In March 2002, the Internal Revenue Service issued guidance in the context of Undivided Fractional Interests (UFI) or Tenancy in Common Interests (TIC) in rental real property. The guidance, delivered in the form of Revenue Procedure 2002-22, is intended to provide a set of guidelines under which the IRS will consider a request for an advance ruling that a TIC in rental real property is not an interest in a business entity such as a partnership. This guidance, while meaningful to sponsors or promoters of TIC interests, has important significance to taxpayers who are completing tax-deferred exchanges of real estate under Internal Revenue Code Section 1031.

Section 1031 allows a taxpayer to sell investment or business-use property and defer current recognition of gain on the sale of the old property. To qualify under Section 1031, the taxpayer must identify a limited number of potential replacement properties within 45 days from the date the old property is transferred and acquire one or more of the identified properties within 180 days from the date the old property is transferred (or the due date for the taxable year of the exchange, including extensions, if earlier). Corporate and individual taxpayers alike have long taken advantage of the benefits afforded by IRC Section 1031, and current estimates indicate that greater than $20 billion worth of real estate assets were exchanged in 2001.

In addition to meeting the time requirements under Section 1031, the taxpayer must acquire “like-kind” property. For purposes of a real estate exchange, “like-kind” means real property for other real property. The code lists specific properties that are excluded from favorable treatment under Section 1031 including stocks, bonds, notes and interests in a partnership.

In the last few years, an entire industry has developed to serve Section 1031 investors looking for replacement property — sponsors or promoters of UFI or TIC interests. Sponsors pre-package and sell tenancy in common interests in all types of property: office buildings, apartment complexes, industrial properties and single-tenant, net-leased properties. The appeal of these structures to the Section 1031 investor is a long-term, low-risk investment, and elimination of the hassle involved in identifying and acquiring suitable replacement property within the time parameters of the code.

While there is some authority that a tenancy in common interest is qualifying property for 1031 purposes [PLR 8836036, PLR 8933019 and PLR 9609016], the overwhelming concern of both sponsors and investors has been distinguishing the acquisition of a tenancy in common interest from the acquisition of excluded property such as an interest in a partnership. The concern arises as a result of the agreements that co-tenants are frequently required to sign. These agreements may restrict the co-tenants’ rights to transfer, partition or encumber the property, and often provide for the continued involvement of the sponsor in the management of the property so that they resemble partnership-type agreements.

In October 2000, the IRS issued notice 2000-46 announcing that the IRS would no longer issue rulings on Section 1031 exchanges where a co-tenancy interest is acquired as replacement property, but would continue to study the issue and publish formal guidance. Revenue Procedure 2002-22 is the culmination of this 2-year study.

The Revenue Procedure provides that where the following conditions are not satisfied, the IRS may still consider a request for a ruling where the facts and circumstances clearly establish that such a ruling is appropriate.

Revenue Procedure 2002-22 Conditions for an advance ruling:

• Tenancy in Common Ownership. Each of the co-owners must hold title to the property, (either directly or through a disregarded entity) as a tenant in common under local law.
• Number of Co-Owners. The number of co-owners must be limited to no more than 35 persons.
• No Treatment of Co-Ownership as an Entity. The co-ownership may not file a partnership or corporate tax return, conduct business under a common name or hold itself out as a partnership or other form of business entity.
• Co-Ownership Agreement. The co-owners may enter into a limited co-ownership agreement that may run with the land. For example, a co-ownership agreement may provide that a co-owner must offer the co-ownership interest for sale to the other co-owners, the sponsor or the lessee at fair market value before exercising any right to partition.
• Voting. The co-owners must retain the right to approve the hiring of any manager, the sale of other disposition of the property, any leases or 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 re-negotiation of indebtedness secured by a blanket lien, the hiring of any manager or the negotiation of any management contract must be by unanimous approval of the co-owners. For all other actions on behalf of the co-ownership, the co-owners may agree to be bound by the vote of those holding more than 50 percent of the undivided interests in the property.
• Restrictions on Alienation. In general, each co-owner must have the right to transfer, partition and encumber the co-owners’ undivided interest in the property without the agreement or approval of any person. However, restrictions on the right to transfer, partition or encumber interests in the property that are required by a lender and that are consistent with customary commercial lending practices are not prohibited.
• Sharing Proceeds and Liabilities upon Sale of Property. If the property is sold, any debt secured by a blanket lien must be satisfied and the remaining sale proceeds must be distributed to the co-owners.
• Proportionate Sharing of Profits Losses. Each co-owner must share in all revenues generated by the property and all costs associated with the property in proportion to the co-owners’ undivided interest in the property.
• Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.
• Options. A co-owner may issue an option to purchase the co-owners’ undivided interest (call option) provided that the exercise price for the call option reflects the fair market value of the property determined as of the time the option is exercised. For this purpose, the fair market value of an undivided interest in the property is equal to the co-owners’ percentage interest in the property multiplied by the fair market value of the property as a whole. A co-owner may not acquire an option to sell the co-owners undivided interest (put option) to the sponsor, the lessee, another co-owner or the lender, or any person related to the sponsor, the lessee, another co-owner or the lender.
• No Business Activities. The co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property. If the sponsor or a lessee is a co-owner, then all of the activities of the sponsor or lessee (or any person related to the sponsor or lessee) with respect to the property will be taken into account in determining whether the co-owners’ activities are customary activities.
• Management and Brokerage Agreements. The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually, with an agent, who may be the sponsor or a co-owner (or any person related to the sponsor or co-owner) but who may not be a lessee.
• Leasing Agreements. All leasing arrangements must be bona fide leases for federal tax purposes. Rents paid by a lessee must reflect the fair market value for the use of the property. The determination of the amount of the rent must not depend, in whole or in part, on the income or profits derived by any person from the property leased (other than an amount based on a fixed percentage or percentages or receipts or sales).
• Loan Agreements. The lender with respect to any debt that encumbers the property or with respect to any debt incurred to acquire an undivided interest in the property may not be a related person to any co-owner, the sponsor, the manager or any lessee of the property.
• Payments to Sponsor. 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.

In some respects, the Revenue Procedure is quite liberal; in other respects, more conservative. In any event, the Revenue Procedure is not a substantive statement of the law with respect to interests in real estate eligible for like-kind exchanges. It will be interesting to observe, over the coming months, how many sponsors of Tenancy in Common programs apply for rulings from the IRS, and how many rely upon opinions issued by law firms and accounting firms based upon analysis of existing law. Perhaps the consumer will ultimately provide the answer.

B. Wyckliffe Pattishall Jr. is president and CEO of the Chicago Deferred Exchange Corporation.

©2002 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.