IRS Expands Replacement Property in 1031 Exchanges

TAX BRIEF

INDIVIDUAL

The IRS released revenue procedure 2002-22 in March to address the use of fractional ownership interests as replacement property in IRC section 1031 exchanges. Commonly referred to as “tenancy-in-common” or TIC interests, these fractional interests offer significant advantages to taxpayers completing 1031 exchanges.

Under section 1031, a taxpayer may defer gain recognition by exchanging for like-kind property. The replacement property cost must equal or exceed the net sales price of the relinquished property and the taxpayer must replace all debt and equity. To successfully complete the exchange, the taxpayer must meet certain requirements. Specifically, he or she must identify potential replacement property within 45 days of selling the relinquished property.

Finding an attractive replacement property in the right price range in such a short time can be difficult, and a taxpayer must take title to the property he or she ultimately buys in the same manner as the relinquished property. (For example, a taxpayer tired of the hassles of owning and managing a rental house cannot exchange it for a partnership interest in a professionally managed shopping center.) This title requirement often precludes taxpayers from buying a share in a larger, potentially more attractive property.

In response to the need for “ready-to-buy” investment products that taxpayers could purchase with varying amounts of cash and debt, a small group of companies began offering TIC interests as replacement property. To address the title issue, they used a co-ownership structure. Despite this arrangement, many CPAs were still concerned the IRS might see the TIC interests as essentially partnership interests, jeopardizing the benefits of an exchange.

After declining to answer several letter ruling requests on this matter, the IRS decided not to issue any more rulings pending further review. Revenue procedure 2002-22 is the result of this review. Although the IRS did not establish a safe harbor provision, it did spell out some requirements for TIC interests to qualify as co-ownership interests.

The maximum number of tenants-in-common permitted is 35.

The sponsor or organizer of the interests may own the property (or an interest therein) for only six months before selling 100% of the units.

Unanimous decisions are required on anything of material or economic impact to the property or its owners.

The management agreement (if applicable) must be at a market rate and renewable annually.

The pronouncement urges taxpayers wanting a definitive blessing on a particular product to seek a letter ruling. The IRS will make such a ruling based on the specific facts of the TIC offering.

Observation. Given this new information, many companies selling TIC interests are likely to structure their offerings to comply with the new guidelines, as well as seek an individual blessing from the IRS on their product. For the group offering the product, revenue procedure 2002-22 appears to provide a foundation to build on. For taxpayers, the guidance opens the door to a new product that may allow them more choice and flexibility when completing a section 1031 exchange.

—Ronald L. Raitz, CCIM, president, Real Estate Exchange Services in Marietta, Georgia, rraitz@rees1031.com . Rob Hannah, president, Tax Strategies Group in Chicago, rhannah@tsgrouponline.com .