REQUIREMENTS OF A TENANT IN COMMON
Exchange
By: Russell J. Gullo, CCIM, CEAOn March 19, 2002, the Internal Revenue Service issued
Revenue Procedure 2002-22, identifying the requirements under
which the Internal Revenue Service would consider a request
for a ruling that an undivided fractional interest in real
estate would be considered an interest in real estate and not
an interest in a business entity.
Although the Revenue Procedure is relevant for a number of
different tax reasons. It is very important to those who own
business (income-producing) or investment held property who
would like to take advantage of a Real Estate Exchangeunder
Section “1031” of the Internal Revenue Code.
This section of the code allows for the Paying Of No
Capital Gains Tax when disposing of either business
(income-producing) or investment held property, but in order
to receive this benefit, the transaction must be structured
through the use of a professional Qualified Intermediary.
One of the requirements to receive this favorable tax
treatment, is that other “like-kind” property must be
acquired within one hundred and eighty days. One of the
biggest problems that we see in the marketplace when someone
wants to take advantage of this “Best Kept Secret”
is that they don’t know what they are going to acquire to
complete their Exchangetransaction. From the closing of the
relinquished property the taxpayer (seller) has forty-five
days to identify the replacement property that they will
purchase within their one hundred eighty day “Exchangeperiod”.
Tenants In Common Ownership To The Rescue
This new Revenue Procedure allows individuals looking
to complete an Exchangethe opportunity to acquire a
replacement property that is Management-Free and
Headache-Free through the ownership of what’s
called Tenants In Common (T.I.C.’s) Ownership. Individuals
have ability to own an undivided interest in a property that
most people would not have the resources to own by themselves.
This is not a partnership. You own an undivided interest as a
Tenant In Common. This form of ownership is being called the
“Real
Estate Opportunity Of The 21st Century”.
This Revenue Procedure provides guidelines for
requesting advance rulings to assist taxpayers who would like
to take advantage of this type of ownership structure. The
following is an overview of the most significant statements in
Revenue Procedure 2002-22.
1. Legal Title Held Direct-No Entities. Co-owners
must hold legal title to the property as tenants-in-common
under local law, directly or indirectly through a disregarded
entity (such as a single member limited liability company).
Thus, “title to the property as a whole may not be held by
an entity recognized under local law.”
A limited liability company structure involving an election
out of subchapter K of the Internal Revenue Code will probably
not be eligible for an advance ruling from the Service.
However, as noted above, the legal authority for analyzing
such a structure’s validity for purposes of Code Section
1031 has not changed.
2. Number Of Co-Owners. The number of co-owners may
not exceed 35 (a husband and wife may be treated as a single
person).
3. No Entity-Like Activities. The co-ownership may
not file a partnership or corporate tax return, may not
conduct business under a common name, may not execute a
partnership or limited liability company agreement and may not
otherwise hold itself out as a partnership or other form of
business entity.
4. Co-Ownership Agreements Allowed. Co-owners
may enter into a limited co-ownership agreement.
5.Voting On Decisions. In the co-ownership
agreement, major decisions such as sale, lease, financing and
the appointment of managing agents must be approved
unanimously. For most other actions, the vote of co-owners
holding a majority of the undivided interests may carry the
day.
6. Required Transfers and Partition Rights. Each
co-owner must have the right to transfer, partition and
encumber (mortgage) the co-owner’s undivided interest in the
property without the approval of any person. However,
restrictions required by a lender will generally not be
prohibited. In addition, granting of a right of first offer
prior to a sale to other co-owners, the program sponsor or the
lessee of the property will be permitted. Finally, while
co-owners must have the right to partition the property, this
right may be made subject to a prior right of first offer (to
other co-owners, the program sponsor or the lessee) at fair
market value.
7. Proportionate Sharing of Capital Event Proceeds.
If the property is sold, any mortgage debt must be satisfied
and the remaining sales proceeds must be distributed to
co-owners in accordance with their undivided interests in the
property.
8.Proportionate Revenue and Expense Sharing.
Co-owners must share in all revenues and all expenses of the
property in proportion to their undivided interests. Except
for short term loans, loans among co-owners, or from the
program sponsor, are not permitted.
9.Proportionate Sharing Of Mortgage Debt. Mortgage
debt generally must be shared in accordance with the co-owners’
undivided interests.
10.Options. A co-owner may issue a call option to
purchase its undivided interest as long as the exercise price
is at fair market value at the time that the option is
exercised (fair market value is determined with reference to
the market value of the property as a whole, multiplied by the
co-owner’s undivided interest). A co-owner may not have the
right to put its interest in the property to the program
sponsor, another co-owner, lessee, lender or any person
related to any of the foregoing.
11.Passive Operations Required. Co-owners’
activities must be limited to those customarily performed in
connection with the maintenance and repair of passive rental
real estate.
12.Management and Administration. Co-owners may
enter into property management and brokerage agreements, but
such agreements may not subsist for more than one year
(although they can be renewed). Management and brokerage
agreements may be entered with the program sponsor or another
co-owner, but not a lessee of the property. The management
agreement may authorize the manager to maintain a bank account
for the collection of revenues and payment of expenses on
behalf of all of the co-owners. Net revenues must be
disbursed at least quarterly. The manager may also be
given responsibility for certain accounting functions, as well
as the responsibility for such matters as insurance, leases
and mortgages (subject to the approval of co-owners). Fees
paid to the manager must be market-based and may not be
dependent on the income or profits from the property.
13.Leasing Agreements. All leases must be true
leases for Federal tax purposes (rents must reflect the fair
value for the use of the property). Percentage rents are
generally prohibited, except for those that are based on a
fixed percentage of a tenant’s receipts or sales. In this
connection, reference is made to the REIT rules at Code
Section 856(d)(2)(A).
14.Mortgage Lender Cannot be a Related Party. The
mortgage lender may not be related to any co-owner, program
sponsor, property manager or lessee of the property.
15.Payment to Program Sponsors. Payments to the
program must reflect the fair market value of the acquired
co-ownership interest and may not depend upon the income or
profits derived from the property.
As with any kind of Real Estate Exchange, always consult
with a professional Qualified Intermediary before getting
involved in such a transaction.
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