Structuring Co-Ownership’s Under Code Section 1031 after Revenue Procedure 2002-22
March 25, 2002
On March 19, 2002, the Internal Revenue Service issued Revenue Procedure 2002-22, specifying the conditions under which the Service would consider a request for a ruling that an undivided fractional interest in rental real estate will be considered an interest in real estate and not an interest in a business entity.
Although the Revenue Procedure is relevant for a variety of tax purposes, it is of acute interest to taxpayers seeking to exchange investment and business real estate under Internal Revenue Code Section 1031. That section provides that gain from the sale of real estate may be deferred if the proceeds of sale are reinvested in new real estate of equal or greater value than the real estate sold. The new real estate generally takes on the tax basis of the old real estate, thus deferring the recognition of gain until the new real estate is sold.
There is a long-standing rule under Code Section 1031 to the effect that one cannot exchange out of real estate and into a corporation, partnership or limited liability company that owns real estate. Code Section 1031(a)(2). However, a variety of interesting structures have been developed over the years which seek to reconcile multiple ownership of exchange property with the business entity prohibition.
For nearly two years the tax community has awaited guidance that the Internal Revenue Service indicated would be forthcoming, anticipating a set of rules which might formally "bless" certain co-ownership arrangements, and thus give taxpayers some certainty in this area. While Revenue Procedure 2002-22 does not create such a safe harbor, it does signify where the Service would be willing to issue a favorable ruling on a specific co-ownership structure.
The most significant statement in Revenue Procedure 2002-22 appears in Section 3:
"This revenue procedure provides guidelines for requesting advance rulings solely to assist taxpayers in preparing ruling requests and the Service in issuing advance ruling letters as promptly as practicable. The guidelines set forth in this revenue procedure are not intended to be substantive rules and are not to be used for audit purposes."
Thus, Revenue Procedure 2002-22 does not change the law under which co-tenancy arrangements should be evaluated for purposes of Code Section 1031. Existing structures are not adversely effected by the Revenue Procedure. Future structures which do not meet the conditions for an advance ruling under the Revenue Procedure will be analyzed under the rules that subsisted prior to the issuance of the Revenue Procedure.
Revenue Procedure 2002-22 should not prompt withdrawal or modification of opinions on co-ownership structures issued prior to the date of the Revenue Procedure. Opinions issued on co-ownership structures after the date of the Revenue Procedure will generally follow the forms of opinion issued prior to the Revenue Procedure, with appropriate reference to the Service's termination of its earlier no-rulings policy and notation that the structure will not qualify for an advance ruling under Revenue Procedure 2002-22.
Although Revenue Procedure 2002-22 does not change the law of co-ownership arrangements and does not demand reconsideration of existing structures, practical considerations in marketing may do so. In time, co-ownership products will be marketed as having received favorable advance rulings or as being "ruling-eligible" under the Revenue Procedure. Structures that do not receive an advance ruling or are not ruling-eligible may in time be at a competitive disadvantage from a marketing perspective.
Finally, the level of disclosure required to discharge a sponsor's obligations under federal and state securities laws should be strengthened so that prospective investors are aware that the structure is ineligible for a favorable advance ruling under Revenue Procedure 2002-22.
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The following paragraphs briefly summarize the 15 conditions that must be satisfied before the Service will consider a co-ownership structure for a ruling under Revenue Procedure 2002-22. As will become evident upon review of these conditions, a ruling is likely to benefit only those simple co-ownership programs whose sponsors may use the ruling (or ruling-eligible status) to increase their volume of brokered transactions. Revenue Procedure 2002-22 will be of little relevance to program sponsors seeking structures that create higher margins (for the program sponsor) and higher returns (for investors).
1. Legal Title Held Direct-No Entities. Co-owners must hold legal title to the property as tenants-in-common under local law, directly or indirectly through a disregarded entity (such as a single member limited liability company). Thus, "title to the Property as a whole may not be held by an entity recognized under local law."
A limited liability company structure involving an election out of subchapter K of the Internal Revenue Code will probably not be eligible for an advance ruling from the Service. However, as noted above, the legal authority for analyzing such a structure's validity for purposes of Code Section 1031 has not changed.
2. Up To 35 Co-Owners. The number of co-owners may not exceed 35 (a husband and wife may be treated as a single person).
3. No Entity-Like Activities. The co-ownership may not file a partnership or corporate tax return, may not conduct business under a common name, may not execute a partnership or limited liability company agreement and may not otherwise hold itself out as a partnership or other form of business entity.
4. Co-Ownership Agreements Permitted. Co-owners may enter into a limited co-ownership agreement.
5. Voting-Unanimity for Major Decisions. In the co-ownership agreement, major decisions such as sale, lease, financing, refinancing and the appointment of managing agents must be approved unanimously. For most other actions, the vote of co-owners holding a majority of the undivided interests may carry the day.
6. Required Transfers and Partition Rights. Each co-owner must have the right to transfer, partition and encumber (mortgage) the co-owner's undivided interest in the property without the approval of any person. However, restrictions required by a lender will generally not be prohibited. In addition, granting of a right of first offer prior to a sale to other co-owners, the program sponsor or the lessee of the property will be permitted. Finally, while co-owners must have the right to partition the property, this right may be made subject to a prior right of first offer (to other co-owners, the program sponsor or the lessee) at fair market value.
7. Proportionate Sharing of Capital Event Proceeds. If the property is sold, any mortgage debt must be satisfied and the remaining sales proceeds must be distributed to co-owners in accordance with their undivided interests in the property.
8. Proportionate Revenue and Expense Sharing. Co-owners must share in all revenues and all expenses of the property in proportion to their undivided interests. Except for short term loans, loans among co-owners, or from the program sponsor, are not permitted.
9. Allocation of Mortgage Debt. Mortgage debt generally must be shared in accordance with the co-owners' undivided interests.
10. Puts and Calls Limited. A co-owner may issue a call option to purchase its undivided interest as long as the exercise price is at fair market value at the time that the option is exercised (fair market value is determined with reference to the market value of the property as a whole, multiplied by the co-owner's undivided interest). A co-owner may not have the right to put its interest in the property to the program sponsor, another co-owner, lessee, lender or any person related to any of the foregoing.
11. Passive Operations Required. Co-owners' activities must be limited to those customarily performed in connection with the maintenance and repair of passive rental real estate. This continues the general rule and practice that co-ownership arrangements should generally be structured with single tenant or master net leased properties.
12. Management and Administration. Co-owners may enter into property management and brokerage agreements, but such agreements may not subsist for more than one year (although they can be renewed). Management and brokerage agreements may be entered with the program sponsor or another co-owner, but not a lessee of the property. The management agreement may authorize the manager to maintain a bank account for the collection of revenues and payment of expenses on behalf of all of the co-owners. Net revenues must be disbursed at least quarterly. The manager may also be given responsibility for certain accounting functions, as well as the responsibility for such matters as insurance, leases and mortgages (subject to the approval of co-owners). Fees paid to the manager must be market-based and may not be dependent on the income or profits from the property.
13. True Leases-Participating Rent Prohibitions. All leases must be true leases for Federal tax purposes (rents must reflect the fair value for the use of the property). Percentage rents are generally prohibited, except for those that are based on a fixed percentage of a tenant's receipts or sales. In this connection, reference is made to the REIT rules at Code Section 856(d)(2)(A).
14. Mortgage Lender Cannot be a Related Party. The mortgage lender may not be related to any co-owner, program sponsor, property manager or lessee of the property.
15. Customary Fees to Program Sponsors. Payments to the program sponsor must reflect the fair market value of the acquired co-ownership interest and may not depend upon the income or profits derived from the property.
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It may be evident upon review of these conditions that advance rulings under Revenue Procedure 2002-22 will be available only for the most simply structured co-ownership arrangements, ones that may not be attractive to program sponsors seeking enhanced economic returns.
Program sponsors who are brokering single tenant triple-net leased properties for customary brokerage and property management fees may see value in a ruling from a marketing perspective.
Sophisticated structures sold through broker-dealer networks involving enhanced returns to program sponsors through master leases and similar arrangements generally will not be eligible for advance rulings under Revenue Procedure 2002-22.
Where does the 1031 net lease market go from here? We predict as follows:
A. The larger high-volume sponsors of Code Section 1031 programs will seek rulings for their simpler structures. Their ability to obtain a ruling will allow them to differentiate themselves from the remainder of the market which may not have obtained (or be eligible for) a ruling.
B. The more sophisticated higher return programs that are ineligible for a ruling will continue to be sold, since Revenue Procedure 2002-22 does not change the law under which those programs are analyzed. Sponsors of such programs, however, may see some investor attrition as the market becomes aware that favorable ruling (or ruling-eligible) product is available.
C. Over the next year or so, the tax literature is likely to abound with ideas of how sponsors of more sophisticated structures might be eligible for a ruling and thus claim (for marketing purposes) ruling-eligible status. Two critical points here: (i) claiming ruling-eligible status may be imprudent for securities law purposes and (ii) the Internal Revenue Service's approach to rulings in this area is likely to be rather conservative. Favorable "authority" for non-vanilla programs is unlikely to develop for some time.
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For further information on this topic, please call Michael Tuchman, senior partner in the tax and real estate groups of Levenfeld Pearlstein, Chicago, Illinois. 312-476-7550.
 Revenue Procedure 2002-22 supercedes earlier Revenue Procedures which stated that the Internal Revenue Service would not issue advance rulings on this question until the Service completed an analysis of this area.
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