Tenants-In-Common Arrangements In Connection With Tax Deferred Exchanges

	By Yunna Barats Co-Partner In-Charge Real Estate Group barats@rbz.com
Publication Date: Fall 2005
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 Soaring real property values combined with a possibility of long-term (or infinite) tax deferrals lead to an explosion of like-kind exchanges. A like kind exchange is a transaction where, under certain circumstances, a property owner can exchange his current holding for another similar property without recognizing an immediate taxable gain. On the surface, a likekind exchange transaction resembles a simple sale of an existing property and an acquisition of another. However, there are quite a few conditions that must be satisfied in order to distinguish a fully taxable sale-and-reinvestment transaction from a tax-deferred like-kind exchange. This article will only focus on one aspect of these rules.

In laymen’s terms, in order to defer a gain in a like-kind exchange, a taxpayer must reinvest the proceeds from a sale of his existing property into a bigger property within a specified time frame. In the tax world we refer to this as “replacing cash, debt and value.” This means that in addition to utilizing all cash received from the sale of a relinquished property, a replacement property must be of the same or greater value and carry the same or greater debt than that of a relinquished property.

The biggest challenge of likekind exchange transactions lies, however, in locating that elusive replacement property that would make a good investment and satisfy all of the requirements of a like-kind exchange. In many cases, unable to locate a suitable replacement, real estate investors turn to tenancy-in-common arrangements (i.e. acquiring a partial interest in a particular property), which, until recently, would make tax professionals somewhat uneasy. So, what is wrong with tenants-in-common arrangements?

This point can be best illustrated by way of an example: Mike is a proud owner of a small apartment building, which he acquired 10 years ago for $500,000. Mike receives an offer to sell this building for $2Mill. The building is subject to a $300,000 liability. Assume that after paying off his debts and selling expenses, Mike receives $1.6Mill in cash. Mike would like to enter in a tax-deferred exchange transaction. In order to qualify for preferential tax treatment, Mike has to replace the cash (i.e. $1.6Mill), the debt ($300K) and the value ($2M) of the old property within a short period time, prescribed by tax law. Mike is diligently looking for a replacement but all of the suitable properties are significantly out of his price range. Fortunately, Mike meets Jack and Joe who are also looking for replacement properties for their exchanges. Jack and Joe have actually found a replacement property, but are about $2M short. They offer Mike to use his “exchange dollars” to acquire 1/3 tenant-in-common interest in that property. Can Mike exchange into a partial interest?

Until 2002, we could not answer this question with any kind of certainty. Tax law disallows tax deferrals when a taxpayer exchanged in or out of partnership interests. The IRS, in many cases, viewed the tenants-in-common arrangement, as described above, as partnerships. The issue was litigated many times but, unfortunately, the courts did not provide any bright line tests how to distinguish partnerships from co-ownerships. In 2002, however, the IRS came out with a Revenue Procedure that gave us some guidance in this area.

Revenue Procedure 2002-22 sets forth the requirements for a transaction involving an undivided fractional interest – tenants-in-common (TIC) or marketable tenants-in-common (MTIC) – in a 1031 exchange context that must be satisfied before the Service issues a private letter ruling blessing or condemning the tenants-in-common arrangement.

The scope of Revenue Procedure 2002-22 is limited to “co-ownership of rental real property…in an arrangement classified under local law as a tenancyin- common.”

Although technically the Revenue Procedure only establishes minimum requirements to obtain a private ruling, it gives the tax practitioners much needed guidance in this area.

Revenue Procedures 2002-22 sets forth fifteen minimum conditions that a co-ownership arrangement must satisfy in order to be considered a TIC, rather than a partnership. Some of the major conditions discussed in the IRS Procedure include:

1. Each co-owner must be a tenant-in-common under the applicable state law, which means that title to the property may not be held by one aggregate entity, but must be held by tenants-in-common.
2. The number of the co-owners is limited to 35. For this purpose, husband and wife are treated as a single owner.
3. The TIC arrangement cannot be treated as an entity for tax purposes, which means that there can be no partnership or operating agreement among the co-owners, no business may be conducted under the co-ownership name, and no partnership returns may be filed. The only two types of agreements that the investors may enter into are (i) a co-ownership agreement, which may only address issues common to co-owners, but not partners; and (ii) a management and brokerage services agreement, which must be renewable not less frequently than annually.
4. Each co-owner must be able to hire any manager, sell or otherwise dispose of the underlying real estate, or create a lien. The Revenue Procedure allows for these decisions to be reached by a majority of co-owners, but each co-owner must have a right to vote.
5. Each co-owner must have the right to encumber, transfer or partition its undivided interest in the real estate without prior approval of any other person. All profits and losses, excess proceeds on sale, and debt must be shared by the co-owners proportionately.
6. Co-owners are allowed to issue call options with respect to their interests, but are not allowed to issue put options to the sponsor of a MTIC, another investor or the lender.
7. The co-owners are not allowed to perform any activities other than those customarily performed by owners of real estate, such as maintenance and repair.

In the only private letter ruling issued by the Service under Revenue Procedure 2002-22, the taxpayer was substantially in compliance with all of the IRS requirements (PLR 165157-02 March 7, 2003). The Service ruled that the departures from requirements of the Revenue Procedure were in compliance with the intent of the specific conditions departed from, and blessed the proposed TIC arrangement. Although a private letter ruling cannot be used as a precedent, it gives us some indication as to the IRS’s “frame of mind.”

To summarize, TIC co-owners should exercise caution and prudence. The co-owners must conform closely to the Revenue Procedure in order to withstand potential IRS challenge. However, one should keep in mind that even reliance on the Revenue Procedure may not always be equated to a safe harbor and that uncertainty surrounding this area still exists. Taxpayers should be very careful signing TIC agreements and should have them reviewed by their tax advisors.