- Section 1031 of the internal revenue code allows a taxpayer to defer capital gains taxes on the profitable sale of an investment property.
- Under the rules of the exchange, the taxpayer must identify a replacement property within 45 days of the sale of the relinquished property and close on the transaction within 180 days.
- Given the time constraints and competition, finding a suitable replacement property can be a challenge.
- IRS Revenue Procedure 2002-22 allows for a tenants in common ownership interest in a replacement property to be used in a 1031 exchange as long as it meets certain conditions.
- If used correctly, taxpayers can defer taxes indefinitely, diversify their portfolio, and gain an interest in a higher quality asset than they would have been able to afford on their own.
Section 1031 of the Internal Revenue Code allows commercial real estate investors to defer capital gains taxes on the profitable sale of an investment property as long as the proceeds are “exchanged” into another property that is “like kind.”
In order to realize the benefits of the 1031 Exchange, the value of the replacement property must be the same or greater than the value of the relinquished property. In addition, the replacement property must be identified within 45 days of the sale of the relinquished property, and the transaction must be closed within 180 days.
Given the time constraints and the popularity of the 1031 Exchange program, competition for the best replacement properties can be significant, and the time constraints can often cause investors to “settle” for suboptimal property choices. Fortunately, there are other options that involve a fractional interest in a larger property, rather than 100% ownership of a smaller property. This is accomplished by using a “Tenants In Common” ownership structure.
If you are interested in learning more about FNRP’s 1031 Exchange options, click here to check out some of our latest deals.
What Are Tenants In Common?
Tenancy in Common is a commercial real estate ownership structure that allows multiple owners of the same property. The property can be commercial or residential and when one of the owners passes away, their interest is passed to an heir. Each “tenant” has a fractional ownership interest in the property and these can vary. For example, Sam can own 50%, Bill can own 25% and Frank can own 25%, and together, the group owns all areas of the property.
The legal agreement governing a tenants-in-common arrangement can be created at any time, meaning that an owner can further split his or her interest if additional individuals wish to join the ownership group. This is particularly helpful when it comes to a 1031 Exchange.
How Is a Tenancy In Common Arrangement Used to Facilitate a 1031 Exchange?
IRS Revenue Procedure 2002-22 provides guidance for the use of a fractional ownership agreement as a replacement property in a 1031 Exchange. The text of the procedure outlines 15 conditions under which this arrangement can be used:
- Tenancy In Common Ownership: Each of the co-owners must hold title to the property (either directly or through a disregarded entity) as a tenant in common under local law.
- Number of Co-Owners: The number of co-owners must be limited to no more than 35 persons.
- No Treatment of Co-Ownership as an Entity: The co-ownership may not file a partnership or corporate tax 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 otherwise hold itself out as a partnership or other business entity.
- Co-Ownership Agreement: The co-owners may enter into a limited co-ownership agreement that may run with the land. For example, a co-ownership agreement may provide that a co-owner must offer the co-ownership interest for sale to the other co-owners, the sponsor, or the lessee at fair market value (determined as of the time the partition right is exercised) before exercising any right to partition (see section 6.06 of this revenue procedure for conditions relating to restrictions on alienation); or that certain actions on behalf of the co-ownership require the vote of co-owners holding more than 50 percent of the undivided interests in the property (see section 6.05 of this revenue procedure for conditions relating to voting).
- Voting: The co-owners must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any leases of a portion or all of the property, or the creation or modification of a blanket lien. Any sale, lease, or re-lease of a portion or all of the property must be by unanimous approval of the co-owners.
- Restrictions on Alienation: In general, each co-owner must have the rights to transfer, partition, and encumber the co-owners undivided interest in the real property without the agreement or approval of any person.
- Sharing Proceeds and Liabilities upon Sale of Property: If the property is sold, any debt secured by a blanket lien must be satisfied and the remaining sales proceeds must be distributed to the co-owners.
- Proportionate Sharing of Profits and Losses: Each co-owner must share in all revenues generated by the property and all costs associated with the property in proportion to the co-owners’ undivided interest.
- Proportionate Sharing of Debt: The co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.
- Options: A co-owner may issue an option to purchase the co-owners undivided interest, provided that the exercise price for the call option reflects the fair market value of the property, determined as of the time the option is exercised.
- No Business Activities: The co-owners activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property (customary activities).
- Management and Brokerage Agreements: The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than 13 times annually, with an agent, who may be the sponsor or a co-owner (or any person related to the sponsor or a co-owner), but who may not be a lessee.
- Leasing Agreements: All leasing arrangements must be bona fide leases for federal tax purposes. Rents paid by a lessee must reflect the fair market value for the use of the property.
- Loan Agreements: The lender with respect to any debt that encumbers the property or with respect to any debt incurred to acquire an undivided interest in the property may not be a related person to any co-owner, the sponsor, the manager, or any lessee of the property.
- Payments to Sponsor: Except as otherwise provided in this revenue procedure, the amount of any payment to the sponsor for the acquisition of the co-ownership interest (and the amount of any fees paid to the sponsor for services) must reflect the fair market value of the acquired co-ownership interest.
If the above conditions are met, a replacement property owner under a TIC structure qualifies for tax deferral under the 1031 Exchange program.
Benefits and Risks of Using a TIC Structure for a 1031 Exchange
The most obvious benefit of a 1031 Exchange is the tax deferral. But, such a strategy can also be used as a way to add diversification to a commercial real estate investment portfolio. In addition, when a TIC property is used, the exchanger gains fractional ownership of an institutional-grade property. However, this approach comes with risks.
The biggest risk to the taxpayer is that the exchange is not completed in compliance with the IRS rules and, as a result, it becomes taxable. For this reason, investors should always consult with a qualified real estate attorney or CPA to make sure they understand the parameters of the transaction. In addition, they should ensure that a qualified intermediary is used to facilitate the like-kind exchange to make sure all interests are protected.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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