Friday, December 13, 2019
The Tax Cuts and Jobs Act (TCJA) changed the like-kind exchange rules of I.R.C. §1031 such that only real estate can be exchanged in a tax-deferred manner. Personal property trades no longer qualify for tax-deferred treatment if entered into after 2017. But what if the real estate is not owned 100 percent outright by the taxpayer? What if the taxpayer owns a fractional interest in real estate either for convenience or as part of a business entity? In that situation, can the fractional interest be traded for other real estate with any gain on the transaction deferred under I.R.C. §1031? Or, instead, is it possible that owning property in that manner could constitute a partnership with the result that the taxpayer’s “partnership” interest wouldn’t qualify for like-kind exchange treatment?
Fractional interests in real estate and qualification for gain deferral under I.R.C. §1031 – it’s the topic of today’s blog post.
Like-Kind Exchange Basics
A like-kind exchange of real estate is a popular method to dispose of appreciated real estate without incurring tax currently. I.R.C. §1031. A tract of real estate can be traded for other real estate that the taxpayer will hold for business or investment purposes. The rules are liberal enough that the exchange of the properties need not be simultaneous – the taxpayer has up to 45 days to identify the replacement property after the transfer of the relinquished property and must receive the replacement property within the earlier of 180 days after the transfer or by the extended due date of the return for the year of the transfer.
Eligibility of Undivided Fractional Interests
In prior posts, I have looked at the issue of what constitutes “real estate” for purposes of the like-kind exchange rules of I.R.C. §1031. In those posts, implied in the analysis was outright, full ownership of the taxpayer’s interest in the real estate that the taxpayer sought to exchange on a deferred basis. But, what if the interest in real estate is a fractional interest such as a tenancy in common? A tenancy-in-common is an arrangement where two or more people share ownership rights in real estate or a tract of land that can be commercial, residential or farmland/ranchland. When two or more people own property as tenants-in-common, all areas of the property are owned equally by the group – they each own a physically undivided interest in the entire property. In addition, the co-tenants may have a different share of ownership interests. Also, each tenant-in-common is entitled to share with the other tenant 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. When a tenant in common dies, the decedent’s interests in the property becomes part of the decedent’s estate and passes in accordance with the decedent’s will or trust, or state law if the decedent did not have a will or trust.
A significant question is whether a tenancy-in-common ownership arrangement constitutes a partnership for tax purposes. The question is important because the like-kind exchange rules don’t apply to exchanges of partnership interests – a partnership interest is not like-kind to a fee simple interest in real estate. I.R.C. §1031(a)(2)(D). Presumably, the exclusion of partnership interests also applies to multi-member LLC interests where the LLC is taxed as a partnership. Under Treas. Reg. §1.761-1(a) and Treas. Reg. §301.7701-1 through 301.7701-3, a partnership for federal tax purposes does not include mere co-ownership of property where the owners’ activities are limited to keeping the property maintained, repaired, rented or leased. However, the regulations point out that a partnership for federal tax purposes is broader in scope than the common law meaning of “partnership” and may include groups not classified by state law as partnerships.
In 1997, the IRS issued a private letter ruling noting that, in some situations, a tenancy in common arrangement resulting in multiple owners holding an undivided fractional interest in real estate could result in a partnership such that the exchange of the owners’ interests would not qualify for like-kind exchange treatment. Priv. Ltr. Rul. 974017 (Jul. 10, 1997). The issuance of the ruling created a stir and the IRS, in 2000, indicate that it would further study the issue. Rev. Proc. 2000-46, 2000-2 C.B. 438. Later, in 2002, the IRS issued Rev. Proc. 2002-22, 2002-1 C.B. 733 setting forth 15 conditions (factors) indicating that an undivided co-ownership in rental real estate would not result in the creation of a federal tax partnership. In essence, the factors point to the tenant-in-common owners not going beyond mere co-ownership of property to the point of engaging in business together. The factors (e.g., “guidelines”) aren’t intended to be substantive rules and are not intended to be used for audit purposes.
The factors (guidelines; conditions) set forth in Rev. Proc. 2002-22 are as follows:
- Each co-owner must hold title as a tenant-in-common under local law;
- The number of co-owners must be limited to no more than 35 persons;
- The co-owners must not file a partnership or corporate tax return; conduct business under a common name; or execute an agreement identifying any or all of the co-owners as partners, shareholders or members of a business entity;
- The co-owners may enter into a limited co-ownership agreement that may run with the land. These agreements may provide that a co-owner must offer its interest for sale to another co-owner at fair market value before exercising any right to partition;
- The co-owners must unanimously approve the hiring of any manager; the sale or other disposition of the property; any leases of the property; or the creation or modification of a blanket lien;
- Each co-owner must have the right to transfer, partition and encumber the co-owner’s undivided interest without the agreement of any person;
- Upon the sale of the property, the net proceeds (after payment of liabilities) must be distributed to the co-owners;
- Each co-owner must proportionally share in all revenues and costs generated by the property and all costs associated with the property pro-rata;
- Each co-owner must share in all debt secured by blanket liens on the property;
- A co-owner may issue an option to purchase its TIC interest, as long as the exercise price reflects the fair market value;
- The activities of the co-owners must be limited to those customarily performed in connection with the maintenance and repair of rental real property;
- The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually;
- All leases must be bona fide leases for federal tax purposes. Rent must reflect the fair market value of the property;
- The lender may not be a related person.; and
- The amount of any payments to a “sponsor” must reflect the fair market value of the acquired co-ownership interest and may not depend on the income or profits derived from the property.
Private Letter Rulings
As noted above, one of the factors of Rev. Proc. 2002-22 is that a co-owner’s activities must be limited to those customarily performed in connection with the maintenance and repair of rental property and that the income from performing such activities is not unrelated business taxable income. All of the activities of the co-owners and their affiliates concerning the property are taken into account, including the sponsor’s efforts to sell the tenancy-in-common interests in the property. But, the activities of a co-owner or related person with respect to the property is ignored if the co-owner owns a tenancy-in-common interest for less than six months. In Priv. Ltr. Rul. 200327003 (Mar. 7, 2003), however, the IRS determined that an undivided fractional interest in real estate qualified for like-kind exchange treatment and was not an interest in a business entity. This ruling helped alleviate concerns about the imputation of activities of a sponsor.
In Priv. Ltr. Rul. 200513010 (Dec. 6, 2004), the IRS provided a good roadmap for real estate investors (and others) to follow when structuring fractional ownership arrangements. The ruling was favorable to the taxpayer and detailed how to structure partition rights; co-owner purchase options; manager substation rights; and how a management company can properly operate without the arrangement being deemed to be a partnership.
PMTA 2010-005 (Mar. 15, 2010) involved a situation where tenants-in-common had taken action to deal with a master tenant’s bankruptcy. They appointed interim agents and there were temporary non-pro-rata contributions from some of the tenants-in-common. The IRS concluded that the owners would not be treated as partners in a partnership for federal tax purposes.
In 2016, the IRS issued additional guidance on a tenancy-in-common arrangement. Priv. Ltr. Rul. 201622008 (Feb. 23, 2016). The facts involved in the private ruling involved a co-ownership agreement between a landlord and a tenant and a management agreement that would become effective after the parties entered into a lease for the property at issue, and a call/put option for the lessee to buy a portion of the property. The landlord owned a commercial office building via a single member limited liability company (LLC). The tenant was to enter into a triple net lease with the LLC set at fair market value with the rental amount not tied to the income or profits derived from the property. The transaction was incredibly complex, but the IRS determined that if the landlord/LLC were to exercise the option and sell a tenancy-in-common interest to the tenant, the relations would not be considered to be a partnership, with the result that each a co-owner could sell his undivided interest in the property in a I.R.C. §1031 exchange because the conditions of Rev. Proc. 2002-22 had been satisfied.
Accounting and Management
To avoid having a tenancy-in-common ownership arrangement be characterized as a partnership with the interests not eligible for like-kind exchange treatment, proper recordkeeping, accounting and management of the arrangement is essential. Care should be taken not to account for the arrangement or manage it in the manner of a business entity. Certainly, a partnership or corporate income tax return should not be filed, even though doing so might simplify reporting expenses and revenues of the arrangement.
A co-tenancy that is established for investment purposes (and not for trade or business purposes can elect to be excluded form partnership treatment. I.R.C. §761(a)(1). But, qualifying for the election can be difficult. See Treas. Reg. 1.761-2. The co-tenants must have chosen to be treated as a partnership pursuant to state partnership law and they must have limited involvement in the operation of the property (which might be the case with bare land ownership). There also must be limited to no restrictions on the rights of co-owners to individually sell their interests, and there should not be any provision in the partnership agreement requiring a vote of a majority to transfer the asset. In addition, each owner must be allocated a constant pro rata share of income and loss based on their share of ownership. If these requirements can be satisfied, the election can be made by attaching a statement to the partnership return that is filed by the filing deadline for the partnership return for the year in which the partnership wants the election to be in place. Whether a partnership agreement can be amended to satisfy the requirement so that an election can be made is an open question.
Many tenancy-in-common arrangements exist in agriculture and elsewhere. Avoiding partnership status so that a like-kind exchange can be achieved can be important in certain situations. Knowing the IRS boundaries is beneficial.