By: Louis Rogers And Todd R. Pajonas
New York Law Journal
Volume 227, Number 68
© 2002 NLP IP Company
Wednesday, April 10, 2002
In recent years, many taxpayers and their counsel have become increasingly aware of the benefits of an IRC 1031 tax deferred exchange. Properly structured, a tax deferred exchange allows a taxpayer to defer the capital gain tax realized upon the sale of business or investment property if the taxpayer acquires property of like-kind which is also held for business or investment purposes.
To obtain the benefit of tax deferral, taxpayers must adhere to a strict schedule of identifying and purchasing replacement property. These requirements sometimes leave taxpayers scrambling and, on occasion, unable to complete an exchange. Taxpayers must identify potential replacement property (one or more) within 45 calendar days and acquire the replacement property within 180 calendar days, both periods running from the date of closing the relinquished property. IRC 1031(a)(3)(A)-(B). In addition, to obtain a complete deferral of the capital gain tax, the taxpayer must acquire replacement property of equal or greater value, obtain equal or greater debt on the replacement property, reinvest all the net proceeds realized from the sale of the relinquished property, and acquire only like-kind property. Treas. Reg. 1.1031(d)-2 and IRC 1031(a)(1).
The drive to satisfy both the statutory deadlines and reinvest all of the net proceeds in qualifying replacement property has spawned a boutique industry of companies that sell undivided tenant in common (TIC) interests in real property, most often triple net leased properties. Typically, a sponsor identifies and purchases a desirable property. The sponsor then determines the offering price and how many TIC interests (typically computed on a percentage basis, for example, a 5.5 percent interest) they will sell. The TIC sponsor may earn a commission or acquisition fee and typically manages the property for the TIC owners for a customary management fee. The TIC owners receive a distribution check monthly or quarterly, without having any management responsibilities.
TIC interests are desirable for a number of reasons. First, the investor is not responsible for any property management. Second, novice real estate investors can benefit from working with experienced national or regional real estate sponsors who handle the due diligence, acquisition, financing, leasing, management, etc. and provide the investors with a “net” return. Third, most TIC investors do not have sufficient net proceeds to acquire a first class building, with credit (or other quality) tenants and a nationally recognized property manager; by acquiring an undivided TIC interest, the investor can acquire a small portion of a bigger and better quality replacement property. Fourth, most TIC investors are able to reinvest all of their net proceeds because TIC interests are sold on a percentage basis (versus traditional replacement property that does not come in just the right size to permit the complete reinvestment of the taxpayer’s net proceeds). Finally, a taxpayer may diversify by acquiring TIC interests in a number of properties.
Because TIC interests resemble partnership interests in some respects, it has been unclear whether TIC interests would qualify under Section 1031. This distinction is critical because, since 1984, interests in a partnership specifically do not qualify as replacement property in a tax deferred exchange. IRC 1031(a)(2)(D).
Like-kind property is defined as property held for productive use in a trade or business or for investment purposes that is exchanged solely for property to be held for productive use in a trade or business or for investment purposes. IRC 1031(a)(1). Like-kind refers to the “nature or character” of the property and not its grade or quality. Thus, “[t]he fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.” Treas. Reg. 1.1031(a)-1(b). Real property that conforms to this definition should be considered “like-kind” even though very different in a practical sense. For example, vacant land which is held for investment can be exchanged for industrial property held for business or investment purposes. There is no requirement that properties be similar in type or class.
In addition, personal property fitting the above definition of like-kind may also be exchanged. However, personal property and real property are not like kind. Therefore, real property must be exchanged for real property and personal property must be exchanged for personal property. The determination as to what is considered real property and what is considered personal property is generally determined by state law. Treas. Reg. 1.1031(a)-1(b), (c), Aquilino v. U.S., 363 U.S. 509, 80 S. Ct. 1277, 4 L.Ed.2d 1365, 5 A.F.T.R.2d 1698, 60-2 USTC P 9538 (U.S.N.Y., 1960); Coupe v. Commissioner of Internal Revenue, 52 TC 394 (Tax Ct., 1969), acq. in result, 1970-1; and Rev. Rul. 55-749.
The IRS has recently provided much needed guidance on the qualification of TIC interests in Revenue Procedure 2002-22 issued on May 19, 2002. Unlike the “safe harbor” that had been expected, the guidance takes the form of advance ruling requirements. While not a statement of substantive law, the advance ruling requirements are likely to become a litmus test for many sponsors of tenant in common replacement property programs.
Previously, in Revenue Procedure 2000-46 (Oct. 12, 2000), the IRS stated that it would no longer issue advance rulings on whether an undivided (fractional) tenant in common interest in real property is an interest in an entity that is eligible for tax-deferred exchange treatment under Section 1031. The IRS was concerned that taxpayers were taking the position that certain arrangements where they acquire tenant in common interests in real property may constitute an interest in an entity classified as a partnership for federal income tax purposes. Revenue Procedure 2000-46 has now been repealed. A copy of Revenue Procedure 2002-22 is attached.
The advance ruling guidelines are set forth in Section 5 and the conditions to issuance of a ruling are set forth in Section 6, which are set out below. The Revenue Procedure states that the IRS “ordinarily” will not consider a request for a ruling unless the information described in Section 5 is included and the conditions described in Section 6 are satisfied. However, even if Sections 5 and 6 are satisfied, the IRS may decline to issue a ruling “whenever warranted by the facts and circumstances of a particular case and whenever appropriate in the interest of sound tax administration.” This will create fertile ground for creative sponsors of tenant in common programs and their able tax counsel.
Section 5 outlines the information to be submitted as part of a ruling request, including detailed information on each co-owner and the property. In addition, the ruling request must contain a complete statement of all the facts relating to the tenant in common ownership, including those relating to promoting, financing and managing the property. All of the following information must be included to the extent related to the property:
All documents and supplementary materials submitted to the IRS must contain applicable exhibits, attachments and amendments. Keep in mind that rulings will only be granted for “real” (and not hypothetical) deals.
However, much of the required information may only be known at the end of an offering, when the sponsor is ready to acquire the property, close the loan and sell interests to the tenants in common. Accordingly, it is unlikely that many sponsors will be able to keep a deal open long enough to obtain a ruling.
The IRS “ordinarily” will not consider a request for a ruling unless the conditions described in Section 6 are satisfied. However, where the conditions in Section 6 are not satisfied, the IRS still may consider a ruling request “where the facts and circumstances clearly establish that such a ruling is appropriate.” The conditions are summarized below.
In conclusion, the IRS may now render advance rulings on tenant in common programs. However, very little new guidance has been given on the difference between a qualifying tenant in common interest and a non-qualifying interest in an entity. Also, there is no mention of the much anticipated master lease programs.
The conditions stated above are understood and being followed by many sponsors of tenant in common programs. However, the IRS retains the authority under appropriate circumstances to decline to issue a ruling. The absence of a “safe harbor” or other bright line test will create fertile ground in the future for creatively structured tenant in common programs. Apparently, the IRS decided to defer the hard questions to the future, when ruling requests are received and considered.
Therefore, those interested in tenant in common programs will need to wait for guidance to follow from the IRS in future rulings and, possibly, announcements. Until then, sponsors of tenant in common programs are likely to adapt their programs to conform with most of the conditions stated in the Revenue Procedure. However, sponsors of other programs, for example, those that make use of a master lease or election out of Subchapter K, are free to continue offering their programs because the Revenue Procedure is not a statement of substantive law and not to be used for audit purposes.
Louis Rogers is a shareholder with Hirschler Fleischer in Richmond, Va. Todd R. Pajonasis an attorney and division manager with 1031 Exchange Place, in White Plains, a sister company of Stewart Title Insurance Company.