Sellers of real property have long enjoyed the opportunity to defer recognizing the gain on a sale and thus, to defer paying capital gains taxes, by exchanging their property for other real property of a like kind. These changes typically are not true exchanges; they are delayed Starker exchanges in which an accommodation party holds the proceeds of the first sale until the replacement/exchange property can be acquired. This is provided for under Internal Revenue Code §1031 and extensive case law.
The price for this deferral right is compliance with very stringent requirements for qualifying exchanges. One of the requirements for a §1031 exchange is that the qualifying property be exchanged solely for like-kind property. The range of real estate that can be exchanged within the meaning of §1031 is very broad, but does not allow exchange of real estate for an interest in a business entity. Nevertheless, an exchange for an undivided fractional tenancy-in-common interest in real property has been qualified under limited circumstances. Two years ago, the Internal Revenue Service (the ‘Service’) approved a revenue procedure, technically intended only to facilitate letter rulings but also establishing the guidelines for a significantly more expansive use of the exchange rules. Tenancy-in-common acquisitions. Rev. Proc. 2002-22, 2002-14 IRB 733. This revenue procedure has resulted in an explosion of §1031 real estate exchanges, with promoters and investors alike aggressively pursuing exchanges of real estate for undivided fractional interests in real estate investments. The May 5, 2004 Wall Street Journal projects that §1031 real estate exchanges will exceed $2 billion in 2004, which is four times the 2002 level. As a result, if you are exchanging real property, expect to be presented with this type of investment opportunity.
Accordingly, the clear advantage to this option is that it allows the seller to move into a much larger property by acquiring only a partial or fractional ownership interest. Also beneficial is the greater flexibility in locating a replacement parcel or parcels. On the other side of the equation, the owner of a ‘big property,’ which requires a substantial investment, may see few qualified individual prospective buyers. By offering fractional interests, the owner may now find more ‘groups’ of buyers interested in their property. This has spawned yet a new niche for brokers who assemble and market the fraction-of-ownership groups — at a profit for themselves, of course.
Is it always this easy and uncomplicated? No. Careful planning and coordination among counsel, brokers, and accountants is essential. But the stakes are high because a disallowance of the tax-free nature of the exchange can result in substantial tax liability, including penalties and interest.
As noted above, one key to these transactions is that the new ownership interest must be an ownership of real property, not an ownership in a partnership or another form of ‘business entity.’ Acquiring an interest in a business entity, such as corporate stock or partnership interests, would vitiate the exchange criteria and trigger recognition of the gain and imposition of the resulting taxes. The Service has, however, allowed an individual to use a single-member limited liability company as the investment vehicle in the replacement process, which can provide asset protection. Because typically a tenancy-in-common agreement will be put into place, much of the litigation in this area involves efforts by the Service to declare the tenancy-in-common agreements equivalent to partnerships. Not surprisingly, the legal decisions do not provide bright-line, consistent treatment of what often appear to be similar provisions. Avoiding a fight, let alone an adverse ruling, is key, since the fight commonly will not occur for two or three years after closing, given the time lag for closing the acquisition, filing returns, review by the Service, etc.
The revenue procedure sets forth 15 conditions or factors that the Service considers critical for establishing a tax-free exchange for an undivided fractional interest in real estate. Failure to fulfill those conditions may not be fatal, so long as the facts and circumstances clearly establish that such a ruling is appropriate. But failure to comply with all requirements increases the risks. The conditions require, among other things, co-ownership that is recognized under local law as a tenancy-in-common; a limitation of no more than 35 persons; no treatment of the co-ownership as a partnership; proportionate sharing of profits and losses; proportionate sharing of proceeds and liabilities upon sale; limitations on payments to sponsors; and technical restrictions on the structure of the contractual relationships. These are in addition to the standard requirements of §1031, which include relatively short and absolute time deadlines.
Exchanging real property for an undivided fractional interest in real estate is becoming a popular and powerful investment tool, with many advantages. But it is also extremely technical, may be a tax risk, requires careful planning, and requires careful evaluation by professionals experienced in the technique and its limitations. The return on the investment should reflect the tax risk and the technical analysis that these investments require. The alternative is to pay taxes on the capital gain, rather than reaping the benefits of investing the capital gain. We love the tool and structure, but be careful!
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