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Rev. Proc. 2002-22: co-ownership of property or partnership interest?

On March 19, 2002, the IRS released Rev. Proc. 2002-22, establishing the conditions under which a taxpayer may request a letter ruling that an undivided fractional interest in rental real property is not an interest in a business entity within the meaning of Regs. Sec. 301.7701-2(a) (i.e., that the co-ownership of property is not a corporation or a partnership for Federal tax purposes).

In general, the determination of whether an organization creates an entity separate from its owners for Federal tax purposes is a matter of Federal tax law, not dependent on whether the arrangement is recognized as an entity under local law (Regs. Sec. 301.7701-1(a)(1)). A joint venture or other contractual arrangement may create a separate entity for Federal tax purposes if the participants carry on a trade, business, financial operation or venture, and divide the profits therefrom. However, mere co-ownership of property that is maintained, kept in repair and rented or leased generally does not constitute a separate entity for Federal tax purposes (Regs. Sec. 301.7701-1(a)(2)).

Taxpayers that co-own real property often lease the property and share in the rents, as well as the costs and expenses of maintaining the property. For each co-ownership of income-producing property, taxpayers must determine whether the arrangement is merely property co-ownership or whether the taxpayers' joint activities rise to the level of a separate entity. The line, however, is not always clear.

In Rev. Rul. 75-374, the IRS concluded that co-ownership of an apartment building in which the co-owners' agent provided customary services (such as heat, air conditioning, trash removal and maintenance of common areas) to the tenants was not sufficient joint activity for partnership status. Conversely, the Tax Court determined that a partnership existed when the economic benefits enjoyed by the co-owners resulted not from co-ownership of the property, but from the pursuit of a common goal; see Bergford, 12 F3d 166 (9th Cir. 1993); Bussing, 88 TC 449, aff'd on reh'g, 89 TC 1050 (1987); and Alhouse, TC Memo 1991-652, aff'd sub. nom. Bergford, 12 F3d 166. Specifically, the Tax Court concluded that a partnership exists when (1) the co-owners or their agent performs services that are more than customary (such as arranging financing, collecting rents, preparing statements and purchasing and leasing equipment), (2) the co-owners' ability to sell, lease or encumber either their undivided fractional interests or the underlying property is limited and (3) the co-owners share the property's profits and losses with the manager or agent.

In Rev. Proc. 2000-46, the IRS indicated that it was studying the circumstances under which it intended to treat co-ownership of real property as a separate entity for Federal tax purposes. Specifically, it was interested in transactions in which a "sponsor" (i.e., a person who divides a single interest in property into multiple co-ownership interests with the intention of offering the interests for sale) "packaged" tenancy-in-common interests in rental real estate and marketed them to a taxpayer as eligible replacement property under Sec. 1031 for the taxpayer's like-kind exchange. If the IRS determined that it should treat such co-ownership interests as interests in a separate entity (i.e., partnership interests or corporate stock), the co-ownership interests would not be eligible replacement property under Sec. 1031; see Sec. 1031(a)(2). Because the IRS was studying these issues, Rev. Proc. 2000-46 announced that the IRS no longer intended to issue advance rulings or determination letters on whether an undivided fractional interest in real property is an interest in a separate entity for Federal tax purposes.

As a result of this study, the IRS issued Rev. Proc. 2002-22, which supersedes Rev. Proc. 2000-46 and provides the general guidelines under which the IRS will now consider a request for a ruling that a co-ownership of rental real property (other than mineral property) does not create a separate entity for Federal tax purposes. The co-ownership must generally meet all of the revenue procedure's requirements for the IRS to consider the ruling request. However, even if the co-ownership satisfies all the requirements, the IRS may still decline to rule whenever warranted by the facts and circumstances or when appropriate in the interest of sound tax administration.

The revenue procedure's requirements fall into the following general categories. (Note: In addition to the requirements described below, Rev. Proc. 2002-22 also includes a detailed list of the information to be submitted by a taxpayer requesting a ruling under the revenue procedure.)

Characteristics of the co-owners. No more than 35 co-owners may own the property for the IRS to consider a ruling request. For this rule, a husband and wife are treated as a single person and all persons who acquire interests from a co-owner by inheritance are treated as a single person. With certain exceptions, each co-owner must have the right to transfer, partition and encumber its undivided property interest, without the agreement or approval of any person. However, certain restrictions on these rights imposed by a lender under customary commercial lending practices are not prohibited. In addition, the co-owners may enter into a limited co-ownership agreement that runs with the land. For example, a co-ownership agreement may provide that a co-owner must offer its co-ownership interest for sale to the other co-owners at fair market value (FMV) before exercising its right to partition. Moreover, the co-owners, the sponsor or the lessee may have a right of first offer (i.e., the right to have the first opportunity to offer to purchase a co-ownership interest) for any co-owner's interest. (Note: According to informal comments by an IRS official, a right of first offer is different from a right of first refusal.)

The co-owners must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any leases, and the creation or modification of a blanket lien (i.e., a mortgage against the entire property). These actions must be subject to the co-owners' unanimous approval. However, the co-owners may agree that they may undertake other actions by a vote of those holding more than 50% of the undivided property interests. A co-owner may provide the property manager or another person a power of attorney to execute a specific document for an action. However, a co-owner may not provide the manager or other person with a global power of attorney for the co-owner's property interest.

Each co-owner must share in all revenues generated by the property and all associated costs, in proportion to its undivided interest. Neither the co-owners, the property manager nor the sponsor may advance funds to a co-owner to meet expenses associated with the co-ownership interest, unless the advance is recourse to the co-owner and does not exceed 31 days.

A co-owner may generally issue an option to purchase its undivided interest in the property (i.e., a call option). However, a co-owner may not acquire an option to sell its undivided interest (i.e., a put option) to the sponsor, a lessee, another co-owner, a lender or any person related (within the meaning of Sec. 267(b) or 707(b)(1)) to the sponsor, a lessee, other co-owners or a lender.

Finally, any payment to a sponsor to acquire a co-ownership interest must reflect the acquired interest's FMV and may not depend on the income or profits derived from the property.

Characteristics of the co-owned property. Under the revenue procedure, each co-owner must hold tide to the property, either directly or through an entity disregarded for Federal tax purposes, as a tenant-in-common under local law. An entity recognized under local law may not hold title to the property. In addition, the co-owners must not otherwise treat the co-ownership as a separate entity. For example, the co-ownership may not file a partnership or corporate return, conduct business under a common name, execute an agreement identifying any or all of the co-owners as partners, shareholders or members of a business entity or hold itself out to others as a separate entity. The IRS will generally not provide a ruling on co-ownership of property if the co-owners held interests in the property through a partnership or a corporation immediately prior to forming the co-ownership.

The co-owners must limit their activities to those customarily performed for maintenance and repair of rental real estate; see Rev. Rul. 75-374. The IRS will take into account all the activities of the co-owners, their agents and any persons related to the co-owners, whether or not the co-owners perform those activities in their capacity as co-owners.

The co-owners may enter into a brokerage or management agreement with an agent who may not be a lessee. The agreement must be renewable no less frequently than annually. The co-owners may authorize the manager to maintain a common bank account to deposit rents and pay expenses, prepare statements, obtain insurance and negotiate modifications to the terms of any debt encumbering the property (subject to the owners' approval). The manager must distribute net revenues to the co-owners within three months of receipt. The manager's fees may not be dependent on the income or profits derived from the property and may not exceed the FMV of his services.

All leases must be bona fide for Federal tax purposes. Rental amounts must reflect the FMV of the property's use and may not depend (in whole or in part) on the income or profit derived from the property.

Characteristics of debt encumbering the property. The co-owners must share in any debt secured by a blanket lien in proportion to their undivided interests. If they sell the property, the co-owners must satisfy any debt secured by a blanket lien and receive any remaining proceeds. The lender of any debt on the property or any debt incurred to acquire an undivided interest in the property may not be related (as previously defined) to any co-owner, sponsor, manager or lessee.

Finally, in Rev. Proc. 2002-22, the IRS provided guidance on the application of the revenue procedure to multiple parcels of property held by the same co-owners. The IRS will generally treat multiple parcels of property owned by the same co-owners as a single parcel if (1) such parcels are leased to a single tenant under a single lease agreement and (2) any debt incurred by one or more of the co-owners is secured by each of the parcels. In addition, the IRS will consider a ruling request for multiple parcels only if (1) each co-owner's percentage interest in each parcel is identical to his interest in all other parcels; (2) each co-owner's percentage interest in the parcels cannot be separated and traded independently; and (3) the parcels are properly viewed as a single business unit.


Rev. Proc. 2002-22 provides only advance ruling guidelines and does not represent substantive rules for when a co-ownership of property rises to the level of a partnership or corporation for Federal tax purposes. Nevertheless, it gives some insight into the circumstances that the IRS considers important in making this determination and should help taxpayers in structuring future co-ownership arrangements.

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Author:Belanger, Holly
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jun 1, 2002
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