The Internal Revenue Service released Revenue Procedure 2002-22 on March 19, 2002. This procedure has been long awaited by taxpayers and exchange professionals concerned with tax deferred exchanges involving ownership of an interest in real property that is held, or will be held, as tenants in common. Such transactions have produced significant concern over the years due to the possibility of the exchange failing to preserve the deferral of the recognition of gain or loss resulting from the IRS treating the tenants in common as a partnership. Parties who follow the guidance provided by this new procedure should be on solid ground. The procedure is somewhat of a disappointment for those structuring investment opportunities because it is only a procedure for requesting a ruling from the IRS on specific transactions. It was hoped that the procedure would provide guidance in the nature of a safe harbor instead. The result is that questionable transactions will need a letter ruling in order to proceed with any assurance of favorable tax treatment. Some provisions of the procedure seem less than clear in application, but do appear to provide a limited safe harbor for inherited property and will be discussed further later in the article. Care must be taken in using the procedure for guidance when a ruling will not be sought. The guidelines in this revenue procedure are not substantive rules and the Service will not permit them to be used for audit purposes.
The stated purpose of the revenue procedure is to set out the conditions under which the Internal Revenue Service will consider a request for a ruling that an undivided fractional interest in qualified real property is not an interest in a business entity as defined in Sec.301.7701-2 (a) of the Procedure and Administration Regulations. This revenue procedure supersedes earlier revenue procedures that provided that the Service would not issue advance rulings or determination letters on this question.
Section two of the procedure is a detailed exegesis of the issue starting with the regulations defining business entities. It then defines a tenancy in common by quoting
Powell on Real Property, (Michael Allan Wolf ed., 2000). The section then moves through a comparative analysis of Rev. Rul. 75-374, 1975-2 C.B. 261, and Bergford v. Commissioner, 12 F.3d 166 (9th Cir. 1993). The Revenue Ruling concluded that a two-person ownership of an apartment building that was rented to tenants did not constitute a partnership for federal tax purposes. Bergford, involved a fact situation where seventy-eight investors purchased ownership interests in equipment that was subject to a net lease and they were deemed to be a partnership. It is important to note that the Services regulations provide that determining whether an organization is an entity separate from its owners for federal tax purposes, is a matter of federal law. The service may construe a tenancy in common as a partnership because it is not bound by whether the entity is recognized as an entity under local law, Section 301.7701-1(a)(1).
The Service will not consider a request for a ruling under this revenue procedure unless the information required in section 5 is included in the request. The conditions set out in section 6 must be satisfied as well. The procedure makes provision for a business property consisting of several separate parcels being treated as a single business unit included in one ruling request. The Service will generally treat contiguous parcels as a single business unit. If multiple parcels are not contiguous, they may be treated as a single business unit where there is a close connection between their business use.
The following definitions are set out in the procedure:
Section 8 of Rev. Proc. 2002-1 contains the general requirements for the information to be submitted as part of any ruling request. The ruling request must provide all that information as well as that specified in Sections 5 and 6 of this revenue procedure. If the information does not exist or is not relevant, the request must so state for all of the items. Merely submitting documents and supplementary materials required will not satisfy the information requirements. All material facts must be set out and explained in the ruling request, not incorporated by reference. The following information and copies of documents and materials must be submitted with the ruling request:
The Service will not consider a request for a ruling under this revenue procedure unless the conditions set out are satisfied. Exceptions may be made where the facts and circumstances clearly establish that issuing a ruling is appropriate. The conditions are set out (edited) as follows.
.01 Tenancy in Common Ownership. Each co-owners must hold title to the "Property" (either directly or through a disregarded entity) as a tenant in common under local law. Thus, title to the "Property" as a whole may not be held by an entity recognized under local law.
.02 Number of Co-Owners. The number of co-owners must be limited to no more than 35 persons. For this purpose, a husband and wife are treated as a single person and all persons who acquire interests from a co-owner by inheritance are treated as a single person.
.03 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 form of business entity (nor may the co-owners hold themselves out as partners, shareholders, or members of a business entity). The Service generally will not issue a ruling under this revenue procedure if the co-owners held interests in the "Property" through a partnership or corporation immediately prior to the formation of the co-ownership.
.04 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"
.05 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", any negotiation or renegotiation of indebtedness secured by a blanket lien, the hiring of any manager, or the negotiation of any management contract (or any extension or renewal of such contract) must be by unanimous approval of the co-owners. For all other actions, the co-owners may agree to be bound by the vote of those holding a majority of the undivided interests in the "Property".
.06 Restrictions on Alienation. In general, each co-owner must have the rights to transfer, partition, and encumber the co-owners undivided interest in the "Property" without the agreement or approval of any person. However, restrictions that are required by a lender and that are consistent with customary commercial lending practices are not prohibited. Moreover, the co-owners, the sponsor, or the lessee may have a right of first refusal with respect to any co-owners exercise of the right to transfer the co-ownership interest. In addition, a co-owner may agree to offer the co-ownership interest for sale to the other co-owners, the sponsor, or the lessee at fair market value before exercising any right to partition.
.07 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 proceeds distributed to the co-owners.
.08 Proportionate Sharing of Profits and Losses. Each co-owner must share in all revenues and costs associated with the "Property" in proportion to the co-owners undivided interest. No co-owner, sponsor or manager may advance funds to a co-owner to meet expenses unless the advance is recourse to the co-owner and is for a period less than 31 days.
.09 Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.
.10 Options. A co-owner may grant an option to purchase the co-owners interest if the exercise price reflects the fair market value of the "Property". A co-owner may not acquire an option to sell the co-owners undivided interest (put option) to the sponsor, the lessee, another co-owner, or the lender, or any person related to the sponsor, the lessee, another co-owner, or the lender.
.11 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. Activities will be treated as customary activities for this purpose if the activities would not prevent an amount received from qualifying as rent. In determining the co-owners activities, all activities of the co-owners, their agents, and any persons related to the co-owners with respect to the "Property" will be taken into account, whether or not those activities are performed by the co-owners in their capacities as co-owners. For example, if the sponsor or a lessee is a co-owner, then all of the activities of the sponsor or lessee (or any person related to the sponsor or lessee) with respect to the "Property" will be taken into account in determining whether the co-owners activities are customary activities.
.12 Management and Brokerage Agreements. The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than 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. The management agreement may authorize the manager to maintain a common bank account for the collection and deposit of rents and to offset expenses associated with the "Property" against any revenues before disbursing each co-owners share of net revenues. In all events, however, the manager must disburse to the co-owners their shares of net revenues within 3 months from the date of receipt of those revenues. The management agreement may also authorize the manager to prepare statements for the co-owners showing their shares of revenue and costs from the "Property". In addition, the management agreement may authorize the manager to obtain or modify insurance on the "Property", and to negotiate modifications of the terms of any lease or any indebtedness encumbering the "Property", subject to the approval of the co-owners. The determination of any fees paid by the co-ownership to the manager must not depend in whole or in part on the income or profits derived by any person from the "Property" and may not exceed the fair market value of the managers services. Any fee paid by the co-ownership to a broker must be comparable to fees paid by unrelated parties to brokers for similar services.
.13 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". The determination of the amount of the rent must not depend, in whole or in part, on the income or profits derived by any person from the "Property" leased (other than an amount based on a fixed percentage or percentages of receipts or sales). See section 856(d)(2)(A) and the regulations thereunder. Thus, for example, the amount of rent paid by a lessee may not be based on a percentage of net income from the "Property", cash flow, increases in equity, or similar arrangements.
.14 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".
.15 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 (or the services rendered) and may not depend, in whole or in part, on the income or profits derived by any person from the "Property".
We have some observations concerning the application of this new procedure. It does not clearly exclude replacement property purchased in the same proportions as an inherited interest from the need of obtaining a ruling for assurance of favorable treatment. This type of purchase would fit within the definitional context of the procedure although it seems clear that the procedure has been adopted to address other concerns by the Service. It seems apparent that the procedure will have the effect of curbing investment schemes that use the tenancy in common form of ownership in order to defer taxes on gains that occur when trading holdings in real estate investment entities. It also seems clear that the drafters of this procedure did not consider the context within which tenancy in common traditionally arises, inheritance. We do have an indication that the Service does not consider this source of joint ownership as any concern. In determining the 35 co-owner limit, the procedure defines the heirs of a deceased co-owner as one person, Sec. 6.02. A Sponsor is defined strictly in the context of a sale. A traditional, inherited, joint ownership does not fit within the context of this procedure and it would seem to follow that a replacement purchase in the same proportions should not be a concern for the Service. Nonetheless, a replacement purchase clearly does fit within the context and the need for an advance ruling must be evaluated until we have clearer guidelines.
It would also seem that the procedure will allow the use of joint ownership as an investment vehicle. It is clear that the sponsor will not be permitted to share in the profits and the pool of investors is limited. It is also clear that when joint ownership is used as an investment vehicle, an advance ruling is more than just prudent, it is vital.