This article presents the conduct which characterizes vested co-owners on title to real estate as owners of fractional interests in a partnership barring the transfer of any fractional interest from §1031 tax-exempt treatment.

Exchanging fractional interests

A group of no more than ten co-owners, husband and wife being one, acquire income-producing property. They take title as tenants in common, each with their pro rata share of “undivided ownership” based on their contribution to the down payment. The property is occupied by tenants under leases and periodic rental agreements providing for the landlord to care for and maintain the premises.


A partner may use or possess partnership property only on behalf of the partnership.

The co-owners orally agree:

  • to divide annual operating income (or losses) and resale profits pro rata based on their percentage of ownership; and
  • to hire a broker, typically the group organizer, sometimes called a syndicator, to manage the property and collect rents.

Each co-owner will separately report his pro rata share of annual property operating data (APOD) – which includes income, expenses, interest and depreciation – on Schedule E of his Federal 1040. The APOD is typically provided by the managing member of the investment group, usually the syndicator who located the property and organized the group.

No partnership filing will be made on a 1065, and no K-1 Forms will be used by the co-owners.

Are the co-owners treated as a partnership under California partnership law and federal tax law, despite the tenancy-in-common vesting placing each co-owner on title?

Yes to both! When co-owners of real estate, vested as tenants in common, are engaged in the business of jointly owning and operating the property on terms that call for the sharing of profits, they are conducting themselves as partners in a partnership, not as tenants in common. [Corp C §§16202(a),(c)(3)]

A tenancy-in-common vesting does not control the possessory rights of each of the co-owners when the co-owners in fact act as a partnership. A partner may use or possess partnership property only on behalf of the partnership. [Calif. Corporations Code §16401(g)]

Further, a co-owner on title to jointly-owned property who is actually a partner is not a co-owner of the partnership property. The vested co-owner has no use or possessory interest in the property which he can transfer. [Corp C §16501]

The only transferable interest a vested co-owner has is his fractional interest in the partnership which entitles him to share profits and receive distributions. Thus, the co-owner’s fractional interest is no more than a personal property share ownership in the partnership. [Corp C §16502]

Trustees for one another

Each co-owner actually holds title as a trustee.

 Although title to the income-producing property they own and operate is vested in all the co-owners, each co-owner actually holds title as a trustee on behalf of all the tenants in common, collectively called a partnership. [Calif. Civil Code §682; Corp C §16404(b)(1)]

As co-owners and operators of a rental, they have inarticulately formed a partnership, holding title in the most troublesome of all vestings: tenants in common.

When the joint ownership of property, which by its nature requires the co-owners to provide care, maintenance and services, is vested in the co-owners as tenants in common, the co-owners are an informal and undisclosed partnership. [Cusick v. Commissioner (1998) 76 TCM 241 1998-286]

Thus, the conveyance of a co-owner’s tenant-in-common interest to another person conveys nothing more than the partnership’s equitable ownership interest in the property which is held in trust by the co-owner while vested in the co-owner’s name.

The group should have created a formal limited partnership (LP) or limited liability company (LLC) and vested title in the LP or LLC. An entity vesting eliminates any confusion or mischaracterization by co-owners of their individual rights and obligations in the partnership, as distinguished from their use and possessory rights in the real estate owned and operated by the partnership.

The defining acts of partners

Prior to California’s 1949 enactment creating tenancies in partnership, tenants in common who owned rental property that required centralized management did not constitute a partnership. No agency relationship existed between them to protect the common interests of the group. [Johnston v. Kitchin (1928) 203 C 766]

Since 1949, a partnership is created when two or more co-owners join together to carry on a business for income and profit. A business includes every trade, occupation or profession. [Corp C §16101(1)]

While landlording is not a trade or business for tax purposes (it is a passive rental operation), it is an occupation under partnership law since the co-ownership is involved in sharing earnings and profits from operations and resale. [Corp C §§16202(a),(c)(3)]

Also, the receipt of income and profits by co-owners from their business venture is considered evidence of a partnership, unless the earnings are received by a co-owner in payment:

  • of an installment note, including one given in consideration for the sale of good will or property;
  • for wages or rent;
  • on an annuity to a surviving spouse or representative of a deceased partner; or
  • as interest on a loan. [Corp C §16202(c)(3)]

A tenancy-in-common partnership

With a tenancy-in-common vesting, the sharing of income and profits earned by each co-owner’s separate use of the property – such as the extraction of minerals by each co-owner for their own separate use – does not in itself create a partnership. It takes more than the sharing of use and possession to constitute conduct on the level of a partnership. [Corp C §16202(c)(1)]


Even when co-owners do not characterize their mutual working relationship as a partnership, they are still obligated to act on behalf of the group.

The interactions and coordinated conduct of the co-owners while managing or operating the investment determine whether a partnership relationship exists between them. Once the conduct of co-owners in an ongoing operation of the property constitutes a joint and mutually beneficial activity, an agency relationship exists between the co-owners. With the agency relationship comes fiduciary duties as partners to act in the best interest of the group. [Corp C §16404; Leff v. Gunter (1983) 33 C3d 508]

Thus, co-owners of rental property who are vested as tenants in common and who act collectively to operate the property hold the real estate under what has been best titled a tenancy-in-partnership, each co-owner being a tenant in partnership with the other co-owners.

A tenancy-in-common partnership is now established by the sharing of profits among co-owners vested as tenants in common, with each co-owner acknowledging his rights and obligations under the partnership, such as:

  • the duty to hold title to the real estate as trustees for the partnership [Corp C §16404(a)(1)];
  • the right of each co-owner to use and possess the real estate but only for group purposes [Corp C §16401(g)];
  • the right to use and possess the real estate is nontransferable unless all co-owners collectively transfer the partnership’s rights [Corp C §§16203; 16501]; and
  • the property co-owned by the group is not subject to attachment or execution on a judgment against an individual co-owner, only on claims against the partnership [Corp C §§16201; 16501].

Even when co-owners do not characterize their mutual working relationship in a profit sharing investment as a partnership, they are still obligated to act on behalf of the group. [Corp C §16202(a)]

Editor’s note — See Figure 1 for a diagram of the management of the property depending on the type of vesting.

State law controls the classification of ownership interests bought and sold in an IRC §1031 transaction – unless preempted by the federal partnership definition in the Internal Revenue Code. In California, the profit-sharing tenants in common/co-owners have only a personal property interest in the partnership, and hold no interest in the real estate they co-own to be transferred as like-kind §1031 property. [Corp C §16502]

Tax reporting and §1031 transactions

Taxwise, a co-ownership vested as a tenancy-in-common in which the co-owners carry on a trade, business, financial operation or venture is a partnership if:

  • services are rendered, directly or indirectly, through centralized property management; and
  • income, profits and losses are divided. [Revenue Regulations §1.761-1(a)]

For example, co-owners vested as tenants in common own rental property, residential or nonresidential. They provide typical landlord services to the tenants in the form of care and maintenance of the property and control over other tenants.

The property requires day-to-day management, either directly by the co-owners or indirectly through a property manager, as a jointly-operated financial venture.

Is the group of co-owners characterized as a partnership for federal and state income tax purposes?

Yes! The conduct of the co-owners in the management of the property resembles partnership activity more than that of separate, independently acting owners. Taxwise, a partnership exists, regardless of the real estate vesting allowed under state law. The co-owners intended to act as a group, not to manage their affairs in the property separate from one another. [Estate of Aaron Levine (1979) 72 TC 780]

Further, California income tax law adopted the federal tax laws for purposes of reporting gains and losses and all the tax-deferred exemptions, such as IRC §1031. [Calif. Revenue and Taxation Code §18031]

Centralized management

To avoid partnership status, the co-owners must be able to manage their own fractional ownership interest in the property separate from one another.

 Rarely do co-owners of income-producing property manage their interest in the property separate from one another, a characteristic of the common law tenancy-in-common vesting permitted before 1949.In contrast, the co-ownership of rental property is actively operated for the benefit of all co-owners – unless the property is subdivided to provide each co-owner with the exclusive right of possession in separate lots or units, such as in parceled land or a condominium project.

Also, when the number of unincorporated co-owners, no matter how vested, exceeds the limit of 10 members in the ownership group for the small partnership reporting exception, they must report the group’s income, profit or loss on IRS 1065 “snitch sheets,” even though no formal partnership exists. [Revenue Procedure 84-35]

To avoid partnership status for any legal or tax purpose, the property co-owned by tenants in common must not require a joint effort or centralized management to provide services to the tenant, such as maintenance of the property, nor should the property be subject to mutually agreed-to improvements, engineering, subdivision, plant husbandry or other value-increasing or upgrading activities. [Leff, supra]

To be common law tenants in common, the co-owners must be able to manage and care for their own fractional ownership interest in the property separate from one another, without concern for a joint investment undertaking.

For example, an exception to tenancy-in-partnership treatment would be the co-ownership of a fee interest in real estate, vested as tenants in common or joint tenants, which does not file an IRS 1065 return or operate under an oral, written or implied partnership agreement, and which is subject to:

  • a ground lease held by a tenant;
  • a totally management-free triple-net lease; or
  • is land held only for profit on a resale and not as dealer property.

Exchanging tenant in common interests

Co-owners holding title as tenants in common can, as a group acting in concert, sell the real estate and acquire replacement property to complete a §1031 transaction.

However, one co-owner decides to independently sell or exchange his fractional tenancy-in-common interest in rental real estate for replacement property he will separately acquire for his own account.

Does the co-owner, now acting independently of the group, qualify under IRC §1031 to avoid reporting the profit on the sale or exchange of his fractional interest?

No! The co-owner’s fractional interest in §1031 like-kind property requiring management cannot be deeded out separately, independent of the other co-owners, and qualify for a §1031 exchange since the owners have conducted their joint ownership of the property as partners and the fractional interest held by a co-owner is not like-kind §1031 property. Further, the interest held by the co-owner is personal property under state law. [Internal Revenue Code §1031(a)(2)(D)]

The profit taken by a co-owner on the sale or exchange of his fractional ownership interest in actively-managed real estate must be reported and taxed on his leaving the group – whether the co-ownership is vested as tenants in common, a partnership, or an LLC. [Levine, supra]

Thus, the tenants in common who have conducted themselves as partners in the ownership and management of property unexpectedly find themselves characterized as a partnership, bound together as partners under California partnership law and federal partnership tax rules. [Corp C §15025; IRC §§761; 1031(a)(2)(D)]

A better approach to vesting the co-ownership of any real estate (other than solely-owned community property) is to form a limited partnership or LLC to hold title to real estate acquired and operated for the benefit of all owners.

Avoiding partnership status

A co-owner is not considered a partner in the co-ownership of real estate and can sell or exchange his fractional interest and qualify for the §1031 profit reporting exemption in only two situations.

In the first situation:

  • the co-ownership is vested as tenants in common, or joint tenants, and no agreement exists to conduct themselves as partners;
  • no management is required for the maintenance of the property or the rendering of services to tenants, nor does the property house a business operated by the co-owners; and
  • each co-owner separately manages his share of any income, expenses and interest payments, and no centralized accounting exists, nor is an IRS 1065 return filed. [Rev. Regs. §1.761-1]

In the second situation allowing a co-owner to sell his fractional interest in a §1031 tax exempt transaction:

  • the vesting is a partnership, LLC, or tenancy in common that files an IRS 1065 return; and
  • the co-ownership qualifies and has elected with the IRS to be excluded from partnership tax treatment by establishing that the property requires no active management (it is a management-free, triple-net lease income property or a parcel of real estate held only for profit on resale). [Rev. Regs. §1.761-2]

A vesting change doesn’t benefit a co-owner

A multiple-unit, income-producing real estate project is owned and operated by an investment group as an unincorporated association, structured as a partnership or LLC. One of the co-owners is selling his fractional interest to another co-owner or exchanging it with an outside party.


Changing the vesting of the partnership in a related series of events does not change the underlying nature of the transaction.

The investment group (10-or-fewer) does not file an IRS 1065 return or hand the co-owners K-1 information on annual operating income, expenses, interest and depreciation, since they are excused from doing so. [Rev. Proc. 84-35]

Each co-owner separately reports his fractional share of each year’s rental operations on Schedule E of his return.

The price or value the co-owner receives for his fractional interest exceeds his adjusted cost basis remaining in his share of the investment. Thus, the co-owner will take a profit on the sale or exchange, which for tax purposes must be reported – unless exempt. [IRC §1001]

In spite of the co-owner’s desire to get out of the investment group, he does not want to report the profit and pay taxes. He needs all the net proceeds from the sale, undiminished by taxes, to invest in his personal trade or business.

The co-owner locates other real estate which he will acquire for his own account and use as the premises to house his business.

Since the real estate the co-owner wants to buy will be used in the co-owner’s trade or business (or rented to his corporate business), the property to be acquired qualifies as §1031 like-kind property. [IRC §1231]

Editor’s note — If the property acquired is rented to the co-owner’s corporate business, it will be a rental also classified as §1031 investment property. [IRC §1221]

The co-owner proceeds to structure the sale of his ownership share in the investment group as a §1031 tax-exempt transaction and use the net proceeds to buy the real estate he will use in his business.

As part of the transaction, the co-owner’s interest in the investment group will first be converted to a tenant-in-common vesting by the investment group’s conveyance of a pro rata fee ownership in the real estate held by the partnership or LLC in exchange for the co-owner’s assignment of his interest in the partnership or LLC to the partnership or LLC.

To carry out the proposed §1031 transaction, the co-owner will sell and convey his newly-acquired, tenants-in-common ownership in the fee title to the individuals who are buying out his interest.

Thus, the co-owner believes he is both selling and acquiring like-kind real estate to complete a fully qualified exemption from reporting profit under IRC §1031.

Does the sale of the fractional interest held by a co-owner in the income-producing property qualify as like-kind property?

No! The interest sold is an interest in a partnership. The type of real estate vesting, be it a partnership, LLC or tenancy in common, does not prevent the co-ownership from being (re)characterized as a partnership when the joint, ongoing operations of the real estate necessitate the real estate be managed for the benefit of all the co-owners.

The step transaction doctrine does not allow a taxpayer to do in two steps what cannot be done in one (not to mention the continuing joint purpose of ownership and centralized management of the property). Under the step transaction doctrine, changing the vesting of the partnership in a related series of events does not change the underlying nature of the transaction, which is the exchange of a fractional interest in a partnership operation. [Magneson v. Commissioner (1985) 753 F2d 1490]

No portion of the real estate is separately owned, managed and operated by one co-owner, devoid of an accounting to the other co-owners. This property has not been subdivided or partitioned in law or in fact. Thus, a partnership exists among the co-owners – no matter how title to the real estate may be vested. [IRC §761]

Even though the property held by the group qualifies for the entire group to sell it as a §1031 like-kind property and reinvest tax free, the sale of a fractional interest in an actively-managed group investment is barred from qualifying under §1031. It is not the sale of a separate and exclusive ownership interest in the property. [IRC §1031(a)(2)(D)]

Equity sharing co-ownership

The equity sharing transaction, though not structured as a formal partnership, will have difficulty avoiding partnership status.

 Now consider an equity sharing transaction. The real estate will be co-owned by two individuals; one will occupy the property as his principal residence and the other will hold an ownership interest as an investor. [IRC §280A]The property is vested in the co-owners as tenants in common. The resident co-owner possesses the property under his ownership (of 1/2 the property) and under a triple-net lease with the investor (of the other 1/2 of the property).

Later, the co-owner who merely invested in the property sells his interest to the resident co-owner.

Will the interest sold by the investing co-owner qualify as like-kind property in a §1031 exchange?

Probably not! The joint ownership of the property will be considered an undisclosed partnership. The equity sharing transaction, though not structured as a formal partnership, will have difficulty avoiding partnership status. The co-owners are not able to separately manage and care for their fractional interests in the property.

In fact, all care and maintenance of the co-owned property is the responsibility of the co-owner who happens to occupy the property. The issue remaining to be decided is whether the occupying co-owner is a managing co-owner or just a tenant of the investing co-owner under a triple-net lease.

Thus, the co-owners in an equity sharing transaction should structure their relationship as a formal partnership or LLC, vest the property in the partnership or LLC, and enter into a management-free, triple-net lease with the co-owner who will be a tenant in possession of the partnership property.

The co-owners should then qualify the partnership or LLC for the IRC §761 partnership exclusion. The §761 exclusion allows the investing co-owner to sell his fractional interest in the partnership as an interest in the property – not as an interest in the partnership.

After qualifying for the exclusion from partnership treatment, the investing co-owner can sell his fractional interest and acquire like-kind replacement property in a §1031 transaction, since the entire property is occupied under a management-free, triple-net lease which shifted all care and maintenance to the tenant, leaving no joint ownership operations remaining in the property. [See first tuesday Form 550]

Acquiring a fractional interest in replacement property

The concurrent contribution of real estate to a partnership does not alter the tax consequences of acquiring investment real estate to complete a §1031 transaction.

 Although the IRS does not allow a co-owner to separately sell or exchange his fractional interest in jointly-owned and actively-managed real estate as part of a §1031 transaction, the acquisition of a fractional interest is allowed. However, the interest acquired in like-kind real estate cannot already be a fractional interest in an existing co-ownership which conducts itself as a partnership.

For example, an owner who sells his like-kind property locates replacement property with an equity far greater than the net proceeds from his sale.

Unable to negotiate the purchase of the replacement property by executing a carryback note for the difference, and unwilling to contribute additional cash himself, the owner induces a cash investor – or some other investor with cash from the sale of real estate who needs to complete a §1031 transaction – to join with him to buy the property.

They do so, and each becomes a vested owner for their percentage of contribution to the down payment, called a syndicated exchange or consolidation exchange.

Concurrently, they form a limited partnership or LLC and convey title to the entity in a separate, tax-free transaction. [IRC §721]

Having sold solely-owned property, the owner must acquire like-kind property. The conveyance by the seller of the entire ownership interest in the replacement real estate is not a transfer of a fractional interest in a partnership, such as a partner’>s assignment (conveyance) of a co-ownership interest held in a partnership. The interest conveyed was not subject to prior tenancy-in-partnership rules and restrictions. Thus, the replacement property qualifies as §1031 like-kind property.

It was the conveyance of the replacement property to the co-owners which created the fractional interests. The fractional interests did not previously exist to be conveyed. Thus, the owner has completed a §1031 tax-deferred exchange.

The concurrent contribution of the real estate to a partnership does not alter the tax consequences of acquiring investment real estate to complete a §1031 transaction, since the partnership is a “pass-through” entity which is not taxed. Conversely, a concurrent contribution of the replacement property to a corporation for stock, an exempt exchange itself, would trigger disallowance of the §1031 exemption on the acquisition, since the replacement property becomes disposition property on its further conveyance to a separate taxable entity such as a corporation. [IRC §351; Magneson, supra]

Now consider an owner who sells like-kind real estate and acquires a fractional interest from a co-owner in a partnership that owns like-kind real estate.

Can the owner avoid reporting his profit on the sale as a §1031 tax-deferred transaction?

No! The ownership interest acquired is an interest in a partnership, not an interest in real estate – whether or not it was vested as tenants in common or in the name of a partnership or LLC. [IRC §1031(a)(2)]

The §1031 by twist of events

A lack of understanding exists among taxpayers, CPAs and drafters of IRS forms regarding the consequences of IRC partnership definitions, 1065/K-1 co-ownership forms, the exemption from filing by partnerships comprising 10 or fewer members, and Schedule E filing by co-owners. Thus, an unintended application of the §1031 exemption from profit tax reporting permits the profit taken on the sale of a fractional interest in an actively-managed group investment to go unreported.

For example, when co-owners in small, jointly-operated investment groups file their individual returns, they report the operating data for rental properties on Schedule E, attached to their annual 1040 return.

Schedule E lists the income, expenses, interest and depreciation earned or deductible by the co-owner, separately and without reference (unless volunteered) to the aggregate data generated by the combined ownership (partners) of the real estate described in Schedule E.

The individual co-owner’s itemized data are but an undisclosed fraction of the income, expenses and deductions of the property identified on each co-owner’s Schedule E. So far, so good!

On the sale of the interest (real estate) listed in Schedule E, the IRS does not know (without an audit or a gratuitous disclosure) whether the interest is an:

  • interest in a partnership and excluded from tax-free treatment under IRC §1031; or
  • interest in the asset itself and thus qualified as §1031 like-kind property.

The defect in Schedule E is the failure of the IRS to request information from the taxpayer on whether:

  • the interest listed is a fractional interest; and
  • the property requires active management.

Further, the IRS §1031 disclosure form does not inquire whether:

  • the interest sold or exchanged is a fractional interest in property which requires active management (an interest in a partnership);
  • sole ownership in the asset; or
  • a fractional interest in management-free property. [See IRS Form 8824]

Thus, a co-owner’s annual reporting of his fractional interest on Schedule E (or F or C), and the sale and replacement of the interest on a §1031 disclosure form, does not trigger automatic audit or disallowance by the IRS, and the exemption from profit taxes declared by the taxpayer is cleared.

Editor’s note — A school of thought holds the view that these deficiencies in the IRS forms produce the result intended by the IRS. However, this is not the case!