Section 1031 “like-kind” exchanges – Use of Tenants in Common to “Pool” Capital and to Create Liquidity
By Stephen M. Breitstone
When the IRS issued Rev. Proc. 2002-22, 2002-1 CB 733, it provided a degree of guidance as to when a tenants in common arrangement (“TIC”) would not be treated as a partnership for Federal income tax purposes. This guidance has greatly expanded the utility of IRC section 1031, which provides for non-recognition of gain on exchanges of property of a “like kind” held for use in a trade, business or investment. It has greatly enhanced the utility of section 1031 since TICs can qualify for non-recognition of gain while partnership interests cannot.
TIC syndications provide a vehicle for small sellers of investment property to exchange into much better quality properties. The TIC syndication also offers the small TIC investor access to professional management. TICs create large pools of capital to be raised in section 1031 transactions and they are being used to create liquidity in what would otherwise be illiquid real estate. Here’s how it works.
Increasingly, TICs are being used as a vehicle for diverse and separate sellers of larger properties to combine their capital to upgrade their portfolios. In some instances, multiple partnerships (or LLCs) disposing of properties in section 1031 transactions are pooling their capital to purchase properties together as TICs. When you combine the ability to avoid recognition of gain in a section 1031 transaction with the ability to join together with other selling entities as TICs, you greatly enhance the amount of capital that can be deployed to make new acquisitions.
In addition, TICs are being used to create liquidity. A developer or owner of a project who has a need to raise cash, can sell a TIC interest in a portion of the project without having to dispose of the entire project. This technique can be especially valuable to projects that are already overleveraged.
Structuring these TICs requires a great degree of care to avoid de facto partnership status. If the arrangement is “deemed” to be a partnership for tax purposes, the acquisition of interests will not qualify for non-recognition treatment under section 1031. Compliance with the criteria in Rev. Proc. 2002-22 will provide a degree of comfort. However, the fact that an arrangement strictly adheres to the criteria set forth in Rev. Proc. 2002-22 is not a guaranty that de facto partnership status will be avoided. Underlying the determination is that parties who “intend” to be partners will be treated as partners regardless of the labels.
The criteria in Rev. Proc. 2002-22 are designed to avoid arrangements that evidence the partnership “intent”. For example, one criterion is that the property manager cannot have an agreement with a term greater than one year. In addition, the property manager’s compensation cannot be based upon the income (presumably “net income”) from the property. The requirement appears to be designed to preclude disguising a de facto partnership as a management agreement.
Similarly, many decisions relating to the operations of the TIC property require unanimous approval of the individual TIC owners. These include 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). All other decisions, require the approval of the holders of majority of the interests in the property.
Pooling of multiple section 1031 sellers as TICs present many challenges in structuring them in a manner that permits orderly governance. Each TIC owner must be an independent owner and, for the most part, centralized decisionmaking is not permitted. This is a major distinction from other forms of ownership that permit capital to be pooled. In addition, Rev. Proc. 2002-22 does not constitute legal authority that can be relied upon. There is a long history of case law (and a statute – section 761) that describes what is a partnership for Federal income tax purposes. T he types of TIC arrangements that are evolving in the market (and the mechanisms that are evolving to address the concerns of decentralized management) are largely untested by the courts. Experienced tax practitioners should be experienced in working with untested arrangements. That is the nature of tax practice in an evolving economic and legal environmnet. Nevertheless, a high degree of care is warranted in structuring, implementing and operating these arrangements in order anticipate how the courts will apply long established legal principals to these novel arrangements.
As to concerns about governance, many TIC structures address the possibility of deadlock by including a “call” option in the TIC agreement in the event the parties disagree. Rev. Proc. 2002-22 permits such “call” options as long as the option price is the product of the fair market value of the property and the individual TIC owner’s percentage.
Often, separate partnerships or LLC’s that are TIC owners have overlapping or common control. There is no express prohibition in Rev. Proc. on separate TIC owners having common control, and the selected form of the transaction as TICs should, in general be respected. However, commonly controlled TIC owners may be treated as de facto partners if they do not strictly adhere to the formalities of the TIC arrangement and do not, in fact, act independently of the others. Agreements should be drafted, wherever possible, so that no TIC owner (or its manager) owes a fiduciary duty to any other commonly controlled TIC owner.