Tenancy in Common

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IRS Provides Guidance on Using Tenancy-in-Common Interests in 1031 Exchanges

IRS Provides Guidance on Using Tenancy-in-Common Interests in 1031 Exchanges

by Ronald L. Raitz, CCIM

On March 19, the Internal Revenue Service released Revenue Procedure 2002-22, which addresses the use of real property fractional ownership interests as replacement property in Internal Revenue Code Section 1031 tax-deferred exchanges. Commercial real estate professionals commonly refer to these fractional ownership opportunities as tenancy-in-common interests.

The potential advantages of using fractional ownership interests to complete a 1031 exchange are significant for both investors and their advisers. Tenancy-in-common interests offer increased opportunities to identify a replacement property within 45 days, the option to buy into institutional-grade product for less money, and the potential to diversify into multiple properties with fewer dollars.

Like-Kind Exchange Primer Under Section 1031, property owners may defer gain recognition on a sale by exchanging for like-kind property; however, they must meet numerous requirements to complete a successful exchange.

In order to achieve 100 percent tax deferral, the cost of the replacement property must be equal to or greater than the net sales price of the property being sold, and all the proceeds must be used. Further, the seller must identify a suitable replacement property within 45 days of the relinquished property sale. Finally, the seller must take title to the property he ultimately buys in the same manner in which he gives title to the property he sells.

In the past, tax professionals and other investment advisers were wary of recommending fractional interests as replacement properties because the IRS often considered the investor’s interest in the new property to be a partnership, thereby invalidating the exchange. Along with partnerships, Section 1031 prohibits owners from exchanging out of real estate and into a corporation or limited liability company.

This concern often prevented investors from buying shares of larger and potentially more attractive properties. In response to the need for high-quality replacement property in a range of prices, a niche group of companies began offering tenancy-in-common interests to complete 1031 exchanges. To meet the title requirements, investors receive a deed for a portion of the property, rather than a share of a partnership. To encourage referrals, many tenancy-in-common program sponsors offer referral fees ranging from 1 percent to 6 percent of the equity value placed in the product.

Fundamentals of the New Guidelines Rev. Proc. 2002-22 provides guidance on the use of fractional interests as replacement properties in 1031 exchanges. Although the IRS did not provide the ultimate safe harbor blessing for these investments, it outlined 15 minimum standards tenancy-in-common interests must meet to be considered as potential replacement property. A few of the key criteria are:

  • the number of tenants-in-common cannot exceed 35;
  • the sponsor of the interests may own the property (or an interest therein) for only six months before 100 percent of the interests are sold;
  • any decision that has material or economic impact on the property or its owners must be approved unanimously by the owners; and
  • the management agreement must be renewable annually and must provide for market rate compensation.

For the complete listing of requirements, visit the IRS Web site at http://www.irs.gov/. Investors should seek private-letter rulings on specific offerings for more concrete assurance that their fractional interest meets the specified qualifications.

Some investment advisers have found that recommending properly structured tenancy-in-common programs can result in a win-win situation for all parties. For example, one of your clients owns a small apartment building that requires an inordinate amount of time to manage. As he nears retirement, your client receives a $750,000 offer on the building and wants to exchange into an institutional-grade investment. With the amount he will be able to invest from the sale, your client doesn’t think he can afford a high-quality investment offering a strong yield and greater appreciation potential. However, in this scenario, your client should consider a tenancy-in-common program that complies with the recent IRS ruling. With his sale proceeds, your client feasibly could exchange into a 15 percent interest in a class A office building worth $5 million.

The new guidelines also open the door for investors who want to structure fractional interests in a desirable replacement property on their own. For instance, Jennifer Reed owns a high-quality rental property in suburban Atlanta worth $500,000. She notices a small strip shopping center for sale in the area and, after some due diligence, discovers the center can be purchased for $1.5 million. Though individually she cannot afford the center, she has two friends who would like to invest a portion of their portfolio in real estate. The three decide to purchase the property together. When Jennifer sells the rental property, she exchanges all of the debt and equity from the sale for a one-third interest in the shopping center as a tenant-in-common. The other two investors provide the balance of the funds necessary to close the deal.

Proceed With Caution As tenancy-in-common programs are in their infancy, commercial real estate professionals should review them carefully before advising clients to consider them as viable replacement property options. Because all programs are not created equal and may have been structured prior to the release of Rev. Proc. 2002-22, careful due diligence is essential. As more sponsors modify their programs to seek and receive private-letter rulings certifying compliance, less due diligence will be necessary.

Whether for groups sponsoring fractional interests or creative investors looking to pool resources into a larger property, the new IRS guidelines are good news for the commercial real estate industry. For investment advisers, this guidance provides exciting new options for clients who don’t want to forego the benefits of a Section 1031 tax-deferred exchange.

Consult a tax professional for further information on individual cases.


Tenants in Common Defined

What Is Tenants in Common?

One way for more than one person to hold property

By Moshe Pollock of Realtor.Com
There are various forms of property ownership.¬†Tenants in common (or tenancy in common) is one of these. While the term “tenants” might imply renting, tenants in common are the owners of the property. There is no maximum number of persons who can be tenants in common, and the tenants do not have to hold equal shares. For example, one tenant in common can own 75 percent of the property and the other tenant can own 25 percent. Such an arrangement frequently reflects the portion of the purchase cost the respective tenants paid.

Features of tenancy in common
Typically the tenants sign a tenancy in common agreement that sets out the percentage of ownership for each party and other relevant matters. This is significant, because each tenant is able to sell his or her shares separately. Also, unlike joint tenancy, tenancy in common does not involve the right of survivorship. This means that in tenancy in common, each tenant’s interest does not pass to the other tenants upon death. Each tenant can bequest his or her interest by will and if there is no will, the interest passes by applicable law.

No matter what the ownership percentage of the tenants, all tenants in common have the right to possess and to have access to the property. Even if just one tenant resides in the property, he cannot exclude other tenants from entering it. The tenants are each responsible for the mortgage, taxes, maintenance and other necessary expenses. But these costs are apportioned based on the percentage of ownership.  

Advantages of tenancy in common
Tenancies in common can be created relatively easily through a simple written agreement. Similarly, the tenancy can be terminated readily in one of several manners. The tenancy can be dissolved by the tenants agreeing to sell their shares to one of the tenants. All of the tenants might sell their interests to someone who is not already a tenant. Each tenant is free to sell his or her interest to someone outside the tenancy. That purchaser would then join the tenancy in common. The individual percentage of the tenant’s contribution to the purchase price can be reflected in the ownership interest.
Tenancy in common disadvantages
Because each tenant’s interest can be passed on to the heirs, the remaining tenants may be forced to continue ownership with an undesired party. An heir might want to sell the property when the other tenants do not. A tenant’s sale of his or her interest to an outside party might also result in an unwelcome tenant in common. If the tenants cannot agree upon to whom to sell the property, there could be problems. In all of these situations, the tenants would need to turn to the courts in a partition action. A partition action involves asking the court to sell the property and to divide the proceeds among the tenants. It might result in one of the tenants buying the shares of the other tenants. In some cases, such as vacant land, it might be possible to divide the property, giving each tenant his or her own piece. In any case, partition actions are frequently lengthy, unpleasant and expensive.
Final notes on tenancy in common
Tenancy in common is one way of owning property that protects each purchaser’s interest. Each tenant holds an individual, separate share of the real estate as a whole. But there are legal ramifications of ownership by tenancy in common that might not be desirable in every situation. When considering tenancy in common as the form of ownership, purchasers should consider all the implications and obtain advice from knowledgeable professionals.