The same question keeps reappearing in tax planning discussions: “We formed a partnership to buy a property, but now some of us want out and some of us want to reinvest. How do we do this with the least amount of tax impact?” At face value, distributing the property as tenancy in common (“TIC”) interests and executing a §1031 like-kind exchange is a win-win, but this approach leaves the taxpayer open to scrutiny by the IRS as discussed below.
Section 1031 allows for the deferral of gain or loss on the exchange of like-kind property held for productive use in a trade or business or for investment. Interests in partnerships are specifically excluded from favorable treatment under §1031. This creates an issue when a property is held through a partnership, and the partners want to go their separate ways. On the other hand, a TIC interest, which is an undivided percentage interest in a property, qualifies for non-recognition treatment under §1031. Unlike a condo, there are no physical divisions of the property, but there are multiple direct owners. Each co-owner is entitled to share in the possession of the property and bear the benefits and burdens of ownership. To take advantage of a like-kind exchange, the property needs to be moved out of the partnership and into the hands of the partners.
The challenge is that the difference between a TIC and a partnership interest can be subjective, and there is no bright line test for making the distinction because it is not determined solely by the legal structure of an entity. A partnership can be created if the owners carry on a business or financial operation together, and divide the profits and losses; merely sharing expenses does not create a partnership—see how that could be open to scrutiny? There are multiple rulings out there and in 2002 the IRS issued Rev. Proc. 2002-22 providing a guideline for the use of TICs as like-kind property in a §1031 exchange. Some of the items to consider when determining whether a TIC will be respected or recast as a partnership are:
- Whether the documentation supports TIC ownership. Is title held by each co-owner? Do loan documents separately identify the co-owners? Do the co-owners hold themselves out as a single business?
- How profits, losses and debt are shared. In a TIC structure, amounts should only be shared proportionately to the ownership percentage in the property.
- Ability to sell, encumber or lease the property without the consent of the other owners.
- Whether value is being created by the co-owners working together towards a common goal or from the property interest independent of the other owners. For example, working jointly to renovate and improve a property is creating value more like a business than a fractional ownership in real property.
- What services are provided to tenants of rentals? Are they customary and minimal in nature? Providing services to tenants beyond customary repair and maintenance items such as heating and trash is again closer to a business model than ownership of property.
- Lease structures. Rental income should not be dependent on the net income or profit of any lessee, as this would be considered as participating in a business.
It should be noted that under Rev. Proc. 2002-22, the IRS generally won’t confirm if a TIC is not a business entity if it was held through a partnership immediately prior. The IRS also includes a question on Form 1065 asking whether a tenancy in common interest was distributed to partners. This should be an indication that the IRS is carefully scrutinizing the movement of property from a partnership to the hands of the partners.
If the co-owners and service providers can get comfortable that the TIC will be respected as a fractional interest in real estate, there is still another hurdle before a successful §1031 exchange can be executed. As noted above, it is required that the exchanged property be “held for productive use.” Immediately distributing and selling a fractional property interest may not satisfy the “held for productive use” requirement. This type of transaction is commonly referred to as a “drop and swap.” While there is guidance that receiving property in a tax-free distribution prior to the exchange still qualifies as being held for business or investment use, taxpayers should be wary of executing an exchange too quickly.
BPM is here to assist you.
As always, we advise anyone considering the use of a tenancy in common for a §1031 exchange to consult with their tax advisers and begin planning as far in advance as possible. For additional information on this topic, please contact Jackie Matsumura at (925) 296-1035.
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This alert contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this alert. On any specific matter, reference should be made to the appropriate advisor.