This article presents the arrangements co-owners of fractional interests in a real estate investment must undertake to qualify a fractional ownership interest as §1031 property.

Table of Contents

  1. Introductory facts: tax partners or independent §1031 co-owners
  2. A tax partnership vs. a California partnership
  3. A Tax partner’s profits disqualified
  4. Resale by an individual TIC as §1031
  5. Equity sharing co-ownership investment
  6. Qualifying fractional interest as §1031
  7. The §1031 by a twist of Schedule E
  8. Co-owner’s guidelines for non-partner tax status

Tax partners or independent §1031 co-owners

For the profit taken on the sale or exchange of an interest in real estate to be exempt from taxes under Internal Revenue Code (IRC) §1031, the interest sold or exchanged must be an ownership which qualifies as like-kind property, commonly called §1031 property. The ownership acquired in the replacement real estate must also be §1031 property.

In any §1031 reinvestment plan, both “legs” of the plan, namely the property sold and the property acquired, must qualify as the investor’s ownership of §1031 property. Section 1031 property is property held either for investment or productive use in a business. [Internal Revenue Code §1031]

Consider the sale or acquisition of a fractional ownership interest in income-producing real estate co-owned by two or more investors for investment under each of the following four scenarios:

1. An investor joins with one or more other investors, all of whom contribute cash to jointly acquire income-producing real estate.

2. An investor sells his ownership interest in §1031 property producing §1031 money which he reinvests either by, 1) joining with one or more other investors to pool funds and acquire income-producing real estate, or, 2) buying a fractional interest from a co-owner in a property presently owned by a group of investors.

3. An investor sells his fractional ownership interest in income-producing real estate, while the other co-owners remain in ownership of the property, and reinvests his net sales proceeds by acquiring the sole ownership of §1031 property.

4. An income-producing property co-owned by two or more investors is sold and one co-owner withdraws his share of the net sales proceeds and reinvests the funds independently of the other co-owners by acquiring sole ownership of like-kind property.

In each example, co-owners joined together to buy, own or sell a property held or to be held for investment. Also, the parcel of real estate bought or sold in each of these examples is itself managed and operated as §1031 property. Thus, the real estate qualifies its group ownership (the group) for a §1031 exemption on the sale of the entire parcel, regardless of whether the ownership of the real estate is a limited partnership (LP), limited liability company (LLC), common law tenants in common (TIC), tax partnership, corporation or sole ownership.

However, a fractional ownership interest sold or acquired by an investor does not qualify as §1031 property if the interest is a co-ownership interest in an entity, such as an LP, LLC, corporation or other co-ownership arrangement calling for the alienation of the property or fractional interest by less than unanimous consent. It is the entity which owns the real estate. An investor’s reinvestment plan does not qualify for the §1031 exemption when the plan includes the sale or purchase of a fractional ownership interest in an entity. [See Scenarios 2, 3 and 4, ante]

Taxwise, a co-owner vested as a tenant-in-common with a group of co-owners is considered a tax partner in the co- ownership of §1031 property if he has agreed to restraints on his common law rights as a tenant-in-common to freely manage his interest in the property, independent of control by other co-owners and as he sees fit.

Once classified as a tax partner for income tax reporting, the tenant-in-common investor is considered a co-owner of an interest in a tax partnership, not a co-owner holding an ownership interest in the real estate. As a result, the tax partnership is treated for tax purposes only as the sole owner of the §1031 property, since the tenants in common are now partners who only own the partnership.

When a tenant-in-common co-owner, by agreement or by definition, is a tax partner with others in each of the four scenarios given above, then none of the profit taken on the sales leg in each scenario qualifies as exempt from taxes. Both the sales and purchase legs of a §1031 plan must manifest the attributes of an ownership interest directly in the real estate, not the investor’s mere ownership of an interest in a partnership. A partnership operates independently of each tenant-in-common to control the ownership rights of all co-owners.

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A tax partnership vs. a California partnership

The coordinated conduct of co-owners in the exercise of ownership rights to operate the investment real estate they co-own is viewed differently under federal income tax law than under California partnership law.

Basically, if co-owners share the income, profit and losses generated by a joint investment in real estate operating under an unincorporated ownership arrangement, California partnership law, which broadly defines a partnership, classifies the profit-sharing group as a partnership. Thus, California imposes agency obligations on each co-owner to act in concert for the mutual benefit of the group from the moment of first discussions about a syndicated investment. Thus, anarchy within the group of co-owners is legally avoided as public policy.

Conversely, federal tax law places emphasis on TIC law to establish co-owner rights. Tenant-in-common ownership does not rise to tax partner status unless the co-owners are operating as a declared partnership, LLC or cooperating TICs.

To avoid tax partnership status, each co-owner vested as a tenant- in-common must have the unrestricted common law right to independently alienate his fractional interest without the prior consent of other co-owners. Further, each co-owner must have the unrestricted right to independently block any alienation of the entire property co-owned by the group.

Alienation of the entire property refers to its sale, further encumbrance or a lease for a period exceeding one year.

Taxwise, the ownership of a TIC interest which retains its common law right of alienation in real estate is viewed as being the ownership of a fractional interest in the real estate itself. Thus, the tenant-in-common is not the owner of an interest in a partnership that actually owns the property.

Further, TIC co-ownership arrangements may provide for cooperation among the co-owners in the ongoing management and operation of the property. Operating the property by centralizing management does not violate the requirement of unanimous approval for alienation of property owned by common law TICS. Thus, the alienation rights inherent in ownership are distinguished from the day-to-day operations of the property.

An understanding of the distinctions between federal tax law, which defines §1031 property investments as excluding fractional interests held by tax partners, and California’s partnership law, which controls joint ventures and profit sharing ownerships, is helpful to all individuals involved in investment groups, such as:

  • syndicators structuring the ownership for acquisition of property by an investment group they are forming;
  • investors acquiring or withdrawing a fractional interest from a syndicated real estate investment; and
  • brokers (or other advisors) representing a person who is buying into or withdrawing from a real estate syndicated investment.

Knowing the parameters for activities that establish a partner under California partnership law versus activities that establish a tax partnership for federal income tax reporting avoids unintended and unexpected results under either set of laws, or worse, the loss of a transaction because of insufficient knowledge to explain the distinctions to clients, their advisors and others.

Accordingly, this article contains an analysis and application of the overlapping partnership laws controlling the syndication of real estate investments (state law) and the exemption of profits from taxes (federal law) on a sale or purchase with §1031 money of a fractional interest in a syndicated investment.

TICs cooperate in California

A group of investors acquire income-producing property located in California. Title is taken as tenants in common, naming each investor and stating his percentage or fractional share of undivided ownership in the property. The property is occupied by tenants under short-term leases and periodic rental agreements which provide for the landlord to care for and maintain the premises.

The co-owners orally agree:

  • to divide annual operating income (or losses) and resale profits pro rata based on their percentage of ownership;
  • to hire the broker who organized the group to manage the property with authority to locate tenants, enter into short-term lease and rental agreements, collect rents, contract for the repair, maintenance, utilities and security to be provided by the landlord under the lease agreements, pay operating expenses and mortgage payments, and distribute spendable income to the co-owners quarterly;
  • to grant each other a right of first refusal on a resale of their fractional TIC interest; and
  • to grant the syndicator the option to purchase the property at its fair market value.

Are the co-owners conducting themselves as partners under California partnership law despite the tenancy in common vesting placing each co-owner on title?

Yes! Co-owners of California real estate vested as tenants in common, when engaged in the business of jointly operating the property on terms calling for them to share income and profits, are conducting themselves as partners. Thus, they are considered agents of one another, charged as a fiduciary with the duty to cooperate in the ownership of the property. [Calif. Corporations Code §§16202(a), 16202(c)(3)]

A tenancy in common vesting does not control the possessory rights of the co-owners when the co-ownership in fact constitutes a state law partnership. For example, a partner may use or possess partnership property only on behalf of the partnership, while a tenant-in-common (at common law) may use, possess or lease the property himself. [Corp C §16401(g)]

Further, tenants in common who conduct themselves as joint operators of a property, such as occurs with a rental property, are not co-owners of the real estate. They are partners who co-own their partnership. Thus, the partnership owns the property without concern for the type of vesting the group of investors has chosen. As a partner, the vested co-owner holds no right to a possessory interest in the property which he can independently possess or separately transfer by leasing the property to a tenant without concern for the other co-owners.

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

Trustees of one another by law

Although title to the income-producing property held by the co- owners for profit is vested in the names of 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 property, they have formed a partnership, holding title in the most troublesome of all California co-ownership vestings: tenants in common, a TIC.

Thus, the conveyance of a co-owner’s TIC interest to another person conveys nothing more than the co-owner’s interest in the partnership’s equitable ownership of the property. The partnership’s title to the property is held in trust, in the name of each co-owner for the benefit of all co- owners.

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 tenants in common before 1949 to protect the common interests of the co-owners to share profits. The federal tax law defining TIC interests remains the same today. [Johnston v. Kitchin (1928) 203 C 766]

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

While landlording is not a trade or business category activity for federal income tax purposes (as the property is a passive rental operation or a portfolio asset), landlording by a syndicated group is an occupation under California partnership law. A co-ownership is a California partnership if the co-owners are involved in sharing earnings and profits from rental operations, refinancing and resale of the property they own. [Corp C §§16202(a), 16202(c)(3)]

Also, the receipt of income (from operations) and profits (from a sale) by co-owners from their joint investment is considered evidence of a California 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 goodwill or property;
  • for wages or rent due the co-owner;
  • on an annuity to a surviving spouse, representative or a deceased co-owner; or
  • as interest on a loan. [Corp C §16202(c)(3)]

The 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 occurs with the extraction of minerals from the property by each co-owner for their own separate use — does not in itself create a California partnership. It takes more than the sharing of use and possession by co-owners to constitute conduct on the level of a partnership. [Corp C §16202(c)(1)]

It is the interaction and coordinated conduct of the co- owners while directly or indirectly managing or operating the investment that determines whether a state law partnership relationship exists between them. Once the conduct of co-owners in a coordinated 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 owed to partners which obligates each prospective or actual co-owner to act in the best interest of the group, not to act independently on the investment opportunity before them. [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 manage the property or authorize a property manager to operate the property on their behalf, hold ownership to the real estate under what has been best entitled a tenancy in partnership, each co-owner being a tenant in partnership with all other co-owners.

By the sharing of income among co-owners who are vested as tenants in common, a tenancy in common partnership is established, subjecting each co-owner to the rights and obligations of a partner, such as:

  • the duty to hold title to the real estate as a trustee for the benefit of 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 right to possession of the property [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 as though they were partners in a partnership. [Corp C §16202(a)]

Under state law tenant-in-common co-owners hold no interest in the real estate they co-own which they can legally transfer, voluntarily or involuntarily, independent of the rights of the resulting California partnership. [Corp C §16502]

However, federal tax law for determining tax partner status of TICs excludes the results of state laws to the contrary. [Revenue Procedure 2002-22]

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A tax partner’s profits disqualified

The penalty for a tenant-in-common co-owner who is federally classified as a tax partner in the ownership of either the property sold or the property acquired in a §1031 reinvestment plan is the loss of the entire §1031 tax exemption for profit taken on the property sold.

Thus, just what arrangements or activities a co-owner, other co- owners, a property manager, syndicator or lender agree to between themselves which would make a co-owner a tax partner is or may become of great concern to investors in syndicated real estate investments programs.

When a co-owner of investment real estate is classified by the IRC as a partner, the real estate is considered to be owned by a tax partnership. Classified as a partner, the co- owner’s ownership interest is that of a share in a partnership that does not qualify as §1031 property.

To avoid tax partner status, a co-owner in a real estate investment does not want to be financially coupled with a co-owner or manager who provides the tenants with services which are unrelated to the operation of the property.

Thus, an investor with after-tax cash he has accumulated, or §1031 money to reinvest, who makes a capital contribution to a group being formed to jointly own and operate an income-producing parcel of real estate must be assured no co- owner is sharing in any income from tenants other than rent. Co- owners who occasionally provide tenants with business or professional services for a fee separate from rent, or share in the income received by others providing services to tenants which go beyond the customary services required under a lease, establish tax partner status.

Co-owners vs. partners

Tax partner status is of no concern to an investor, unless and until the investor:

  • withdraws from a group to separately invest on his own; or
  • desires to exchange his sole ownership in real estate (or the cash from its sale) for a fractional ownership in a replacement property.

To get a mental grip on the federal distinction between a co- owner’s non-partner status and tax partner status in the co- ownership of an investment in real estate, it is instructive to know the purposes behind the different income categories established to report and account for income, profits and losses from the ownership and sale of real estate.

Three income categories have been established for reporting income. The source or nature of the income, profit or loss determines the income category in which the income, profit or loss will be reported, such as:

  • trade or business income category, which includes real estate occupied and used in the business owned and operated by the person who owns or co-owns the real estate, including residential housing with an average occupancy of less than 30 days, such as motels, hotels, vacation rentals and other transient housing and boarding facilities that provide occupants with services unrelated to the care and maintenance of the property;
  • passive income category, which includes residential and nonresidential rental properties with an average occupancy of 30 days or more, but with a tenancy less than a triple net (master or ground) lease, providing the resident with, by the lease or rental agreements, the repair, maintenance, security, utilities and management typically included in exchange for rent under lease and rental agreements or as required by state law; and
  • portfolio income category, which includes income- producing real estate subject to long-term lease agreements which shift the responsibility for the care, maintenance, repair and operation of the property and the payment of expenses of ownership such as property taxes, assessments and insurance premiums to the tenant (as in a master lease, ground lease or other type of management-free triple-net lease), and includes other like-type flows of management-free income such as bonds, stocks, interest on loans (trust deed investments) and vacant, unimproved real estate held for profit on a resale (not as dealer property).

Thus, income-producing real estate held for investment and leased to tenants is classified as either:

  • rental (passive income) property requiring management services related to the tenancies; or
  • portfolio income property requiring very little or no tenant-related services to be provided by management.

Land held for investment requiring no management services, except for the annual payment of taxes, assessments, insurance premiums and the like, is classified as portfolio property. However, land held for development, subdivision and resale by the owner or a co- owner is trade or business category inventory.

Stated another way, rental (passive income) property and portfolio income property are not business property. On the other hand, a motel or hotel is a business property since services unrelated to rental property operations are provided.

And as a further distinction, the co-ownership arrangements relating to the management of rental or portfolio properties consists of services customarily provided for tenants by a landlord, directly or through an agent. The landlord’s services provided for tenants are not business-related services, such as maid services, food, laundry pickup and delivery and towels and linens, which are provided to more transient occupants of trade or business category property, such as hotels, motels, transient housing or vacation rentals.

Thus, negotiations with prospective tenants to lease units or space within the property, limited to providing customary landlord services, such as the collection of rent, evictions, repairs and maintenance of the property, utilities, security and other real estate-related services typically included in the rent, is not a business. Obviously, the property is not a business income category asset which provides business-related service, as an operator of a hotel, motel, boarding house or vacation rental property does.

Without being coupled to a business service, the capital contribution of a co-owner and landlord services the co-owner provides in the form of rental property operations for the care and operation of the property as a rental or portfolio asset, does not make the co-owner a tax partner. None of the co-owners are involved rendering additional services to the tenants through a business, enterprise or joint venture in which one or more of the co-owners share profits or losses in trade or business services offered to tenants.

A property manager and his authority

Co-owners can join together to own and operate income-producing property and will not be considered tax partners when they hire a broker (who may be a co-owner) as an independent property manager. The manager may be given all the authority he needs to do all acts necessary to provide for tenants under standard leasing arrangements.

However, the manager may not be given the authority to enter into long-term leases, sell or encumber the property. These are the rights of alienation held by each co-owner which must remain unrestrained and require unanimous approval by all co-owners to be exercised.

The authority co-owners may give a property manager without becoming tax partners is extensive, and includes the authority to:

  • act on behalf of the co-owners to negotiate and enter into leases and rental agreements with prospective or current tenants;
  • collect deposits, rents and other amounts due from tenants and deposit them into a common bank account maintained for (but not in the name of) the co-owners;
  • contract for all services customarily provided to tenants under similar circumstances as part of the rent, including normal repair and maintenance of the property, utilities, garbage/trash pickup, a resident manager and security;
  • pay from rents (and additional funding by co-owners made necessary due to insufficient rental income) the charges for all services the manager contracts for as authorized, including the payment of property taxes, assessments, insurance premiums, mortgage payments and management fees;
  • disburse to the co-owners no less than quarterly their share of spendable income; and
  • prepare annual statements for each co-owner setting forth his share of income, expenses, interest and depreciation. [IRS Revenue Ruling 75-374]

Thus, co-owners are merely limited to the classic relationship between a property manager and an owner of income-producing property. No co-owner, directly or indirectly through another person, will carry on or share profits in a trade or business which will provide additional services to the tenants beyond those customarily provided under common leasing arrangements in exchange for rent.

However, each co-owner will be considered a tax partner who is carrying on a trade or business, financial operation or venture in a tax partnership if he is:

  • any co-owner renders the additional business-related service to tenants; or
  • the property manager renders the additional business services and one or more co-owners share in the income the manager receives for providing the business-related service to the tenant.

Thus, the tax partnership includes the person rendering the business-related services whose income for those services provided is shared with one or more of the co-owners of the real estate. It does not matter that the person rendering the services (such as the property manager) may have no claim to the spendable income from the rental operation, proceeds from a refinance or net proceeds from its resale.

The property manager hired by the co-owners may not be a tenant and must be on a short-term management agreement not to exceed one year. The management agreement may only be extended or renewed for a period not to exceed one year by a unanimous vote of the co- owners (or by a failure to vote). The property manager’s pay must be comparable to fees paid brokers in the area for managing similar properties and providing similar management services.

While the manager may not be a tenant, a long-term lease, pre- existing or unanimously agreed to by all the co-owners, could provide for a lessee to care for, operate and incur at his expense all the typical services (sub)tenants may need to occupy the premises, including the right to sublet the property, an arrangement called a master lease.

Also, the property manager may be granted an option to purchase the property. However, the price to be paid for the property on exercise of the option must be set as the fair market value of the property at the time of purchase.

The devolution of TIC control

Some flexibility exists regarding the annual unanimous consent of the tenant-in-common co-owners to the renewal of property management agreements and the extent of authority which may be granted to management to enter into long-term leases of portions of the property. [IRS Private Letter Ruling 2005-13010]

Each long-term lease must be unanimously approved by all tenant-in- common co-owners to qualify each individually owned fractional ownership interest as §1031 property. This unanimous approval may be satisfied by an annual unanimous approval of a set of leasing guidelines for management. Management would then follow the guidelines in the exercise of the leasing authority given management in the property management agreement.

Thus, the authority given in the leasing guidelines is viewed as a method by which each tenant-in-common co-owner retains direct control over his right to disapprove a proposed lease. The parameters set in the guidelines place a limit on management’s flexibility in the discretionary leasing of the property.

The Internal Revenue Service example for leasing guidelines include the typical standards any landlord sets for qualifying prospective tenants and structuring the terms and conditions of lease provisions. Guidelines for leasing include the tenant’s and landlord’s obligation to care for and maintain the property, selection of the type of tenants, tenant creditworthiness, a range of rent amounts to charge tenants, the term of the lease and the content of lease provisions.

Interestingly, the syndicator managing the property is allowed, as outlined in the IRS letter ruling, to bar any tenant-in-common co- owner from altering the guidelines during the year following their approval since the unilateral change would be less than unanimous approval. Until the next annual approval of leasing guidelines occurs, each tenant-in-common co-owner agrees not to alter the guidelines by exercising his ownership rights to lease the property, himself or through a competitive leasing agent, on conflicting, and possibly more advantageous, long-term arrangements. [PLR 2005-13010]

Also, while the requirement for unanimous annual approval of the property management agreement is an anarchic condition detrimental to current management, apparently automatic one-year approval by mere silence at the time of the annual renewal of the management agreement is deemed a sufficient exercise of a tenant- in-common co-owner’s right to approve or disapprove annual contracts with management.

For example, a TIC operating agreement entered into by all tenant- in-common co-owners calls for automatic annual renewal of the property management agreement. Should all tenant-in-common co- owners fail to object to any provisions submitted by the management team in a notice of renewal of the management agreement, management has been approved for another year — by silence. Thus, a tenant-in-common co-owner exercises his right to control his interest in the property by objecting. However, if he does object he will be penalized.

The conduct of management permitted in the letter ruling gives co- owners who agree with management the right to buy out the objecting co-owner’s interest. If not bought out, the objecting co-owner is limited to hiring his own property manager. However, for doing so, he will alone bear the cost of his manager. Further, his manager will only be an advisor to the current management, unable to exercise any objection he or his employing co-owner may have. Could management have it any better? You bet they can!

As a final detriment for objections to the current management’s unaltered or continued involvement, a co- owner’s objection triggers an option for a buy out of the objecting co-owner’s TIC interest (without a corresponding option to buy out his non-objecting co-owners’ interests if they do not purchase his interest). The option price to be paid for the objecting co-owner’s TIC interest is his fractional portion of the property’s fair market value (set by an appraiser chosen by a majority vote of tenant-in-common co-owners). The buy out provision places a co-owner at risk of a loss on his investment if he should object to the renewal.

Normally, a co-owner objecting to management has a reasonable basis for doing so, namely that management procedures and policies are deteriorating the future worth of the property and new management to take corrective action to preserve and build up equity in the property.

Hence, the property’s present fair market value at the time of a co-owner’s objection, especially in syndicated property which attracted §1031 monies, is an amount less than the price paid by the group to acquire the property (usually from the syndicator or a related entity) since poor management has deteriorated its worth.

Accordingly, if the non-objecting tenant-in-common co-owners exercise their option to purchase the objecting tenant-in-common co-owner’s co-ownership interest, they will most likely be able to pay an amount less than the price paid by the objecting co- owner for his fractional interest in the property.

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Resale by an individual TIC as §1031 property

Consider a syndicator who seeks to bring together several property owners and cash investors to form a group to co-own an income- producing property located by the syndicator. They will take title as tenants in common, each for their fractional share of undivided ownership, based on the pro rata value of their contribution to the purchase price.

The entire property is or will be leased to a single tenant. The tenant will be either a single user of the property or a master tenant with the right to sublet portions of the premises. Either way, the lease is a triple-net lease which imposes no responsibility on the co-owners for maintenance of the property or the supplying of any tenant services.

The co-ownership agreement places no restrictions on each co- owner’s ability to sell or encumber their individual TIC interest. Also, no voting is established to sell, release or encumber the whole of the property. Thus, any alienation of the entire ownership of the real estate requires unanimous approval of all the co-owners — the essence of the conduct required to avoid the status of a tax partnership.

Based on these co-ownership arrangements, the syndicator requests of the IRS an advance ruling stating the arrangements for the TIC investment do not establish the investors as tax partners or members in an entity. On receipt of the IRC ruling, the fractional interest of a co-owner vested as a tenant-in-common can be acquired or sold as like-kind property.

Thus, an investor’s acquisition of a fractional interest in a TIC investment group (with §1031 monies) which is the subject of an IRS advance ruling that the group is not a tax partnership allows the profits an investor realizes on the sale of his property to qualify for the §1031 profit tax exemption by buying replacement property. [Rev. Proc. 2002-22]

To receive an advance ruling, the syndicator of a TIC co- ownership arrangement must, as a minimum, present extensive documentation to the IRS. In particular, the syndicator must demonstrate the following conditions exist:

1. Title will be vested in the name of all co-owners as tenants in common as to their fractional or percentage ownership based on their proportionate contribution to the purchase of the property.

2. The co-owners will share in the income, profit and losses based on their percentage ownership.

3. No more than 35 participants will be co-owners, husband and wife are considered as one.

4. The co-owners will not file a joint partnership return, will not operate the property under a common business name, and the co- ownership agreement will not classify the co-owners as shareholders, members or partners.

5. The co-ownership agreement may provide for a right of first refusal to anyone (co-owner, manager, syndicator or lessee) to acquire a co-owner’s fractional interest should the co-owner decide to sue for a partition and sale of the property. The fractional interest will be sold at a price set as the fair market value of the property at the time the right to purchase is exercised.

6. Any sale, encumbrance, lease, management or release agreement may only be entered into by unanimous approval of all co-owners (and no one related to the investment may hold a co-owner’s power of attorney to act on his behalf).

7. Each co-owner may sell, encumber or lease his fractional ownership interest in the real estate without any prior restraints or approvals needed to permit the transfer, and should a transfer occur, a right of first refusal may exist in favor of any co-owner, the syndicator or the tenant to purchase the fractional interest transferred (based on the current market value of the entire property).

8. Any advances made by any other co-owner, the syndicator or manager to cover a co-owner’s failure to meet a call for additional funds must be recourse and due within 31 days.

9. A co-owner may grant an option to purchase his interest to anyone. The price to be paid is the co-owner’s fractional share of the whole property’s fair market value on the date the option is exercised, however, no guaranteed buy out (put option) can be held by a co-owner to sell to anyone involved in the investment or the property.

10. A property manager may be hired for a period of no more than one year, renewable by unanimous agreement of the co-owners. He may be anyone except a lessee of the property, may collect rents, pay expenses incurred for the services to be provided to tenants as part of the rent, make distributions to co-owners from one bank account, prepare annual profit and loss statements for each co- owner’s proportionate share of income, expenses, interest and depreciation, place insurance, negotiate leases to be executed only by unanimous approval of the co-owners and receive a fee in an amount comparable to fees received by competitive brokers, but the fee cannot be based on a percentage of distribution to co-owners.

11. No lender providing funds for the investment program may be a related person to the co-owners, the syndicator, manager or lessee.

12. The syndicator may not sell any co-owner an interest in the property for less than the fractional interest’s proportionate share of the whole property’s fair market value (and services rendered by the syndicator to form the group), and no promotional fee or contribution by a co-owner may be contingent on the financial success of the investment program. [Rev. Proc. 2002-22]

However, in spite of all these threshold arrangements to obtain a ruling, the IRS provides no rules or guidelines for the syndicator’s actual formation of a group of co-owners outside the confines of a ruling. Further, the IRS provides no guidance for their audit on a co-owner’s sale or exchange of a fractional co-ownership interest. The IRS only provides a procedure for requesting an advance ruling by a syndicator based on a very limited set of facts.

As a legal complication, an investment program designed to qualify for an advance ruling from the IRS and sold to investors in California most likely creates a risk of loss for the co-owners which is controlled by California’s securities law and the Subdivided Lands Act (SLA). Ironically, both laws require more protection for investors than is required by the IRS for the TIC to qualify for an advance ruling regarding the non- partner status of a fractional co-ownership interest sold or acquired in a §1031 reinvestment plan.

Also, the issues of property reassessment and due-on rights in trust deed on the conveyance of a fractional TIC interest are involved and are not discussed in this article.

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Equity sharing co-ownership investment

Now consider an equity sharing transaction, called a shared equity financing agreement by the IRS. The real estate, a single family residence, will be co-owned by two individuals, generally on the basis of 50:50 proportionate contributions of the cash required for a down payment, closing costs and reserves.

One or both of the co-owners will qualify for a purchase-assist loan or an assumption of the existing loan to pay the balance remaining due on the purchase price.

One co-owner will occupy the property as his principal residence; the other will hold his ownership interest for investment, called a mixed use property. Often the investor is a parent of the resident co-owner. [IRC §280A(d)(3)]

The resident co-owner’s motivation is to own a home. However, he does not have sufficient cash reserves for the down payment needed to make up the difference between the maximum loan available and the price demanded by the seller. The investor co- owner’s motivation is to simply invest in appreciable real estate which will require no management on his part and is likely to turn a profit (on a sale) after three to five years of ownership.

The economic glue holding the two co-owners together is an option to purchase which the investor grants to the resident co-owner so he can acquire sole ownership of his residence in the future. The price under the option to purchase the ownership held by the investor co-owner is one-half of the net equity in the property based on the fair market value of the property when the option is exercised or the capital contribution of the investor, whichever amount is greater.

The price to be paid on exercise of the option to purchase is not pre-set. If it is, the amount of return the investor would receive for his investment would be set, as though he had made a loan. Normal closing costs of a sale and the remaining principal balance due on the loan encumbering the property are first deducted from the property’s fair market value before the price is set.

A co-owner’s equity sharing agreement is entered into calling for these conditions:

1. The resident co-owner will occupy the entire property as a single user under a triple-net lease for a term of five years. The rent amount is set at the fair market value for the use and occupancy of the property. The rent is variable (to cover rising costs, interest, etc.), and in an amount sufficient to cover mortgage payments, property taxes, assessments and insurance premiums.

2. The resident co-owner will pay for all other expenses incurred to repair and maintain the property to protect and conserve its value, as well as for services the resident co-owner may require to occupy the property as his residence.

3. The lease will not prohibit the resident co-owner from subletting or assigning his interest in the lease.

4. No restrictions will be placed on each co-owner’s right to individually transfer his undivided fractional ownership interest in the property by sale, encumbrance or long-term lease, called the right of alienation. However, each co-owner holds a right of first refusal to buy the other co-owner’s interest should the other co-owner actually exercise his right to alienate his undivided interest. The price paid on exercise of the option is the co-owner’s proportionate share of the property’s fair market value at the time of exercise of the first refusal right, less normal closing costs for a sale.

5. The property in its entirety can be sold, encumbered or leased for a long term only with the unanimous approval of the co-owners (both agreeing on the initial five-year lease to the resident co- owner).

6. Any income, profit or loss on the operations, sale, further encumbrance or leasing of the property will be shared based on each co-owner’s contribution to capital.

7. The co-ownership will file no partnership returns, nor issue K-1 schedules. The investor co-owner will report his proportionate share of the annual income and expenses on his Schedule E and the resident co-owner will report his proportionate share of those expenses which are deductible by the owner of a principal residence.

8. The investor co-owner will be designated as the property manager (or a real estate broker is employed as the property manager) to collect rent from the resident co-owner under the lease, maintain a bank account in his name (not a trade name or common name) for deposit of income and payment of expenses (property taxes, insurance premiums, homeowners’ association charges and mortgage payments), and to disburse, at least quarterly, to the co-owners in proportion to their share of ownership, the spendable income remaining after paying operating and ownership expenses.

9. The investor co-owner will grant an option to purchase (call option) to the resident co-owner, exercisable at anytime during the fourth and fifth year of co-ownership by paying the amount of one half of the net equity in the property after deducting the loan balance remaining and customary seller closing costs from the fair market value of the property on the date of exercise, but the amount will not be less than the original capital investment of the investor co-owner in the property.

Should the resident co-owner exercise the option he holds to purchase the property, will the investor co-owner be able to qualify any profit on the sale of his one-half fractional ownership interest in the property for the §1031 profit tax exemption?

Before a quick answer can be given, one more co-ownership fact must be known: How did the co-owners vest title to the real estate?

If the co-owners vest title to the real estate in their individual names as tenants in common, each as to their individual fractional interest the answer is yes. As a tenant-in-common co-owner, the investor’s ownership of a fractional interest in the real estate, not a partner’s interest in a tax partnership, will qualify any profit taken on the sale of his interest for the §1031 exemption.

Here, the capital interest of the co-owners in the property, represented by a fractional share of participation in income, expenses and loan payments, was managed solely to protect and conserve the property held for investment. The services rendered to the tenant to meet those objections were established by the lease in exchange for rent. No source of income existed which was related to a business service provided to the tenant for an additional charge.

Further, each co-owner was vested as a tenant-in-common and retained their fundamental ownership rights of alienation. As tenants-in-common, the co-owners were unrestrained by the requirement that co-owners must consent to the sale, encumbrance or long-term lease or partition of their individual undivided fractional interest in the property.

Also, unanimous approval was required of the co-owners to sell, encumber or enter into a long-term lease of the entire property. The granting of options to purchase and rights of first refusal do not place a restraint on a co-owner’s right to sell or encumber his fractional interest. However, should a co-owner decide to do so, the right of first refusal is triggered and may be exercised by the other co-owners to buy out the interest acquired, — at a price representing the co-owner’s pro rata share of the property’s fair market value on the date of exercise.

However, a tax partnership exists if restrictions on alienation rights held by each co-owner call for prior consent to a transfer by a co-owner, or an agreement exists for a co-owner to share in the profits of a business-related service provided to a tenant. Thus, the co-ownership would be a tax partnership which is then considered the owner of the property, even if the co-owners vest the title in their names as tenants in common.

For co-owners who are tax partners, the §1031 exemption is available to the entire group of co-owners on the sale of the entire property and the joint reinvestment of the net sales proceeds in replacement property. The same analysis applies to investors organized as a partnership or an LLC.

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Qualifying fractional interests as §1031

When the resident co-owner in an equity sharing plan exercises his purchase option to buy out the investor co-owner (or on the investor’s resale of his fractional interest to others), the investor co-owner must avoid partner status if he is to qualify the profit on the sale of his fractional ownership interest for the §1031 exemption.

Three viable exit strategies exist, the selection of one being the investor’s decision, including:

  • an IRC §761-(a) election by the co-owners to be treated as non-partner co-owners of separate interests in the real estate, not as co-owners of the partnership they previously established [IRC §1031(a)];
  • a distribution by the vested partnership, LLC or DBA (“doing business as”) to the co-owner, by granting the co-owner a fractional interest in title to the real estate, vested and with the rights of a common law tenant-in-common, for the co- owner’s proportionate share of the ownership in the partnership or LLC; and
  • a reliance on the co-owner’s prior Schedule E tax reporting as an individual owner of an interest in real estate and on the stated purpose in the partnership/LLC operating agreement that the entity holds title for the co-owners, and does not own or operate the real estate.

The dilemma of an entity

An LLC or LP entity is typically used in real estate syndications to structure the co-ownership by investors of real estate. The use of an entity is both a practical and prudent title holding arrangement.

For example, California’s property tax laws cause a reassessment of the property vested in an LLC or LP only when more than 50% of the ownership of the partnership is assigned to others by the original members of the LLC/LP.

Conversely, when title for the same co-owners is vested as tenants in common, each co-owner who conveys his TIC interests to others (including other co-owners), triggers reassessment of the fractional portion he conveyed. Thus, property taxes rise on each conveyance of a fractional interest, not just the 100% reassessment when a change of more than 50% of the original ownership in an LLC/LP eventually occurs.

Also, a voluntary conveyance or encumbrance by a co-owner of his interest in the property (as required to be allowed without restraint to receive federal non-partner status) may not concern other co-owners. However, a judgment lien imposed by a creditor on a vested co-owner’s interest in title and a foreclosure by way of a judicial sale of the interest becomes an involuntary conveyance of the co-owner’s interest to another person.

The creditor foreclosing or another party will acquire the debtor’s co-ownership interest in the property. On acquisition as the highest bidder, they will in all likelihood file for the partition and eventual sale of the entire property, i.e., a forced sale by a creditor which an LLC/LP vesting avoids.

Another issue for vested co-owners is the release of their names to tenants as required on acquisition or change of management unless they appoint an agent for service of process. An LLC/LP vesting avoids the public release of their names since the co-owners are secreted behind a title holding entity they have formed — the LLC/LP vesting — to either own or simply hold title for the co-owners.

Most important of all, the co-owner is shielded from liability for any uninsured obligation he may incur as an owner of the property.

Thus, LLC/LP vestings are preferable for those co-owners not concerned about managing their profit tax avoidance when they invest or withdraw their investment from the group.

Acquiring a fractional interest

Consider an investor who sells his ownership interest in §1031 real estate. The investor is either the sole owner of the property or the owner of a fractional interest in property co-owned by a group. The investor has located a replacement property with an equity far greater than the net proceeds from his sale.

The seller of the replacement property is unwilling to sell on terms consisting of a purchase-money note for the balance due the seller after a down payment. Further, the investor is unwilling (or unable) to commit additional cash funds himself.

However, the investor has solicited another investor who will join with him as a co-owner and contribute the additional funds needed to cash out the seller’s equity and purchase the property.

A purchase agreement is entered into to acquire the property. On closing, the two investors take title to the property as tenants in common, each as to an undivided fraction of the title in proportion to their contribution of cash toward the purchase.

They enter into a co-ownership agreement to spell out the arrangements they have agreed to between themselves regarding:

  • the management and operation of the ongoing rental of the property; and
  • the management of their ownership interest in the property to sell, encumber or lease (long-term) their interests or the entire property.

The co-ownership agreement addresses their arrangements for management of the entire property, as well as each individual’s management of their fractional ownership interest, as follows:

1. Title will be vested as a TIC.

2. The property will be managed by one of the investors (or a broker) as the property manager for a one-year period with authority to locate tenants, enter into and enforce short-term leases and rental agreements in his own name, provide normal and customary tenant services, repair and maintenance of the property and maintain a bank account in the manager’s name for deposits or receipts from the tenants and disbursements for expenses, mortgage payments and distributions to the co-owners.

3. The co-owners will share income, profits and losses in proportion to their fractional ownership share in the property.

4. Each co-owner will maintain separate tax reporting for their share of operating data, cost basis in their ownership interest and depreciation deductions, and will report their income and losses on their Schedule E with no partnership return to be filed.

5. Any sale, encumbrance, long-term lease or property management contract for the property will be unanimously approved by the co- owners.

6. The right of each co-owner to sell, encumber or partition their fractional ownership interest in the property will be unrestrained by any approval or consent by the other co-owner.

An option to purchase either another co-owner’s fractional interest or the whole property may be granted to a co- owner or the syndicator who packaged the investment program.

Also, a right of first refusal may be granted to co- owners (or the syndicator) to be exercised on another co- owner’s decision to sell, encumber or partition his fractional interest in the property.

The price paid on the exercise of the purchase rights is a pro rata amount of the fair market value of the entire property based on the co-owner’s fractional ownership interest in the property.

Does the co-ownership agreement establish a tax partnership which would disqualify the sale of a co- owner’s TIC interest from use of the §1031 profit tax exemption?

No! Neither co-owner is entering into a business relationship with any tenant by providing services unrelated to the rent paid for the property, nor are they sharing income received by a third party who is operating a business providing tenants with services unrelated to operating the rental, such as laundry, food, maid service or towels and linens.

Further, as tenant-in-common co-owners, they unanimously approve the hiring of a property manager who has authorization to carry out only those managerial steps necessary to operate the rental property, including customary landlord services and the repair and maintenance necessary to protect the property’s improvements and conserve the property’s value.

Thus, the co-owner has not relinquished his common law right of a tenant-in-common to act independently of the other co-owner to sell, encumber, enter into long-term leases and partition the property. No trade name, no joint operating (bank) account and no partnership agreement have been used or entered into to coordinate any sale, further encumbrance or long-term lease of the property.

The only “pooling” by the co-owners is the capital investment and its income, operating expenses and mortgage obligations of the ongoing ownership. Each co-owner has retained the ultimate property right to unilaterally withdraw from the investment by sale, encumbrance or partition without the consent of the other co-owner.

An alternative available for the vesting of a co-owner’s interest is the use of a wholly owned, one-man LP or LLC for the vesting of his fractional interest. Title to his interest would be held in the name of his LP/LLC as a tenant-in-common with all other co-owners. Such a vesting for his undivided fractional interest would be considered by the IRS as title held by a disregarded entity. [Revenue Regulations §301.7701-3]

As a disregarded entity, an individual co-owner’s use of his solely-owned LLC for the vesting of his fractional share of ownership would have absolutely no tax impact on the non- partner status of the co-owner’s undivided interest.

If title to the entire property is vested in an entity such as an LP or LLC, the co-owners’ arrangements must be limited so the entity is merely holding title for each individual co-owner, as tenants in common. Further, the entity and the co-owners will not file a partnership return (as 10 or less are already excused from doing so). The operating agreement for the LP/LLC needs to establish the entity holding title has no ownership interest in the property, and is acting solely as a trustee holding title for the co-owners. [Rev. Rul. 79-77]

A vesting change to benefit a partner

A multiple-unit, income-producing real estate project is owned and operated by an investment group as an unincorporated association structured as an LP or LLC.

A broker operates the property as the property manager, locating tenants, entering into leases, contracting for routine repairs and maintenance, depositing all rents into his trust account, disbursing funds for payment of operating expenses, mortgage payments and distributing spendable income to the co-owners.

The investment group (10 or less) does not file an IRS 1065 return and a K-1 information statement on annual operating income, expenses, interest and depreciation is not handed to the co-owners, since these filings are not required. [Rev. Proc. 84-35]

Each co-owner separately reports his fractional share of each year’s rental operations on Schedule E of his return based on information provided him by the property manager.

One of the co-owners is selling his fractional interest to another co-owner or an outside party.

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

While the co-owner desires to get out of the investment, 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 property which he will acquire for his own account and use as the premises which houses his business.

The property the co-owner wants to buy will be used in the co- owner’s trade or business (or rented to his corporate business). Thus, the property he will acquire qualifies as §1031 property since it will be held for productive use in his trade or business. [IRC §1231]

Editor’s note — If the property acquired is rented to the co-owner’s corporate business, it will then be a rental classified as §1031 investment property, not §1031 business property. [IRC §1221]

To structure the sale of his fractional co-ownership interest in the investment group as the first leg of a §1031 reinvestment plan, the LLC/LP will convey to the co-owner by grant deed an undivided interest in the real estate equal to the co-owner’s percentage share in the partnership.

Thus, a liquidation of the co-owner’s interest in the partnership occurs as a distribution in kind of the partnership asset — conveyance of his pro rata share in title, a non-taxable event. As a result of the conveyance, the partnership becomes a TIC with the prior partner who now holds title to a fractional interest in the real estate as a tenant-in-common. As a tenant-in-common, the co-owner by TIC agreement is given all the rights to alienate his TIC interest, unrestrained, while agreeing to the centralized management of the property’s maintenance and customary tenant-related services for a short period of time (not more than one year).

Now, as owner of a TIC interest in real estate and no longer a partner in the partnership, the co-owner sells (or exchanges) and conveys by grant deed his newly acquired TIC interest to a third party. The cash receipts of the sale are used to acquire the real estate he has located as the replacement property to complete his §1031 reinvestment plan.

Has the co-owner held ownership to the TIC interest for a sufficient length of time and for the right reasons to qualify the TIC ownership for the §1031 profit tax exemption?

Yes! The co-owner acquired ownership of the TIC interest with no intention of liquidating his investment in real estate by “cashing out.” Thus, the co-owner held the TIC interest, unrestrained by the need for prior consent from the co-owners on his sale of his interest. The co-owner’s only intent is to make money by remaining continuously invested in real estate.

The duration of his ownership in any one particular property, such as his ownership of the TIC interest, is not of concern. It is that the ownership must be held either for productive use in a trade or business or for investment. Since it was so held, the continuation of his investment after a sale by acquiring an ownership interest in replacement property (no matter it be for a long or short period of time) demonstrated the intent required to remain unliquidated in real estate investments. [Bolker v. Commissioner (9th Cir. 1985) 760 F2d 1039]

Editor’s note — For property used in a trade or business to qualify as §1031 property, ownership must be retained for a period of one year. [IRC §1231]

The §1031 “no holding” period

The duration of a real estate investment needed to qualify for the §1031 exemption is not the duration of ownership of any one particular property. The investment duration (from one property to the next) required to qualify a property as held for investment is similar to the concept of “tacking” ownerships to qualify for holding periods required under other laws.

To avoid possible duration of ownership questions, the distribution of an asset to a partner to establish his TIC ownership of an interest in real estate should occur in the year prior to the year he sells the TIC interest and purchases replacement property.

However, the duration of the ownership of a particular parcel of real estate which is part of a §1031 reinvestment plan does not determine whether that property is §1031 property. The test for §1031 is whether the ownership, even though temporary, is reinvested in like-kind replacement property, i.e., the owner did not cash out.

A co-owner’s intent when acquiring ownership of a TIC interest as a non-taxable distribution by an LP or LLC, is to make money by owning it as part of the process of reinvesting in replacement real estate on its sale or exchange.

However, the LP or LLC which distributed the fractional interest by grant deed cannot in a related transaction (or series of transactions) become the owner once again of the fractional interest, at least not concurrently. A co-partner can buy the TIC interest and take title to it in his name and hold it as a TIC interest. However, the partnership cannot, in a related or interconnected series of transactions, reacquire the fractional interest distributed to the partner.

If the partnership does reacquire the co-partner’s TIC interest distributed by the partnership for a cash payment made by the partnership, the entire series of related transactions is collapsed. Then, the co-partner who withdrew from the partnership is considered to have personally received the cash, not the TIC interest, as a liquidation of his partnership interest since the partnership paid to re-bundle the ownership of the whole property in the name of the partnership. [Crenshaw v. United States (5th Cir. 1971) 450 F2d 472]

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The §1031 by a twist of Schedule E

A lack of understanding seems to exist among taxpayers, CPAs and drafters of IRS forms regarding the consequences of IRC partnership classification for fractional ownership interests, 1065/K-1 co- ownership reporting forms, the exemption from filing by partnerships comprising 10 or less 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 a group investment which would otherwise be classified as a tax partnership to go unreported.

For example, when co-owners in an investment group file their individual returns, they report the operating data for rental properties on Schedule E, attached to their annual 1040 return. The partnership does not file a return nor provide K-1 reports.

Schedule E lists the co-owners’ proportionate share of income, expenses, interest and depreciation separately. No reference is made (unless volunteered) to the aggregate data generated by the combined ownership of the real estate described in Schedule E.

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

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

  • an ownership interest in a tax partnership and thus excluded from tax-free treatment [IRC §1031(a)(2)(D)]; or
  • a TIC ownership interest in the asset itself which, if unrestrained in its alienation rights, qualifies as §1031 property.

Thus, Schedule E fails to request information from the taxpayer on whether:

  • the property ownership is connected by arrangement to additional tenant services paid for separate from rent; or
  • the interest listed is a fractional interest.

Likewise, the IRS §1031 disclosure form does not inquire into whether the interest sold or exchanged:

  • is a fractional interest in property;
  • a fractional ownership interest in a partnership which owns the property; or
  • a sole ownership interest in the 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. As a result, the exemption from profit taxes declared by the taxpayer is cleared, without a question about the possible tax partner status of the owner whose fractional interest is sold or acquired.

Editor’s note — A school of thought holds the view that these deficiencies in the IRS forms produce the result intended by a more friendly and lenient IRS. However, this might not be the case. [Rev. Proc. 2002-22].

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Co-owner’s guidelines for non-partner tax status

The following is a briefly stated outline of the parameters of the conduct permitted by tenant-in-common co-owners, their manager, lenders and providers of services that will allow each tenant-in- common co-owner to treat his vested TIC interest in the property as §1031 property and, on a sale and reinvestment, qualify its profit as exempt from taxes.

1. The co-owned property must be §1031 like-kind property in the hands of each co-owner, not a partnership, as either:

1.1 Investment property is property in which tenant services provided by the co-owners are limited to those services customarily rendered to tenants under standard leasing arrangements. Income derived from investment property includes:

a. Passive income derived from rental property, residential or nonresidential, actively managed with rental agreements and short-term leases. [IRC §1221]

b. Portfolio income derived from master or ground leases and unimproved land. [IRC §1231]

1.2 Trade or business property is real estate held for productive use in a business owned by co-owners who are treated as a tax partnership. The co-owners share the profits of the business, not a rental property.

2. A tenants in common vesting cannot be held in the name of more than 35 co-owners, each co-owner being an individual or a disregarded entity solely owned by an individual, such as an inter vivos trust, LP or LLC used by an investor to hold his TIC interest.

2.1 Partnership (LP or LLC) vesting is established as an entity holding title for the tenant-in-common co-owners as its stated purpose in the partnership or operating agreement. [Commissioner v. Bollinger (1985) 485 US 340]

3. A co-owner’s right of alienation is defined as each co-owner’s unilateral control over his TIC interest, including:

3.1 Alienation or partition: No restrictions are permitted on each co-owner’s decision to sell, encumber or long-term lease, such as:

a. Prior approval or consent by others to alienate a co- owner’s fractional interest in the property is not allowed.

b. Unanimous approval of all co-owners is required to alienate the whole property.

c. The right of first refusal held by the other co-owners on any one co-owner’s alienation or partition action is permitted at fair market value.

d. A purchase (call) option on the sale of a co-owner’s interest can be granted to anyone at fair market value or cost. [Rev. Proc. 79-77]

e. A guaranteed buy out (put option) for a co-owner to sell is not permitted.

3.2 Loans: Lenders may not participate in the property’s operating income, equity increase or resale proceeds.

3.3 Subordinated interests: All co-owners must share income, profit or loss in proportion to their contribution to capital and on a parity basis.

4. Property protection and conservation:

4.1 The care and maintenance of the property by the property manager is limited to minor or non-structural repairs and maintenance. [Rev. Proc. 79-77]

a. Structural repairs, maintenance or construction of improvements require unanimous approval of the co-owners.

4.2 Tenant services customarily provided under lease and rental agreements can be provided by the property manager as part of the tenant’s rent.

a. Tenant improvements to ready the property for long-term tenants require unanimous approval of the co-owners.

4.3 Additional trade or business related services provided to the tenants by the property manager for an additional charge is permitted, so long as there is no sharing of that income with the co-owners.

5. Property management operations:

5.1 Co-owners may not operate under any trade name or DBA or refer to themselves as partners, shareholders or members of a group.

5.2 Co-owners may not maintain a joint bank account.

5.3 Co-owners may unanimously approve one co-owner as the property manager or hire a broker as the property manager, but a lessee cannot be the property manager.

a. The term of the property manager’s employment cannot exceed one year and any renewal or extension requires unanimous approval by the co-owners.

b. The property manager may be authorized to locate tenants, enter into short-term lease and rental agreements and enforce the agreements in his name by eviction and collection of rent.

c. The property manager’s fee to be comparable to fees paid managers of similar properties and cannot be based on net income or distributions to co-owners, or be subordinated to distribution to co-owners.

5.4 The property manager may, in the manager’s name, but not in a common name for the co-owners:

a. Enter into service contracts to provide customary tenant services normally required by lease and rental agreements and undertake repairs and maintenance necessary to protect and conserve the property.

b. Maintain a bank account for the deposit of rents, disbursements for expenses, payment of mortgages and distribution to co-owners of net spendable income.

c. Place insurance.

d. Hire a resident agent or manager.

e. Prepare profit and loss operating statements reflecting each co-owner’s proportionate share of income, expenses and interest.

6. Tax returns and filings with the IRS:

6.1 No partnership return may be filed.

6.2 Each co-owner must report their share of income, expenses, interest and depreciation on their Schedule E attached to their IRS Form 1041.

6.3 On a change of vesting from a partnership or LLC to a TIC and termination of reporting as a partnership, co-owners must file for an IRC §761 election out of partnership treatment for a distribution in kind to conduct themselves as common law tenant-in- common co-owners as required of §1031 rules.