New IRS Guidance Helps Taxpayers Structure Like-Kind Exchanges of Tenants-in-Common Interests
The IRS in Revenue Procedure 2002-22 has issued guidance concerning whether a taxpayer's acquisition of an undivided fractional interest or tenancy-in-common (TIC) interest in real estate will be treated as the formation of a partnership for federal income tax purposes and thereby jeopardize eligibility for like-kind exchange treatment under Section 1031 of the Internal Revenue Code. The Revenue Procedure was issued in response to requests for private letter rulings on behalf of taxpayers that were selling TIC interests in real estate as replacement property for like-kind exchange transactions.
The purchase of a TIC interest as replacement property is often beneficial for taxpayers because the size of the TIC interest can be tailored to meet the taxpayer's investment objectives in the exchange (e.g., to invest such funds in the replacement property as will be necessary to avoid the gain on the sale). For example, even though it may be possible to acquire as replacement property vacant land, a store or a building, in many cases the equity required to purchase the property is greater than the taxpayer wishes to invest. Through a TIC interest, two or more taxpayers could each acquire an interest in the same property, thereby reducing the cost for the co-owners and tailor the size of the TIC interest to suit their respective needs. The taxpayers, however, must not structure their ownership in such a manner that would cause the IRS to characterize their relationship as a partnership rather than a TIC, because the rules governing tax-free like-kind exchanges do not permit the use of partnership interests as replacement property.
Under Revenue Procedure 2002-22, the IRS establishes guidelines which should help taxpayers (and organizations that engage in the business of marketing replacement properties for like-kind exchanges) acquire and/or sell a TIC interest so that the TIC interest is respected and not re-characterized as an interest in a partnership for federal tax purposes. Revenue Procedure 2002-22 utilizes several factors examined in prior cases and IRS rulings (as well as new factors) to establish guidelines for structuring TIC interests that can be acquired as replacement property in like-kind exchanges. Some of the key factors set forth in the Revenue Procedure are: permitting up to 35 persons as co-owners, establishing parameters for unanimous and non-unanimous voting rights, restrictions on alienation, sharing profits and losses, addressing call and put options, and outlining acceptable terms for management, brokerage and loan agreements. No single factor will have greater weight than any of the other factors. It appears as though the intent of the Revenue Procedure is to ensure that the TIC interests are not, in substance, a business relationship between the co-owners.