Undivided Fractional Interests and Sec. 1031: Revenue Procedure Brings Clarification But With Some Confusion
On March 19, 2002, the IRS released Rev Proc 2002-22, which was the culmination of the study announced in Rev Proc 2000-46, which suspended the issuance of rulings on the question of whether an undivided fractional interest ("UFI") in real property is an interest in an entity that is not eligible for tax-free exchange under Search7RH1031(a)(1) of the Internal Revenue Code ("Code"). Implicit in Rev Proc 2000-46 was the conclusion that there are some UFI arrangements which constitute separate entities for Federal tax purposes under Code Search7RH7701.
Following the release of the final deferred exchange safe harbor regulations that were issued in 1991, an industry developed in which sponsors (i.e. the promoters and organizers) were packaging co-ownership interests for sale as replacement properties for Search7RH1031 exchanges. Since taxpayers had only 45 days from the transfers of their relinquished properties to identify replacement properties, and 180 days thereafter to close, these pre-packaged properties served a real need for those who could not either locate or close on other replacement property in a timely manner. The sponsors would arrange for the financing and negotiate the leasing of the property, sometimes with a related entity who would sublease it to the end users. The agreements among the co-owners, including certain restrictions on their rights as co-owners, the number of co-owners, the continued management role of the sponsor and his related entities, and the ability of the sponsor to indirectly share in the profits (and sometimes losses) of the enterprise caused some concern about whether a separate business entity had been created.
The IRS’s concern is perhaps best reflected in Bergford v. Comm’r, which was discussed by the IRS in Rev Proc. 2002-22, as follows:
[S]eventy-eight investors purchased co-ownership interests in computer equipment that was subject to a 7 year net lease. As part of the purchase, the co-owners authorized the manager to arrange financing and refinancing, purchase and lease the equipment, collect rents and apply those rents to the notes used to finance the equipment, prepare statements, and advance funds to participants on an interest-free basis to meet cash flow. The agreement allowed the co-owners to decide by majority vote whether to sell or lease the equipment at the end of the lease. Absent a majority vote, the manager could make that decision. In addition, the manager was entitled to a remarketing fee of 10 percent of the equipment’s selling price or lease rental whether or not a co-owner terminated the agreement or the manager performed any remarketing. A co-owner could assign an interest in the co-ownership only after fulfilling numerous conditions and obtaining the manager’s consent.
The court held that the co-ownership constituted a partnership for tax purposes. Among the factors that influenced the court’s decision were the limitations on the co-owners’ ability to sell, lease, or encumber either the co-ownership interest or the underlying property, and the manager’s effective participation in both profits (through the remarketing fee) and losses (through the advances).
Many organizers and promoters of UFI’s were far more conservative in their deals, but Rev Proc 2000-46 put a serious damper on all UFI transactions. In fact, because the Rev Proc by its terms was not limited to UFI "sponsor" type transactions, all co-ownership arrangements became suspect. Therefore, the completion of the study, as evidenced by Rev Proc 2002-22, was welcome news. The Rev Proc does significantly clarify the circumstances under which the IRS may consider a UFI arrangement to create a separate business entity. On the other hand, as discussed below, the Rev Proc creates some new uncertainty as well.
General Concepts of Rev Proc 2002-22
In several ways, the Guidelines are very generous, and this may permit one to include provisions in documents that previously may have caused some concern. In other ways, the Guidelines are very conservative and, as explained below, most existing documents will have to be amended somewhat to fully comply with the Rev Proc.
The guidance is not strictly in the form of a safe harbor, but rather in the form of Guidelines that have to be met to obtain an advance ruling. As a practical matter, the marketplace may require that the Guidelines be complied with, at least with respect to promoters or organizers who are selling UFI interests to the public.
The IRS has given itself an out. Even if the Guidelines are met, the IRS may decline to issue a ruling "whenever warranted by the facts and circumstances of a particular case and whenever appropriate in the interest of sound tax administration." There is no indication of what the IRS had in mind here and hopefully this will not serve as a basis for IRS agents to ignore the Guidelines on audit.
Conversely, if the Guidelines are not met, the IRS will consider issuing a ruling "where the facts and circumstances clearly establish that such a ruling is appropriate." Except perhaps in the non sponsor/promoter situation, it is doubtful that this will happen very often, if at all.
The Guidelines only apply to "rental real estate." There is no definition of "rental real estate." Does it mean real estate actually rented, or real estate held for rental?
It is not clear why the Guidelines do not apply to personal property, particularly since the key case cited by the IRS (i.e. Bergford), as an example of the Government’s concerns, is a personal property case. It is not clear whether the concepts in the Guidelines would generally be applied by the IRS to non rental real estate (e.g., personal property, vacant land, etc.). It is not clear whether the concepts apply outside the Search7RH1031 area (e.g. attribution rules, foreign area, etc.).
Not surprisingly, the IRS took a broad view of who is a "sponsor". As used in the Guidelines, the term "sponsor" means any person who divides a single interest in property "into multiple co-ownership interests for the purpose of offering those interests for sale." Query whether one who owns a fee interest and sells a few UFI interests on a private basis is a sponsor?
The Guidelines do not literally have an effective date, but presumably apply to any ruling requested after the date of its issuance (i.e. March 19, 2002).
The Guidelines "are not intended to be substantive rules and are not to be used for audit purposes". From a practical viewpoint, taxpayers and IRS agents will undoubtedly both be looking to these Guidelines. On the other hand, as explained infra, it is clear that a few of the Guidelines have no basis in the substantive law.
Where multiple parcels of property owned by the co-owners are leased to a single tenant pursuant to a single lease agreement and any debt of one or more co-owners is secured by all of the properties, the IRS will generally treat all of the parcels as a single "property." The IRS will not consider a ruling request unless each co-owner’s percentage interests in each parcel is identical to that co-owner’s percentage interests in every other parcel, each co-owner’s percentage interests in the parcels cannot be separated and traded independently and the parcels of property are viewed as a single business unit. The Rev Proc gives an example of an office building and a garage that serves the tenants of the office building. The implication here seems to be that multiple parcels that do not meet these strict tests cannot generally be the subject of a ruling. Query whether that was intended?
Query whether there is any inconsistency between Rev Proc 2002-22 and Rev Proc 2000-37, in which the IRS said the qualifying property (under the Rev Proc) will be treated as "replacement property"? Presumably not, since the latter should relate only to issues of ownership for 1031 purposes, not wether the property is like kind or whether the arrangement among the co-owners results in a business entity.
The Rev Proc’s reference to Rev Rul 79-77 is somewhat peculiar. Aside from the fact that the Rev Proc misstates the facts of the Ruling (i.e. the three individuals did not transfer the building "subject to a net lease"; the trustee entered into the lease), the ruling was cited in the Rev Proc as support for allowing an agent to provide customary services. The ruling has nothing to do with providing services. It merely held that the trust would be treated as a trust for tax purposes and not as a "business entity."
Conditions for Obtaining a Ruling
1. Each of the co-owners must hold title to the property as co-owners under local law (either directly or through a disregarded entity).
2. There cannot be more than 35 co-owners (for this purpose, a husband and wife, and all persons who acquire an interest by inheritance, are treated as one co-owner).
3. The co-owners cannot "conduct business under a common name". One would have thought they could not "conduct business" at all, irrespective of the name. In any event, is not clear whether this precludes utilizing a common name for the property (e.g. for advertising or other purposes), although IRS representatives have said, orally, that was not intended. The co-owners, cannot, of course, file a partnership return or hold themselves out as partners for any purpose.
4. The IRS will not issue a ruling if "the co-owners held interests in the Property through a partnership or corporation immediately prior to the formation of the co-ownership." It is not clear whether this precludes one from having bought out his partners (or shareholders) and then turning the property into a co-ownership.
5. The co-owners "must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any lease of a portion or all of the property or the creation or modification of a blanket lien".
6. The co-owners may enter into a "limited co-ownership agreement." There are then examples given as to what is permitted. This language is unfortunate because it allows an IRS agent to argue that the agreement is not "limited" even if none of the examples is applicable.
7. Any sale, lease or release of the Property, any negotiation or renegotiation of indebtedness secured by a blanket mortgage, the hiring of any manger, and the negotiation (or renegotiation) of any management contract, must be "by unanimous approval of the co-owners." Although not clear, it is reasonable to assume that the manager can act for those co-tenants who do approve, even if some do not. A co-owner who has consented to any such action can provide the manager with a power of attorney, but only with respect to such specific actions (i.e. a "global power of attorney cannot be provided).
8. For all other actions on behalf of the co-owners, the co-owners may agree to be bound by a vote of those holding more than 50% of the undivided interests in the Property.
9. Restrictions on the right to transfer, partition or encumber the co-owner’s interest in the Property "that are required by a lender and that are consistent with customary commercial lending practices are not prohibited." This is generous, but probably required form a practical viewpoint. One presumably should document that a waiver of partition, for example, is required by the lender.
10. The co-owners or the sponsor may have a "right of first offer" (which is defined as "the right to have the first opportunity to offer to purchase the co-ownership interest"). This appears not to include a right of first refusal, which IRS representatives have said orally imposes too much of a restriction on the co-owners ability to transfer their interests.
11. Neither the sponsor nor any co-owner may advance funds to a co-owner to meet expenses associated with the co-ownership interest unless the advance is recourse to the co-owner and is not for a period exceeding 31 days.
12. Options to purchase co-tenancy interests at fair market value (but not puts) are permissible.
13. "Customary" type services (typically performed in connection with maintenance and repair of the property), including cleaning of public areas and the furnishing of heat and light, can be provided to the tenant by the co-owners or their agents.
This is a very significant development because it appears to reaffirm the applicability of Rev Rul 75-374 (some practitioners were concerned that the ruling does not have relevance outside the REIT area, which is what was involved) and in effect renders unnecessary the need, in many cases, to have a master net lease to an entity created by the sponsor.
The Rev Proc states that activities will be treated as "customary" if the activities would qualify as rent under Search7RH512(b)(3)(A). This would include heat, air conditioning (although not mentioned in the ruling, but is mentioned in the Preamble to the Rev Proc), trash removal, unattended parking and maintenance of public areas. Query whether this includes providing and maintaining recreational facilities at no extra charge? IRS representatives have said orally, apparently on the basis of positions taken in the REIT area, that this may be okay.
Query also whether extensive business type activities involved in the leasing of apartments is irrelevant under the Rev Proc, if only "customary" services are provided (i.e the amount of apartments, maintaining a rental office on premises, the size of the leasing staff and the amount of advertising are irrelevant)? The Rev Proc could be read this way, although oral statements made by IRS representative about this issue have been somewhat confusing. Moreover, as indicated above, the IRS has given itself the ability to refuse to issue a ruling even if the conditions of the Rev Proc appear to have been met "whenever warranted by the facts and circumstances of a particular case and whenever appropriate in the interest of sound tax administration." Clarification of this issue by the IRS would be welcome.
14. No business type activities (except perhaps, as discussed above, for "customary services") can be conducted with respect to the property. For this purpose, all activities of the co-owners, their agents and any person related to the co-owners "with respect to the property" will be taken into account and attributed to the other co-owners, except to the extent that a particular co-owner holds his interest for less than six months).
15. The maintaining of a co-ownership interest by the sponsor should not be a problem, provided that either no services are provided with respect to the property or only customary services are provided. Query whether the attribution of activities discussed in the prior paragraph means that the business activities of the promoter in selling the co-ownership interests could somehow be attributed to the other co-owners? It is reasonable to conclude that the activities to be taken into account "with respect to the property" means the activities performed in connection with the underlying real estate, and not the activities performed by any co-owner in connection with his undivided interest. If that were not the case, the business activities of the sponsor in selling undivided interests would be attributed to the other co-owners, which in turn might make them dealers in real estate with respect to their co-ownership interests. Similarly, any other co-owner who happens to be holding his co-ownership interest for immediate resale would have his intent attributed to the other co-owners who then arguably could not qualify under Search7RH1031 (because they would considered to be holding their interests "primarily for sale"). There is no basis in the law for such attribution, even if the language in the Rev Proc could be read to the contrary.
16. Management agreements must be renewable no less frequently than annually. When taken together with the requirement that management agreements must have unanimous approval, this requirement (which apparently was based on one of the conditions in the Search7RH1.761-2(a)(2) regulations) may, from a practical viewpoint, be impossible to meet in many situations. IRS representatives have said orally that neither an automatic renewal in the agreement nor merely giving the co-owners the right to "revoke" the appointment of the manager may be acceptable. However, they have also orally indicated that providing annual written notice to the co-owners of their right to terminate may be acceptable.
17. The manager must disburse to the co-tenants their shares of net revenues within three months from the date of receipt of those revenues.
18. The manager may have the authority to negotiate modifications of the terms of the lease, "subject to the approval of the co-owners." Query what this means as a practical matter?
19. All leasing arrangements must be bona fide leases for Federal tax purposes. The rent must be at fair market value and cannot be based, in whole or in part, on the income or profits derived from the Property.
20. The fees paid to the manager must not exceed the fair market value of the manager’s services and cannot be based in whole or in part on the income or profits derived from the Property. Presumably, the phrase "income or profits" means "net income or profits.
21. 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 the lessee. This seems to be a very conservative requirement, and probably not supported by case law.
Conclusion
Rev Proc 2002-22 provides a significant amount of clarification of the IRS’s views on when a co-ownership may be treated as a business entity. While the Guidelines are not technically substantive rules, they are likely to be treated as such in the marketplace, and perhaps by IRS agents as well. Because of this, it is hoped that the IRS will issue additional guidance in the future on some of the questions referred to above, although that may have to come through the private letter ruling process.