the rental proceeds after the payment of expenses, sending notices of default and otherwise overseeing collection efforts as required, monitoring the payment of taxes by the lessee, and inspecting the underlying premises.
- Each co-owner agrees to be obligated for a proportionate share of all costs associated with the Property. Distributions of each co-owners share of net revenues will be made quarterly.
- Any co-owner may terminate the CTMA provisions concerning accounting and distributions at any time and seek to collect its share directly from the tenant.
- If the Property operates at a loss, or if capital improvements, repairs, or replacements are required, the co-owners shall, upon request, make necessary payments in proportion to their individual ownership interests in the Property.
- Not less than annually, Manager will provide each co-owner with an annual written notice of the renewal of the CTMA. Such notice shall provide each such co-owner with the opportunity to exercise the co-owners right to terminate the CTMA, which can be done at any time under the Agreement with just 60 days notice; otherwise, the CTMA will continue in force until the sale of the entire fee interest in the premises by each such co-owner.
- Any advances made by Manager on behalf of any co-owner are on a recourse basis and must be repaid within the 30-day period following the advance.
- Each co-owner is obligated to pay a fee set at fair market value for the services provided (Management Fee) to the Manager. The Management Fee is payable irrespective of whether rents are actually collected.
- Manager is authorized to offset the costs of operating the Property against any revenues derived from the Property before disbursing each co-owners proportionate share of net income.
- The books and records relating to the Property will be maintained at the principal office of Manager.
The ruling request was potentially in violation of the revenue procedure in several ways: (1) Promoter was requesting a ruling on a generic basis, i.e., there was no actual property identified, nor were there actual co-owners listed (since the property had not even been acquired yet);(5) (2) the documents submitted with the ruling request were generic, form documents used by the Promoter which did not relate to a specific transaction; (3) there would be no affirmative annual vote on retaining or hiring management; and (4) Promoter would retain an ownership interest in the Property for at least 18 months and probably much longer.
In connection with the first two issues, which were procedural, the IRS agreed to issue the ruling even though there was no property identified, the co-owners could not be listed, and the documents submitted with the ruling were in generic form. The IRS presumably recognized that unless it agreed to issue a ruling on such a basis, Rev. Proc. 2002-22 would be of limited use to promoters and syndicators who would never, as a practical matter, be able to apply for a ruling. The IRS is to be commended for helping to make Rev. Proc. 2002-22 practical and usable.
In connection with the two substantive issues, the Promoter argued the following in its ruling request:
Lack of Affirmative Annual Vote
The CTOC provides that any sale, lease, or re-lease of a portion or all of the Property, any negotiation or renegotiation of the indebtedness secured by a blanket lien, and the hiring of a manager, requires the unanimous approval of the co-owners. All other actions on behalf of the co-ownership require the vote of those holding more than 50% of the undivided interests in the Property. Section 6.05 [of the revenue procedure] requires that the renewal of any management contract “be by unanimous approval of the co-owners.” In addition, as explained below, [§]6.12 of the revenue procedure requires that the management agreement be “renewable no less frequently than annually.” We have not been able to ascertain the perceived substantive bases for the annual, unanimous, renewal requirements. In any event, while the language of [§]6.12 is somewhat ambiguous, we assume an actual affirmative vote each year by all the co-owners is not required (certainly there is no basis in the substantive law for such a requirement, and even the one year rule in the §761 election-out regulations does not require an affirmative consent each year so long as the participant can annually terminate the delegated authority)(6) [G]iven that the revenue procedure permits up to 35 co-owners, an annual, affirmative vote requirement for renewal would be totally impractical and unworkable and would make the revenue procedure worthless. In this situation, and we believe consistent with the intent of the revenue procedure, the management agreement requires the Manager to send a notice of renewal to each co-owner annually at which time each co-owner could exercise its right to terminate the management agreement at any time with just 60 days notice. Although not an affirmative consent, this notice requirement coupled with the right to terminate at any time with just 60 days notice should certainly satisfy the concerns of the [IRS] that a co-owner have an opportunity to annually consent to the renewal.(7) Moreover, as the Statement of Facts, provides, the Property will be leased (by unanimous consent) on a triple net lease basis. As a result, the Manager’s responsibilities are quite limited. Accordingly, in this case, the selection of the Manager is a matter of minor importance — oversight, collection of the rents, distributions to the co-owners, and other ministerial functions.
No Business Activities
Rev. Proc. 2002-22 provides that all activities of the co-owners, their agents and any person related to the co-owners “with respect to the property” will be taken into account and attributed to the other co-owners, except to the extent that a particular co-owner holds his interest for less than six months. Therefore the activities of [Promoter] and any person related to [Promoter] “with respect to the Property” must be taken into account in determining whether the co-owner’s activities are customary activities.
It is possible that [Promoter] may own an undivided interest in the Property for a period up to 18 months (or more). However, the Property will be triple net leased to Lessee, requiring only limited activities by the co-owners.(8)
The requirement that all activities of the co-owners “with respect to the Property” be taken into account can only mean the activities performed in connection with the underlying real estate, and not the activities performed by any co-owner in connection with his undivided interest. Otherwise, the business activities of [Promoter] in selling undivided interests would be attributed to all the other co-owners, which in turn might make them dealers in real estate with respect to their co-ownership interests. Similarly, any other co-owner who happens to be holding a co-ownership interest for immediate re-sale would have his intent attributed to the other co-owners who then arguably could not qualify under §1031 (because they would be considered to be holding their interests “primarily for sale”). There is no basis in law for such attribution. Therefore, [Promoter’s] activities “with respect to the property” would not violate the no-business activity requirement set forth in §6.11.
The IRS ruled that a UFI in the Property “will not constitute an interest in a business entity under [Regs.] §301.7701-2(a) for purposes of qualification of the [UFI] as eligible replacement property under §1031(a).” In so holding, the rational of the IRS, in part, was as follows:
Section 301.7701-1(a)(1) provides that whether an entity is an entity separate from its owners for federal tax purposes is a matter of federal law and does not depend on whether the entity is recognized as an entity under local law. Section 301.7701-1(a)(2) provides that a joint venture 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, but the mere co-ownership of property that is maintained, kept in repair, and rented and leased does not constitute a separate entity for federal tax purposes.
Section 301.7701-2(a) provides that a business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under §301.7701-3) that is not properly classified as a trust under §301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code. A business entity with two or more members is classified for federal tax purposes as either a corporation or a partnership.
Section 761(a) provides that the term “partnership” includes 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.
Section 1.761-1(a) of the Income Tax regulations provides that the term “partnership” means a partnership as determined under §§301.7701-1, 301.7701-2, and 301.7701-3.
In Rev. Rul. 75-374, 1975-2 C.B. 261, the [IRS] ruled that a two-person co-ownership of an apartment building that was rented to tenants did not constitute a partnership for federal tax purposes. 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 concludes that the agent’s activities in providing customary services to the tenants, were not sufficiently extensive to be characterized as a partnership. In addition, in Rev. Rul. 79-77, 1979-1 C.B. 448, the [IRS] concluded that the transfer of a commercial office building subject to a net lease to a trust with three individuals as beneficiaries was a trust for tax purposes and not a business entity.
Where a sponsor packages co-ownership interests from 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 co-owners, but also between the sponsor (or persons related to the sponsor) and the co-owners, in determining whether the co-ownership gives rise to a partnership. For example, in Bergford v. Comr., 12 F.3d 166 (9th Cir. 1993),  investors purchased computer equipment that was subject to a seven year net lease. As part of the purchase, 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[%] 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 was a partnership for federal tax purposes. Among the factors that influenced the court’s decision were the limitations on the co-owner’s 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 169-170.
Company’s co-ownership arrangement satisfies all of the conditions set forth in Rev. Proc. 2002-22. Company’s Management Agreement, which the co-owners may enter into, requires the manager to send a notice of renewal to each Co-owner annually at which time each Co-owner could exercise its right to terminate the management agreement at any time with just 60 days notice. Although not an affirmative consent, the notice requirement in Company’s management agreement containing the right of any Co-owner to terminate the agreement at any time with just 60 days notice satisfies the conditions in §§6.05 and 6.12 of Rev. Proc. 2002-22 regarding unanimous annual renewals of any management agreement.”
In connection with the business activities issue and the limited six month grace period in which activities of a co-owner will not be attributed to the other co-owners, the IRS held that because the activities of each co-owner, including the sponsor, “with respect to the property” will be activities that would not prevent an amount received by an organization described in §511(a)(2) from qualifying as rent under §512(b)(3)(A), the company’s activities “in the capacity as co-owner during this period after acquiring and leasing the property will not violate the condition regarding no business activity under §6.11 of Rev. Proc. 2002-22.” In other words, the IRS held that the activities “with respect to the property” refers to activities with respect to the underlying property and not the activities of the co-owner with respect to its individual co-ownership interests. This is a logical conclusion, since otherwise, the activities of a co-owner who is holding his co-ownership interest for sale to customers could be attributed to all other co-owners and disqualify all of them from §1031.
The IRS took a very practical and helpful approach to the procedural impediments that this ruling created. With respect to the substantive issues presented, the IRS could simply have said that although not all the literal conditions of the revenue procedure are met, a favorable ruling would nevertheless be granted under the “savings” clause.(9) Instead, the IRS interpreted the conditions of the revenue procedure and held, in effect, that the conditions were met because there was substantial compliance with the purpose of the particular conditions in question. While this ruling could therefore stand for the proposition that there is a substantial compliance element to the conditions, it would be imprudent of a promoter or a taxpayer in a different set of facts or issues to make such an assumption without his own ruling.
1 - 2002-14, I.R.B. 733.
2 - 2000-2 C.B. 438.
3 - Because of the 45-day identification requirement in §1031(a)(3), promoters and syndicators began packaging and structuring deals whereby a taxpayer could acquire a UFI as replacement property with relative ease. The Property Report section of the Wednesday edition of the Wall Street Journalhas traditionally been an advertising haven for these deals.
4 - 1975-2 CB 261.
5 - This would appear to be in violation of §5.02 of the revenue procedure.
6 - Regs. §1.761-2(a)(2)(iii) states that in order to elect out of Subchapter K, “participants in the joint purchase …. [d]o not actively conduct business or irrevocably authorize some person or persons acting in a representative capacity to purchase, sell, or exchange such management property, although each separate person or persons acting in a representative capacity to purchase, sell, or exchange his share of any such investment property for the time being for his account, but not for a period of more than one year….”
7 - The IRS has previously held that co-tenancy agreements providing for majority rule on matters including the management of the property did not result in a partnership. In PLR 8048064, the IRS ruled that parties to a series of real estate exchanges received undivided interests in an office building (subject to a tenancy in common agreement and a management agreement) and not interests in a partnership, even though “decisions regarding the property will be made by the owners of a majority in interest as tenants in common,” presumably including the management agreement. Similarly, in PLR 8117040, the IRS ruled that owners of an apartment building were co-owners and not partners where the Tenants in Common Agreement provided for majority rule on managing the building, including the decision to hire “a rental agent to rent and manage the property and collect the rent.”
8 - These will certainly be customary activities, not preventing an amount described in §511(a)(2) from qualifying as rent under §512(b)(3)(A) and the regulations thereunder.
9 - Section 6 of the revenue procedure states that the IRS may issue a favorable ruling even if all the conditions are not satisfied if a ruling is warranted based on all the facts and circumstances.
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