TENANCY IN COMMON AGREEMENTS – 1031 EXCHANGE FLEXIBILITY FOR REAL ESTATE CO-OWNERS

Many real estate investors choose to own rental property together with partners, family members, or friends, and the way they hold title can make a critical difference in their ability to complete a tax-deferred 1031 exchange when the property is eventually sold. For groups holding rental property together the decision of how to structure ownership can produce dramatically different tax outcomes. One structure stands out above the others when the goal is to keep full access to 1031 like-kind exchange treatment upon sale. That structure is a properly drafted tenancy-in-common (“TIC”) agreement.

I. THE CORE ADVANTAGE OF TIC OWNERSHIP.

A 1031 exchange lets an owner defer capital gains tax by rolling the proceeds from one investment property into another of like kind. Interests in partnerships and in most multi-member LLCs do not qualify for this deferral because the Internal Revenue Code treats those interests as personal property rather than real estate. A true tenancy in common avoids that problem. Each co-owner holds an undivided fractional interest directly in the real property itself. When the property is eventually sold, every co-owner may independently direct his or her pro-rata share of the proceeds into a separate 1031 exchange. No entity-level dissolution or “drop-and-swap” is required, and each investor remains free to pursue different replacement properties or different timelines.

II. WHAT TURNS A TIC INTO A PARTNERSHIP IN THE EYES OF THE IRS?

The IRS has long recognized that simple co-ownership of rental real estate with normal maintenance and leasing activities does not create a tax partnership. Problems arise when the arrangement begins to look and operate like an active business venture. If that happens the entire structure can be recharacterized as a partnership and the 1031 benefit is eliminated.

In 2002 the IRS published Revenue Procedure 2002-22 (hereinafter the “Rules”) which remains the governing safe-harbor guidance today. The procedure describes specific conditions that if satisfied allow co-owners to request an advance private letter ruling that their tenancy in common will not be treated as a separate business entity.

III. WHO IS THE “SPONSOR” AND WHY DOES IT MATTER?

In the language of the Rules the sponsor is the person or entity that divides an existing fee-simple interest in real property into multiple undivided fractional interests and then markets those interests to investors. The sponsor is often the original owner developer or promoter who assembles the co-ownership group. Because sponsors frequently also serve as manager or receive ongoing fees the IRS scrutiny focuses heavily on the sponsor’s role. The Rules therefore impose strict limits on sponsor compensation loan relationships option rights and management authority to prevent the sponsor from exercising the kind of control that would cause the arrangement to resemble a partnership.

IV. HOW THE RULES KEEP THE ARRANGEMENT IN THE SAFE WATERS.

The Rules build a series of guardrails that together preserve the passive co-ownership character of the investment. See below are the generally defined conditions set out in Revenue Procedure 2002-22.

• Title must be held directly as tenants in common under local law or through disregarded single-member entities.
• The total number of co-owners is limited to thirty-five persons with a husband and wife counting as one person.
• The group may not file partnership returns conduct business under a common name or hold itself out as any form of entity.
• Major decisions such as selling the property entering or renewing leases hiring a manager or incurring or refinancing blanket debt require unanimous approval of the co-owners.
• Day-to-day decisions can be made by majority vote, but no co-owner may grant the manager a broad power of attorney.
• Each co-owner retains the unrestricted right to transfer encumber or partition his or her interest subject only to ordinary lender requirements and optional rights of first offer at fair market value.
• All revenue expenses and blanket debt must be shared strictly in proportion to the undivided ownership percentages.
• Management agreements must be renewable annually and management fees must be reasonable and unrelated to the income or profits of the property.
• Rents must be set at fair market value and may not be based on net income or cash flow of the property.
• No related person may lend money to the co-owners, and no co-owner may receive non-recourse advances from the group or the sponsor for longer than thirty-one days.
• Call options are allowed if priced at fair market value when exercised but put options forcing a buyback by the sponsor lessee or any related party are prohibited.
• The co-owners’ activities are limited to those customarily associated with the maintenance and leasing of rental real estate. Anything more extensive risks turning the arrangement into a taxable business venture.

Although strictly following all the above Rules is not legally required to avoid partnership classification, the IRS and courts treat them as the decisive factors in determining whether a tenancy-in-common arrangement qualifies for 1031 exchange treatment, so the safest and most widely accepted practice is to satisfy every one of them.

V. PRACTICAL EXAMPLES OF TIC IN ACTION.

A group of four unrelated investors forms to acquire a $15 million single-tenant industrial building with a 12-year corporate-guaranteed lease. All four take title at closing as tenants in common (25% undivided interests each) under a TIC agreement that complies with the Rules. They do not form an LLC or partnership because they already know their investment horizons and exit strategies are different. One is a physician building retirement cash flow, another is a developer who may want to roll proceeds into a development deal, the third is a trust that prefers long-term hold, and the fourth frequently engages in 1031 exchanges.

Eight years later the tenant exercises its purchase option and buys the building for $24 million. Because title was always held as a tenancy in common the closing agent simply wires each co-owner his or her exact pro-rata share of the net proceeds (25% each). Within the normal 45-day identification and 180-day closing windows the physician exchanges into a medical office condominium, the developer exchanges into raw land for a ground-up project, the trust exchanges into a larger net-leased retail center, and the frequent exchanger acquires three smaller industrial properties in different markets.

No entity dissolution is required, no drop-and-swap gymnastics are needed, and no one is forced into a taxable event simply because the others want to keep deferring. Each investor independently controls his or her 1031 outcome.

VI. THE BOTTOM LINE.

Tenancy-in-common ownership governed by a carefully drafted agreement continues to offer co-owners the combination of direct real-property title operational simplicity and full 1031 exchange flexibility. Partnerships and multi-member LLCs simply cannot match that result without costly restructuring at the time of sale.

Kirk & Simas regularly structures and reviews tenancy-in-common agreements for investors. If you are considering fractional ownership or preparing for an upcoming disposition, we would be happy to help you preserve your 1031 options.