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Horror of Taxation
This is the third and final installment of a three-part series on Section 1031 like-kind exchanges. Part 1 explained WHY you should consider use of a Section 1031 like-kind exchange when selling commercial or investment real property. Part 2 covered the key rules for HOW to implement a Section 1031 like-kind exchange. This Part 3 covers special issues applicable to a Section 1031 like-kind exchange when a Tenant-In-Common [TIC] interest is being acquired.
A Section 1031 Exchange Danger Zone
All property lawyers learned in law school that interests in real property can be held in a variety of ways. Common ways to hold title include: as a sole owner, as joint tenants with right of survivorship, as tenants by the entirety, and as tenants in common, among others.
Black’s Law Dictionary defines tenancy in common as: A form of ownership whereby each tenant (i.e. owner) holds an undivided interest in property. Unlike a joint tenancy or a tenancy by the entirety, the interest of a tenant in common does not terminate upon his or her death.
A tenancy in common [often referred to as a “TIC Interest”] is well recognized by property lawyers as a real property interest.
Naturally, then, for investors involved in Section 1031 exchanges, the question will arise as to whether a taxpayer can acquire a TIC Interest as a replacement property in a Section 1031 exchange. On its face, the flexibility this would allow, if permitted, would appear to be exceptional.
Consider a taxpayer who owns an office building (“Property A”) that was acquired for $5,000,000, with a $4,200,000 mortgage. During the period it was owned, $1,000,000 was deducted as depreciation expense. As of closing the mortgage balance on Property A is $4,000,000. Property A is now being sold for a net sales price of $7,000,000.
As explained in Part I of this three-part series on Section 1031 exchanges, a taxpayer (in Illinois) would be facing an overall tax obligation of up to approximately $914,000 [$250,000 depreciation recapture at 25% on the $1,000,000 taken as depreciation; $400,000 federal capital gains tax, at 20% on the $2,000,000 capital gain; an additional 3.8% Obamacare Medicare Surtax on passive investment gains; plus, an additional $150,000 to the State of Illinois based upon the 5% Illinois flat tax on the overall $3,000,000 gain]. If the taxpayer is in a state other than Illinois, a different state level tax may apply.
As also discussed in Part I of this series, there can be huge tax advantages to structuring the taxpayer’s sale as a Section 1031 exchange of like-kind property if a suitable replacement property can be found. In a properly structured Section 1031 exchange, the taxpayer could defer the entire $914,000.00 tax obligation indefinitely, and use those funds as additional equity to acquire a replacement property.
Suppose the taxpayer (“Taxpayer”) now wants to invest in a $10,000,000 shopping center (“Property B”), but does not have the funds or credit available to single-handedly acquire the whole replacement property on its own. Suppose also that another investor (“Investor No. 2″) is willing to join with the taxpayer in purchasing Property B, and that Investor No. 2 has $750,000 in cash to invest.
Together, Taxpayer and Investor No. 2 plan to acquire Property B by Taxpayer putting in $3,000,000 in equity (realized from the sale of Property A), and Investor No. 2 putting in $750,000 in equity, with a combined $6,250,000 mortgage. If Taxpayer simply sells Property A and pays the required tax of $914,000, Taxpayer will have only $2,086,000 available to reinvest.
In order to have $3,000,000 available to acquire Property B, Taxpayer needs to structure the transaction as a Section 1031 exchange, so that Taxpayer can defer payment of the $914,000 in taxes otherwise due upon sale of Property A, and thereby have the full $3,000,000 in equity available to invest.
As noted in Key Rules for Section 1031 Exchanges – Part 2 of this series – to completely defer payment of the $914,000.00 in taxes referred to above, the Taxpayer’s replacement property must:
- be “like-kind” (i.e. it must also be real property, and must be held for investment or for use in the Taxpayer’s trade or business); and
- have an acquisition price equal to or greater than the entire sale price (including equity and mortgage) of the relinquished property (Property A), with all equity being used to acquire Property B.
NOTE that, to qualify for Section 1031 tax treatment, the Taxpayer and Investor No. 2 cannot simply pool their funds through a partnership, limited liability company, or other entity to acquire Property B, because Taxpayer would then be exchanging its real property interest in Property A for an interest in a partnership or other business entity, which is not “like-kind” to real estate.
To qualify Taxpayer’s interest in Property B for treatment as a like-kind exchange of real property, the parties may agree that Taxpayer will acquire an 80% tenancy in common interest [“TIC Interest”] in Property B, and Investor No. 2 will acquire a 20% TIC Interest in Property B, based upon their relative cash investments. [i.e. $3,000,000/$3,750,000 = 80%; $750,000/$3,750,000 = 20%]. Although the $6,250,000 mortgage will encumber the entire Property B, the portion allocable to Taxpayer’s 80% TIC Interest equates to $5,000,000 [80% of $6,250,000 = $5,000,000], while Investor No. 2’s proportionate share of the mortgage is 20%, or $1,250,000.
Accordingly, the overall acquisition price of an 80% TIC Interest for Taxpayer is $8,000,000 [$3,000,000 equity + $5,000,000 mortgage]; while the acquisition price for the 20% TIC Interest of Investor No. 2 is $2,000,000 [$750,000 equity + $1,250,000 mortgage].
- Taxpayers’ 80% real property TIC Interest in Property B would be like-kind to the real property interest of Taxpayer in Property A; and
- the acquisition price of Taxpayers’ 80% TIC Interest in Property B [$8,000,000] is more than the sale price of Property A [$7,000,000], with all equity being used;
the transaction should, on its face, qualify for treatment as a tax deferred exchange of like-kind property pursuant to Section 1031 of the Internal Revenue Code of 1986, as amended (the “IRC Code”).
In fact, the transaction will qualify for treatment as a tax deferred Section 1031 like-kind exchange if the ownership of the respective TIC Interests is structured in a way to preserve their character in the eyes of the Internal Revenue Service as independently owned and controlled real property interests.
This sounds easy. Since property lawyers “know” that a tenant in common interest in real property is a legally recognized real property interest, what could possibly go wrong?
WHAT COULD POSSIBLY GO WRONG?
The caveat is that upon acquiring the respective TIC Interests, the owners of those interests (i.e. the TIC Owners) must not operate the overall property as a joint enterprise in a way that effectively transforms the investment, for tax purposes, into an interest in a business entity.
In the real world of real estate investors, and shopping center operations, this is an easy trap to fall into. If not extremely careful in how the TIC Interest ownership arrangement is structured and administered, the IRS may very likely take a position that the exchange fails the like-kind test, by taking the position that the Taxpayer, in substance, exchanged a real property interest for an interest in a partnership or other business entity – which is not like-kind to a real property interest. Result? The Taxpayer must pay the $914,000 in taxes due from the sale of Property A – but the Taxpayer’s funds are already tied up as equity in Property B. Not good.
HOW TO PROCEED
The safest approach to avoid this outcome would be to apply for and obtain a Private Letter Ruling from the IRS pursuant to Revenue Procedure 2002-22 before consummating a contemplated Section 1031 exchange acquiring a TIC Interest, to assure it will qualify for like-kind exchange treatment. As a practical matter, however, because of the time limits for identifying replacement property and consummating an exchange pursuant to Section 1031, there may not be time to obtain an advance Private Letter Ruling. What then?
When seeking to structure a Section 1031 exchange involving acquisition of a TIC Interest in real property, most practitioners agree that ownership of the TIC Interest must be structured strictly in conformance with Revenue Procedure 2002-22, Section 6 – Conditions For Obtaining Rulings. As noted in Revenue Procedure 2002-22, failure to strictly comply with the Section 6 conditions may not necessarily be fatal to Section 1031 treatment – but prudence suggests that compliance with those conditions constitutes a best practice when seeking acceptance by the IRS that the exchange qualifies as an exchange of like-kind property.
The conditions set forth in Revenue Procedure 2002-22, Section 6 are detailed, numerous, and restrictive. Pay close attention. The consequence of getting it wrong will mean disqualification for tax-deferred treatment under Section 1031.
Among the requirements of Revenue Procedure 2002-22 that, if not carefully followed, can present a trap to real property investors and their attorneys [who may naturally visualize the co-ownership of an operating shopping center as a joint venture of sorts], are the following:
1. Each TIC Owner must hold title to the Property as a tenant in common – not in a single entity.
2. There can be no more than 35 co-owners.
3. TIC Owners may not file a partnership return, conduct business under a common name, execute any agreement identifying the co-owners as partners, shareholders or members, or otherwise hold themselves out as partners, shareholders or members of any business entity.
4. The TIC Owners must, respectively, retain the right to approve the hiring of any manager, sale or other disposition of the Property, any leases of a portion or all of the Property, and the creation or modification of any blanket lien on the Property.
5. In general, each TIC Owner must have the right to transfer, partition and encumber the TIC Owner’s undivided interest in the Property.
6. Any sale or financing of the Property must be by unanimous approval of the TIC Owners.
7. Each TIC Owner must share in any indebtedness secured by a blanket lien in proportion to the TIC Owner’s undivided interest in the Property, and if the Property is sold, any debt secured by a blanket lien must be satisfied and the remaining sales proceeds must be distributed to the TIC Owners in proportion to their respective TIC Interests.
8. The TIC Owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property (customary activities). No other business activities are permitted.
9. TIC Owners may enter into management or brokerage agreements with an agent, who may be a sponsor or a TIC Owner, but not a lessee, but such management or brokerage agreements must be renewable not less frequently than annually. The negotiation of any management contract (or any extension or renewal) must be by unanimous approval of all TIC Owners.
10. Each TIC Owner must share in all revenue and expenses generated by the Property in proportion to the TIC Owner’s undivided interest in the Property and the manager must disburse to the TIC Owners their share of net revenues within three (3) months from the date of receipt of those revenues.
11. The determination of any fees paid by the TIC Owners 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 fair market value of the manager’s services.
12. All leases must be bona fide leases for federal tax purposes, and must reflect fair market value for use of the Property.
13. A lender with respect to any debt that encumbers the Property, or with respect to any debt incurred to acquire an interest in the Property, may not be a related person to any TIC Owner, the sponsor, the manager, or any lessee of the Property.
14. A TIC Owner may issue an option to purchase another TIC Owner’s undivided interest (call option), provided the exercise price reflects fair market value of the Property determined at the time the option is exercised. [i.e. Fair Market Value of the Property as a whole multiplied by the TIC Owner’s percentage interest.]
15. A TIC Owner may not acquire an option to sell the TIC Owner’s undivided interest (put option) to the sponsor, lessee, another TIC Owner, the lender, or any person related to the sponsor, lessee, another TIC Owner, or lender.
THE FOREGOING IS NOT A COMPLETE STATEMENT OF ALL CONDITIONS OR RESTRICTIONS OF REVENUE PROCEDURE 2002-22.
If the conditions of Revenue Procedure 2002-22 are not strictly complied with, the risk of having the TIC Interest characterized as an interest in a business entity increases.
NOTE THAT, in the hypothetical case outlined above, such a characterization may not be detrimental to Investor No. 2, because Investor No. 2 is not seeking to qualify for tax-deferred treatment under Section 1031 of the IRC Code. For the Taxpayer in the hypothetical, however, an exchange of Property A for an interest in a business entity will destroy qualification for treatment as a tax-deferred like-kind exchange. As a consequence, all gains will be recognized, and all applicable taxes will be due and payable.
Because of the differing interests and exposure of the parties – particularly between TIC Owners seeking to qualify for Section 1031 exchange treatment, and TIC Owners who are not – negotiation of a viable TIC Agreement can be challenging, and may require use of independent counsel for TIC Owners with conflicting interests. This is a danger zone, and a trap for the unwary.
To effectively negotiate the TIC Agreement on behalf of an exchanging taxpayer, an understanding of the essential requirements of Section 1031 of the IRC Code, and an understanding of the conditions set forth in Revenue Procedure 2002-22 is a must.
Be aware. Be prepared. Get competent help if you need it.*
Thanks for listening,
*Special thanks to my tax partner, James M. Mainzer, for technical consulting on this post. This post is not intended to constitute legal advice and may not be relied upon as such. You are encouraged to consult a tax professional with the particular facts of your transaction.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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