Qualifying Tenancy-In-Common Interests for Like-Kind Exchanges
Please be advised that in order to ensure our firm is in compliance with the new rules and standards as provided in Circular 230 by the Internal Revenue Service, we are informing you that any tax advice contained in this communication is not intended or written to be used for the purpose of avoiding penalties that may be imposed on the taxpayer.
The question of whether tenancy-in-common interests qualify for like-kind treatment under Internal Revenue Code Section 1031 typically arises in two situations:
- When the seller of the relinquished property cannot afford to purchase an entire property but has sufficient funds to purchase an undivided interest in the replacement property, or
- A partnership that owns real property distributes tenancy-in-common interests to its partners because some of the partners want to sell their interest for cash while others want to engage in like-kind exchanges.
IRC Section 1031(a)(2) provides that an interest in a partnership is not eligible for a tax-free exchange under IRC Section 1031. However, co-ownership of the replacement property might not violate the requirements of IRC Section 1031. In Rev. Proc. 2002-22, 2002-1 C.B. 733, the Service issued guidelines that must be met in order for the Service to consider a request for a ruling that an undivided fractional interest in rental real property is not an interest in a business entity within the meaning of section 301.7701-3 of the regulations.
The Rev. Proc. 2002-22, 2002-1 C.B. 733 requirements are as follows:
- 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. Title to the Property as a whole may not be held by an entity recognized under local law.
- The number of co-owners must be limited to 35 persons.
- The co-ownership may not file tax returns, conduct business under a common name, or hold itself out as any form of business entity.
- The co-owners may enter into a limited co-ownership agreement that may run with the land.
- 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.
- Each co-owner must have the rights to transfer, partition, and encumber the co-owner's undivided interest in the property without the agreement or approval of any person. Also, the co-owners, the sponsor, or the lessee may have a right of first offer with respect to any co-owner's exercise of the right to transfer the co-ownership interest in the property.
- If the property is sold, any debt secured by the blanket lien must be satisfied and the remaining sales proceeds must be distributed to the co-owners.
- 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.
- The co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.
- A co-owner may issue an option to purchase the co-owner's undivided interest, provided that the exercise price for the call option reflects the FMV of the property determined as of the time the option is exercised. A co-owner may not acquire an option to sell the co-owner's undivided interest.
- The co-owners' activities 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, with an agent who may be the sponsor or co-owner, but who may not be a lessee. Unanimous approval is required and the manager must disburse net revenues every 3 months from the date of receipt of those revenues.
- All lease agreements must be bona fide leases for federal tax purposes. Rents paid by the lessee must reflect the fair market value for the use of the property. The determination of the amount of the rent must not depend on the income or profits derived by any person from the property leased.
- 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.
- The amount of any payment to the sponsor for the acquisition of the co-ownership interest must reflect the FMV of the acquired co-ownership interest and may not depend of the income or profits derived by any person from the property.
The Revenue Procedure is not technically announcing a "safe harbor" for tenant-in-common exchanges but rather a statement of the conditions needed to be satisfied in order to obtain a private letter ruling from the Service. The tax ramifications of qualifying for like-kind treatment versus not qualifying can be very significant, especially when dealing with real estate. Tax advice should be sought to ensure that your deals meet the like-kind exchange. If you have any questions or would like to discuss how this guidance might apply to your specific situation, feel free to contact Esther Streete at 301-441-2420.