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| Fractional Like-Kind Exchanges Under IRC |
| 1031 Following the Issuance of IRS Revenue |
| Procedure 2002-22 |
| by Andrew R Giannella |
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Real Estate Law Letter
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Fall 2002
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| On March 19, 2002, after spending considerable time studying the issue of "fractional like-kind exchanges", the Internal Revenue Service (IRS) issued Revenue Procedure 2002-22 (Rev. Proc. 2002-22). Rev. Proc. 2002-22 specifies the conditions under which the IRS will consider a request for a ruling that an undivided fractional interest in rental real property is not an interest in a business entity (and is therefore real property which, subject to the satisfaction of various other requirements, may be utilized in a like-kind exchange). Rev. Proc. 2002-22 does not establish objective criteria which, if satisfied, create a safe harbor for a taxpayer who engages in a fractional like-kind exchange. It does, however, outline and discuss 15 "conditions" that the IRS concludes are indicative of a true tenancy-in-common arrangement. Rev. Proc. 2002-22 should, by providing such guidance, have the effect of increasing the number of fractional like-kind exchanges that take place. This article briefly summarizes the conditions outlined in Rev. Proc. 2002-22. |
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| 1. Tenancy-in-Common Ownership. Each co-owner of the property must hold title to the property (either directly or through a disregarded entity) as a tenant-in-common under the law of the jurisdiction in which the property is located. |
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| 2. Number of Co-Owners. The number of co-owners may not exceed 35. A husband and a wife and all persons who inherit interests in a property are treated as a single person. |
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| 3. No Treatment of Co-Ownership as an Entity. The co-ownership may not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying any or all of the co-owners as partners, shareholders, or members, or otherwise hold itself out as a partnership or other form of business entity. |
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| 4. Co-Ownership Agreement. The co-owners may enter into a co-ownership agreement, which may run with the land. |
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| 5. Voting. The co-owners must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any leases of a portion or all of the property, or the creation or modification of a blanket lien on the property. In addition, Rev. Proc. 2002-22 requires that 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) must be by unanimous approval of the co-owners. Any action not specifically mentioned above may be determined by the vote of the co-owners holding the majority of the undivided interests in the property. |
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| 6. Restrictions on Alienation. In general, each co-owner must have the right to transfer, partition or encumber the co-owner's undivided interest in the property. However, customary restrictions on the right to transfer, partition or encumber interests in the property that are required by a lender holding a blanket lien on the property are permissible. In addition, the co-ownership agreement may provide the co-owners with a right of first offer with respect to any co-owner's exercise of the right to transfer his or her co-ownership interest in the property. Finally, the co-ownership agreement may require a co-owner to offer his or her co-ownership interest to the other co-owners at its fair market value before exercising any right to partition. |
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| 7. Sharing of Proceeds and Liabilities Upon Sale of Property. If the property is sold, the co-ownership agreement must provide that any debt secured by a blanket lien must first be satisfied and the remaining proceeds must be distributed to the co-owners in accordance with their respective tenancy-in-common interests. |
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| 8. Proportionate Sharing of Profits and Losses. Each co-owner must share in all revenues generated by the property and all costs associated with the property in accordance with their respective tenancy-in-common interests. No co-owner may advance funds to another co-owner to meet expenses associated with the co-ownership interest, unless the advance is recourse to the co-owner and is for a period not exceeding 31 days. |
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| 9. Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by a blanket lien on the property in accordance with their respective tenancy-in-common interests. |
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| 10. Options. A co-owner may issue an option to purchase his or her tenancy-in-common interest, provided that the exercise price for the option reflects the fair market value of the tenancy-in-common interest as of the time the option is exercised. |
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| 11. No Business Activities. The co-owners' activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property. |
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| 12. Management and Brokerage Agreements. The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually. The amount of any fees paid under the management or brokerage agreement may not exceed the fair market value of the services provided by the manager or broker. Compensation to be paid under a management agreement may not depend, in whole or in part, on the income or profits derived by any person from the property. |
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| 13. Leasing Agreements. All leasing agreements must be bona fide leases for federal income tax purposes, and the rents paid by a lessee must reflect the fair market value for the use of the property. The determination of the amount of the rent must not depend, in whole or in part, on the income or profits derived by any person from the property that is leased (other than percentage rent). |
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| 14. Loan Agreements. 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 manager or any lessee of the property. |
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| 15. Payments to Sponsor. Any payments to a sponsor must reflect the fair market value of the services provided by the sponsor and may not be based on income or profit from the property. |
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| While Rev. Proc. 2002-22 does not establish objective criteria which, if satisfied, create a safe harbor for a taxpayer who engages in a fractional like-kind exchange, it certainly provides guidance as to how co-ownership arrangements should be structured. Ulmer & Berne has developed a co-ownership agreement which has been utilized in several 1031 exchanges. For more information on Rev. Proc. 2002-22 or on properly structuring like-kind exchanges, please contact any member of Ulmer & Berne's Real Estate Group. |
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Copyright 2005 Ulmer & Berne LLP.
Andrew R. Giannella is a partner in the firm's Cincinnati office, focusing on real estate law, business law,
and financing transactions. "Fractional Exchanges under IRC '1031 Following Rev. Proc. 2002-22",
was originally published as an Ulmer & Berne LLP Real Estate Law Letter (Fall 2002).
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