New IRS Ruling Permits Tax-Free Exchanges of Certain Tenancies-in-Common

A new IRS guideline expands the marketplace for Section 1031 Like-Kind Exchanges by making it possible for investors to purchase undivided interests in a larger property as tenants-in-common and have those interests qualify as valid exchange property.

Section 1031 of the Internal Revenue Code provides that any gain or loss realized upon the exchange of investment property for other property of a like-kind may be deferred until the "exchange property" is disposed of in a subsequent taxable transaction. Certain types of "nonqualifying property" are excluded from tax-deferred treatment under Section 1031, including "interests in a partnership." Under certain circumstances, co-owners of property can be treated as partners for tax purposes, even when no formal partnership agreement exists.

In Revenue Procedure 2002-22, the IRS listed the conditions under which it will consider issuing a ruling that an undivided fractional interest (i.e., a tenancy-in-common) in real property is not an interest in a partnership for tax purposes. This will allow smaller investors to compete with institutional investors on larger deals by pooling funds for larger properties that they ordinarily wouldn't be able to afford.

The new IRS procedure outlines a total of 15 requirements to avoid characterization of the exchange as an exchange of a partnership interest, including the following:

• The co-owners must hold title to the property as tenants-in-common pursuant to local law.
• The co-owners may not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying any 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. Also, the co-owners must not have held an interest in the property through a partnership or corporation immediately prior to the formation of the co-ownership.
• Co-owners must retain the right to approve the sale or other disposition of the property, any leases of the property, and the creation of any liens on the property.
• In general, each co-owner must have the right to transfer, partition, and encumber its own undivided interest in the property without the approval of any person.
• If the property is sold, any debt secured by a lien on the property must be satisfied and the remaining proceeds must be distributed to the co-owners.
• Each co-owner must proportionately share in all revenues and costs associated with the property.
• All leasing arrangements on the property must be bona fide leases for federal income tax purposes. Rents paid by a lessee must reflect the fair market value for the use of the property and must not depend on the income or profits derived by any person from the property leased (other than a fixed percentage of receipts or sales).
• The lender with respect to any debt that encumbers the property may not be a person related to a co-owner, a sponsor, a manager or any lessee of the property.

Although the IRS has now clarified the circumstances under which an exchange of an undivided interest in rental real property will not be treated as an exchange of a partnership interest, there continue to be several "traps for the unwary." We suggest that you consult with your tax adviser prior to attempting to consummate a like-kind exchange of any tenancy-in-common.
  

For further information on this topic, please contact Beth Tiggelaar at beth.tiggelaar@strasburger.com.

     
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