Sec. 1031 and fractional property interests.

There is a new market in the Sec. 1031 like-kind exchange arena--exchanging real property for separate, fractional property interests in replacement properties. Fractional property interests offer a more diversified investment and, if exchanged properly, escape gain recognition in a Sec. 1031 like-kind exchange.

Fractional Property Interests

In a fractional property interest, each owner of a piece of property is deemed to own a physically undivided part of the entire parcel. This relationship is a tenancy in common, in which each owner is entitled to a share of the whole parcel and the rights to a portion of the rents or profits therefrom. Co-owners have the right to transfer their interest and demand a partition of the property. However, they cannot exercise any rights that would be disadvantageous to the other tenants in common.

Sec. 1031

Under Sec. 1031 (a)(1), gain or loss on the exchange of property used in a trade or business or for investment can go unrecognized if the property is exchanged solely for like-kind property also used in a trade or business or for investment. This nonrecognition rule is popular, because it allows taxpayers to escape current gain recognition (unless boot is received).

In the past, taxpayers have generally used this provision to exchange one property for another or for a few properties. However, they can now use Sec. 1031's like-kind exchange rules to invest in several fractional property interests without significant tax consequences. Of course, all the rules on qualified like-kind replacement properties (including restrictions on the identification of multiple properties in the case of deferred exchanges) must be observed.

Prior to the IRS rulings discussed below, there was some concern that fractional-property-interest arrangements could be deemed partnerships for Federal tax purposes. Under Sec. 103 l(a)(2)(D), partnership interests do not qualify for a like-kind exchange. According to Regs. Sec. 301.7701-1(a)(2), a joint venture or contractual arrangement creates a separate tax entity, or a partnership, for Federal tax purposes, if the participants carry on a trade, business, financial operation or venture and divide the profits therefrom. Mere co-ownership of property that is maintained, kept in repair and rented or leased, however, does not constitute a separate entity for Federal tax purposes.

Rules

The IRS provided guidance in Rev. Proc. 2002-22 on whether an undivided fractional interest in real property is an interest in a separate tax entity ineligible for tax-free exchange under Sec. 1031(a) (1). It concluded that due to the owners' relationship as tenants in common, fractional property interests should not be considered partnerships, as long as they meet certain conditions. Failure to meet the requirements could result in a fractional property interest being classified as a partnership, dewing Sec. 1031 treatment. The Service later offered further guidance in Letter Rulings 200625009, 200513010 and 200327003.

Ownership: Under Rev. Proc. 2002-22, each co-owner must hold title to the property as a tenant in common under local law. There cannot be more than 35 co-owners of a single piece of property. The co-owners cannot file a tax return as a partnership or a corporation. They cannot conduct business under a common name or create any operating agreement that identifies them as partners, shareholders or members of a business entity.

Co-owners must share in any debt secured by a blanket lien in proportion to their undivided interests. If the property is sold, any debt secured by the lien must be satisfied and the remaining proceeds distributed to the co-owners. All revenues and expenses must also be shared proportionately. A co-owner, manager or sponsor cannot advance funds to a co-owner to cover costs, except in limited circumstances.

Agreements: The property's co-owners are allowed to enter into a limited co-ownership agreement that may run with the land. The agreement must allow the co-owners to have the right to approve hiring a manager, selling or leasing the property and incurring debt secured by a blanket lien. Some of these actions may require the owners' unanimous consent, while others may require only a majority vote.

Co-owners can agree to require a fellow co-owner to offer its ownership interest for sale to the other co-owners, the sponsor or the lessee at fair market value (FMV) before exercising any right of partition. The agreement must allow each co-owner the right to convey, partition and encumber the co-owner's interest in the property without the agreement or approval of any other person. The co-owners may use call options, but the exercise price must reflect the property's FMV at the time the option is exercised. Put options are not allowed.

Business activities: In a tenancy in common, owners can participate in business activities. However, they must limit these activities to those customarily performed in connection with the maintenance and repair of rental real property. Such activities must not prevent the proceeds from being considered rent under Sec. 512(b)(3)(A). Generally, the activities of all parties to the arrangement are taken into account (even activities performed by co-owners not in their capacity as co-owners) in determining whether the arrangement qualifies.

The co-owners may enter into a management or brokerage agreement with an agent who may be a sponsor or a co-owner, but cannot be a lessee. The management agreement may authorize the manager to handle the daily activities associated with renting the property, such as maintaining a common bank account to collect rent and pay expenses associated with the property. The manager must distribute each co-owner's share of the rental revenue within three months of collecting it. Management can also maintain insurance on the property. The management fees paid cannot depend on the income or profits derived by any person from the property and cannot exceed the FMV of the manager's services.

Leasing agreements: All rents paid by a lessee for using the property must reflect FMV, and all leasing arrangements must be bona fide. For example, a lessee's rent cannot depend on the property's annual net income.

Ruling Requests

Rev. Proc. 2002-22 provides a list of documents, information and materials that must be submitted along with a ruling request (e.g., identifying information for each co-owner; the percentage fractional interest of each; the agreements (including leasing and brokerage agreements); voting arrangements; and how proceeds and liabilities would be shared if the property were sold).

Rulings

Letter Rulings 200625009, 20051-3010 and 200327003 all held that an undivided fractional interest was not a partnership. In Letter Ruling 2003-27003, a company intended to acquire a fee interest in commercial real property with its own cash. It would then lease the property to a single tenant at FMV. The lease would be a triple net lease, under which the lessee would be responsible for all the property's costs and expenses. After acquiring and leasing the property, the company would create and sell undivided fractional interests at FMV to no more than 35 others, itself included. It would create management agreements in which the co-owners could participate.

In Letter Ruling 200513010, the facts were similar. A company would acquire property, already rented to multiple tenants. It would then sell fractional interests to no more than 35 co-owners, who would either pay cash and/or assume a portion of the blanket debt on the property. Management agreements would be put in place. The co-owners would have certain rights to influence the choice of property managers.

In Letter Ruling 200625009, a company and a co-owner had acquired a property and operated it as tenants in common. The co-owner's affiliate was a tenant of the property. Both the company and the co-owner retained a 50% interest in the property. The parties wanted to create a buy-sell procedure to be used if a sale would result in a change in the property's control. The co-owner seeking to sell would have to (1) give the other co-owner a pre-offer notice, which would include an initial due diligence disclosure; and (2) provide written notice of the intent to sell the property interest.

Conclusion

Fractional property interests can offer investors options that should be considered when contemplating Sec. 1031 tax-free exchanges of real property. If taxpayers are well-informed, ownership of a fractional property interest can be a profitable investment, offer portfolio diversity and save money.

FROM ERIN MOUNTAIN, AIDMAN, PISER & COMPANY, P.A., TAMPA, FL