Tax-Deferred Exchanges and Tenancy-In-Common
Any experienced real estate investor or lawyer knows that there can always be “a slip from the cup to the lip” when trying to close a real estate purchase transaction. Problems such as structural defects disputed tenant rights, and demanding lenders are some of the obstacles that can delay or even kill a transaction.
The pressure to close can be greatly increased when trying to complete an Internal Revenue Code Section 1031 tax-deferred exchange. Well, the IRS finally threw real estate investors (and their lawyers) a bone to help facilitate these exchanges when they issued Revenue Procedure 2002-22 (the Procedure). It sets forth the conditions under which the agency will consider a request for a ruling that an undivided fractional interest in rental real property is not an interest in a business entity.
For those unfamiliar with tax-deferred exchanges, Section 1031 provides for nonrecognition of gain or loss if a taxpayer engages in a like-kind exchange of properties held for use in a business or for investment. Under Section 1031, an exchangor (the person exchanging properties) must identify the property he or she is going into (the replacement property) no later than 45 days following the sale of the property they are getting out of (the relinquished property). Additionally, the exchangor must take title to the replacement property within 180 days after the transfer of the relinquished property.
Because of the limited number of replacement properties that can be identified under Section 1031, most exchangors designate no more than three replacement properties. Therefore, proper designation of the replacement property is crucial to ensure a timely closing.
A specialized industry has developed to meet the need for last-minute or backup replacement properties. Creative entrepreneurs are purchasing large pieces of real estate with stable tenants (such as Home Depot) and are splitting them up to sell to needy exchangors. These entrepreneurs arrange financing, divide the properties into units of tenancy-in-common (TIC) interests, and sell these interests to exchangors, subject to the debt. These slick entrepreneurs are also known as “sponsors” and they sell these prepackaged units to exchangors who have reached the ends of their identification periods either without suitable replacement properties or in need of back- up alternative replacement properties.
Before the issuance of the Procedure, there was great uncertainty about whether certain arrangements involving co-ownership of TIC interests in real property constituted partnership interests, which are specifically excluded from the tax-deferred benefits of Section 1031. Patchwork case law and the absence of any bright-line rules from the IRS made many exchangors acquiring TIC interests as replacement property nervous that their exchanges would be classified as swaps of business entity interests, and thus invalidated by the IRS.
Exchanges involving TIC interests were further chilled in the year 2000 with the issuance of Revenue Procedure 2000- 46, which stated that the IRS would not issue advance rulings on (1) whether a TIC interest in real property is an interest in an entity (that is, a partnership interest) that is not eligible for a tax-free exchange, or (2) whether arrangements in which taxpayers acquire TIC interests in real property constitute separate entities for federal tax purposes.
Many critics believed Revenue Procedure 2000-46 could be interpreted that the IRS did not look favorably on co-ownership of TIC interests in real property for Section 1031 exchange purposes.
Real estate investors received a break, however, in March 2002 when the Procedure was issued in response to several requests for private rulings filed on behalf of sponsors who were selling TIC interests in real estate as replacement properties for tax-deferred exchanges. While the Procedure states that its ruling guidelines are not substantive rules of law and are not to be used for audit purposes, as a practical matter the guidelines in the Procedure will be inferred by many tax advisers and lawyers as a safe harbor for structuring TIC interests that can be acquired as replacement property in tax-deferred exchanges.
If you are one of those nonbelievers who think the Procedure will be limited to rulings and will not be used for audit purposes, you can probably put this article down and go back to the TV.
However, for those believers, the remainder of this article will discuss a few of the more important and controversial guidelines set forth in the Procedure. It goes without saying that all 15 guidelines of the Procedure should be reviewed when setting up or deciding to use TIC interests for Section 1031 exchange purposes.
Tenancy-in-common ownership – Under Section 6.01 of the Procedure, each of the co-owners must hold title to the property (either directly or through a disregarded entity) as a TIC under local law. Thus, title to the property as a whole may not be held by an entity recognized under local law. This somewhat straightforward requirement has a few key components. First, title to the property as a whole cannot be held by any entity, such as a partnership – this guideline appears reasonable. On the other hand, this guideline specifically endorses the use of disregarded entities, such as single-member limited liability companies, to hold title to the TIC interest.
This is important because each of the co-owners will usually be required by the sponsor or other co-owners to place his or her entity into a disregarded entity in order to avoid adverse legal consequences arising from the bankruptcy or death of a co-owner. The use of disregarded entities allows advisers and lawyers to construct sturdy real estate ownership structures.
Number of Co-Owners
According to Section 6.02, the number of co-owners must be no more than 35 persons, except that a husband and wife are treated a single person and all persons who acquire interests from a co-owner by inheritance are treated as a single person.
With this guideline, it appears the IRS is attempting to mirror the limitations in the securities laws as to offerings to unaccredited investors, which caps such offerings to 35.
No Entity Treatment
Section 6.03 states that the co-owners 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 themselves out as a partnership or other form of business entity. In addition, the co-owners generally cannot have held interests in the property through a partnership or corporation immediately prior to the formation of the co-ownership.
The prohibition by the IRS against filing a partnership or corporate tax returns and the co-owners holding themselves out as a business entity is not too surprising. One interesting note, however, is that the use of a fictitious business name or doing business as (dba) by co-owners could imperil an exchange. For example, the use of a dba such as the “Old Geezer Rest Home” should be avoided to comply with the guideline (and probably not drive away the property’s potential tenants).
Under Section 6.05, 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 the indebtedness secured by a blanket lien, the hiring of any manager, or the negotiation of a management contract (or any extension or renewal of such contract) must be by unanimous approval of the co-owners.
For all other actions, the co-owners may agree to be bound by the vote of those holding more than 50 percent of the TIC interests in the property. A co-owner who has consented to an action may provide the property manager or some other person a power of attorney to execute specific documents with respect to that action, but not a global power of appointment.
While this provision is beneficial in that it allows voting agreements and some actions to be approved by a majority vote of the co-owners, it still requires a lengthy list of actions to be approved by unanimous consent. Some of these actions include any lease of the property or the selection of a manager. Therefore, in the case of TIC interests held in a multi-tenant property, the approval of all TIC interest holders would be required to fill any vacancy in the property or the extension of any management contract. That could prove difficult to obtain in some situations, especially when one or more co-owners are hard to find.
One possible solution to the unanimous consent requirement for all these actions is the use of long-term, triple-net leases. For example, a sponsor could enter into a long-term lease for the property with an affiliate before any of the TIC interests are sold. While the renewal of the lease would require unanimous consent, this could be delayed for a number of years. Furthermore, the selection of the property manager could be a requirement of the lessee, which would be the above-referenced affiliate of the sponsor, and this could further lessen the co-owners required active management of the property.
The IRS could argue that the use of such a lease violates the substantive purpose of this guideline, but this use is not expressly prohibited by the guideline. Furthermore, if the TIC structure is in compliance with the other 14 guidelines, it would seem unlikely that the tenancy arrangement would be invalidated based solely on the use of such a lease.
Proportionate Sharing of Debt
Section 6.09 provides that the co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests (this does not mean, however, that each interest much is liable for the entire indebtedness of the property).
One major drawback of this guideline is that it will be more difficult to tailor debt sharing to accommodate the individual debt needs of TIC interest holders. This is important because an exchangor needs to assume at least as much debt in the replacement property as held in the relinquished property, otherwise, this decrease in debt is taxable.
No Business Activities
One of the most important guidelines of the Procedure is Section 6.11, which states that 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 deemed customary for this purpose if the income received for the performance of such activities would qualify as rent under Section 512(b)(3)(A) (that is, the income received from the performance of such activities cannot be unrelated business taxable income).
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. The first part of the guideline appears to be generally reasonable because too much business activity by co-owners of a property is one of the quickest ways for a tenancy arrangement to be re-characterized as a tax partnership.
An even more important aspect of this guideline is the rule that all activities of the co-owners and their affiliates with respect to the property will be taken into account in determining the co-owners activities, regardless of whether those activities are performed by the co-owners in their capacities as such. These activities could include the sponsor’s efforts to sell the TIC interests in the property.
This could be a major problem because unrelated business activities, such as the selling of the TIC interests by the sponsor, could be imputed to the other co-owners and thus violate the guideline. Thankfully there is an exception that the activities of a co-owner or a related person with respect to the property will not be taken into account if the co-owner owns a TIC interest for less than six months.
This means that neither the sponsor nor a person related to the sponsor can hold a TIC interest in the property for more than six months because if they did, such selling activities (and the proceeds earned) could be imputed to the other co-owners. If such selling activities were imputed to the other co-owners, this would be an express violation of the guideline and the tenancy arrangement could be invalidated. This fear has been lessened, however, by Private Letter Ruling 200327003 because under that ruling the IRS did not disallow a sponsor from owning a TIC interest for more than six months.
Payments to Sponsor
The last guideline, Section 6.15, states that except as otherwise provided in the 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.
This provision is yet another affirmation of the fundamental principle underlying the Procedure that sponsors, although permitted, should not be in a position to participate (directly or indirectly) in the results of the operation of the property.
In conclusion, the Procedure provides relatively clear rules for determining when a TIC interest in real estate should be classified as an interest in a business entity for federal income tax purposes. The rule requiring the unanimous consent requirement of the co-owners for leases and management agreements could create great difficulty in some tenancy arrangements.
As a practical matter, this rule is likely to cause the co-owners of multi-tenant property to use a master lease structure, in which the entire property is net leased to a single tenant who can then sublease the property and hire a manager. The use of this lease structure, if not effectively challenged by the IRS, would effectively eliminate the need to obtain co-owners approval.
One other potential issue regarding TIC structures, especially for lenders, is the fear of bankruptcy. The filing of bankruptcy by one co-owner could theoretically grant an automatic stay over the entire property, particularly if there is only one mortgage securing the loan.
Regardless of these restrictions and concerns, it appears that the Procedure is a positive direction in the expected growth of TIC interests as replacement property and should benefit sponsors and exchangors who plan accordingly.