Tenancy-in-Common: Use in 1031 Exchanges

A 1031 exchange is a frequently used investment vehicle whereby an investor may defer paying taxes on capital gain at the sale of property when replacement investment property is purchased.  There are a number of requirements for such an exchange to qualify for tax exemption, including that the properties must be of like kind (for example, real estate sold to purchase other real estate), and the replacement property must have a value equal to or greater than the property sold.  Navigating a 1031exchage can be difficult on its own, but recently the rising popularity of Tenancy-in-common (hereinafter “TIC”) interest to complete the exchange have added a degree complexity and tax consequences, and anyone considering such an arrangement must be cautious. 

TIC allows a group of 35 or fewer investors to pool their investment money to acquire property as co-owners.  Doing so allows affords investors greater opportunity and flexibility in selecting the value and types of their investments.  In a TIC arrangement, each of the co-owners owns an undivided interest in the entire property.  To reap the substantial benefits of TIC, investors should take care to comply with IRS rules regarding the operation of the TIC.  There are a number of requirements that can be easily missed and result in additional taxes or penalties.

For instance, one of the many benefits of TIC is that investors typically do not need to worry about the day to day management of the property.  A manager is hired to collect rents, make repairs to the property, pay applicable taxes and other bills, and make distributions of excess property income to the owners.  However, to qualify for 1031-TIC treatment, the investors must renew any management agreement no less frequently than once per year, the manager may not lease any portion of the investment property, and the manager's fee may not be based on the income from the property.  Instead, the fee should be based on the reasonable market value of the services provided.  This can be an especially important requirement where one of the investors is employed as the property manager. 

Voting arrangements among investors are an important part of any TIC investment, but investors should be aware the IRS has restrictions in this area as well.  For decisions resulting in the sale or lease of any portion of the property, the hiring of a manager, or decisions regarding debt secured by the investment property, the investors much reach unanimous approval.  Investors have more latitude in other votes, frequently requiring a greater than 50% vote for other decisions. 

Additionally, the co-owners must not be deemed part of business entity.  To comply with this requirement, investors must file individual tax returns (as opposed to a partnership return), and must not hold themselves out as a unified business entity.  The co-owners conduct should be limited to those activities normally associated with real estate management.  Other requirements relate to the co-owners' right to sell their interest, profit and loss sharing, and relationship of lenders to investors, tenants, or managers. 

These requirements, and a litany of others, form the minimum standard for 1031-TIC treatment by the IRS.  Fortunately, pursuant to IRS Revenue Procedure 2002-22, the IRS will issue rulings on a proposed transaction's qualification in advance of an investor purchasing a interest in TIC.  For assistance meeting these requirements, or for preparing an advance ruling request, contact Attorney Benjamin Qualley, Gerbers Law, S.C., 480 Pilgrim Way, Suite 1200, Green Bay, WI, (920)499-5700