Real Property Law

Cecily A. Drucker, is co-author of Real Property Exchanges, 3d ed., 2002, published by CEB. She is a principal of Drucker & Associates, San Francisco, and of 1031 Strategies & Services, Inc., (formerly Pacific Capital Applications, Inc.), a “qualified intermediary” providing IRC §1031 exchange services. Her e-mail address is cdrucker@1031pro.com

Internal Revenue Code (IRC) §1031 provides one of the last opportunities to defer recognition of taxable gain when moving equity from one rental real estate asset to another. When the taxpayer’s asset consists of a tenancy-in-common interest in the rental real estate, the dichotomy between the way co-ownership of such property is treated under state law and under federal tax law mandates advance planning to ensure IRC §1031 eligibility on disposition of the asset. Mere legal title-holding will not determine whether IRC §1031 is available.

If for federal tax purposes, the co-ownership arrangement is not treated as a partnership or any other kind of entity (including a trust, or an association taxable as a corporation), then each owner may, independently of the other owners, consummate an IRC §1031 exchange. However, if for federal tax purposes the co-ownership arrangement is treated as a partnership, IRC §1031 cannot be used by any owner (but can be used by all of them, continuing their investment together into the next asset) because IRC §1031(a)(2)(D) prohibits the tax-deferred exchange by a partner of his or her partnership interest.

Co-owners of rental real estate who hold title as tenants-in-common and who individually may want to take advantage of IRC §1031 treatment when they sell the property, must now also consider the impact of Rev Proc 2002-22, 2002-14 Int Rev Bull 1. This Rev Proc is not a “safe harbor” pursuant to which such co-owners will be assured that they will be treated as owners of separate assets (commonly called an Undivided Fractional Interest or “UFI”) and, therefore, be able to use IRC §1031 to exchange their individual UFIs. Instead, the Rev Proc contains requirements that must be met before the IRS will consider issuing a letter ruling that the co-ownership arrangement constitutes ownership of UFIs, and therefore each owner may use IRC §1031 to defer taxes. Without a letter ruling, the IRS may treat the entire ownership arrangement, in the aggregate, as the ownership by each of the owners of an intangible property right (e.g., a partnership interest) in an entity separate from its owners thus making the disposition of the individual UFI ineligible for IRC §1031 treatment.

There Are Four Major Areas That The Rev Proc Addresses:

1. Formation requirements dictate that the UFI owners (“Owners”) hold the interests as tenants-in-common under applicable state law and that they have not previously held interests in the property in another legal entity (e.g., a partnership). Therefore, existing co-ownership arrangements that are partnerships or LLCs will not be able to take advantage of the Rev Proc.

2. Allocation requirements mandate allocation of income and expense, as well as liability for blanket encumbrances in accordance with the Owner’s percentage ownership interests.

3. Management and control requirements prohibit determination of the amount of fees paid to “sponsors” (the person who structures the UFI arrangement for purposes of offering UFI interests for sale), or property or asset managers based on income or profitability of the property. Owners must have the right to vote on issues of disposition, leasing or re-leasing, or debt encumbrance of the property (in each case by unanimous consent). Other activities of the Owners are limited to those customarily performed in connection with maintenance and repair of rental property. Third party property managers must have their contracts renewed annually (by unanimous vote of the Owners), and during their service must distribute revenue at least quarterly. No Owner, sponsor or manager may advance funds to cover payments due from another Owner (for such Owner’s share of operating or capital expenses) unless the debt is “recourse” and must be repaid within 31 days.

4. Exit requirements mandate that each Owner retains the right to transfer, partition, and encumber their Ownership interest (except as limited by a holder of a blanket lien). However, “first rights” offers with the other Owners (as condition precedents to exercising their rights of transfer) are permitted providing the pricing is Fair Market Value as of the date of offer.

Even though the Rev Proc states “[t]he requirements set forth […] are not intended to be substantive rules and are not to be used for audit purposes” (e.g., may not be relied on as binding the IRS), one can expect that it will be used more often as a basis for structuring co-ownership arrangements than for submission for a letter ruling. The static and time-consuming process of obtaining a letter ruling is inconsistent with the dynamic nature of structuring and closing real estate acquisitions. One can infer, however, that unless the UFI co-ownership arrangement meets all (or perhaps all except for a very few minor and non-substantive aspects) of the requirements, the IRS will not treat any of the Owners as having a UFI in the underlying rental real estate and, therefore, any tax-deferred exchange under IRC §1031 will be disallowed.

The Rev Proc applies to all co-ownership of rental real estate. Although it is primarily focused at the sponsors and participants (as well as professional advisors) of organized UFI programs that are being marketed by national and regional real estate investment and asset management companies, it is not limited to those persons. The Rev Proc should therefore be heeded by all practitioners in this area when structuring the ownership and operations of the UFI arrangement to ensure maximum flexibility for the individual owners who at a later date may want to take advantage of IRC §1031 tax-deferred exchange.

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