Is Your Property in a “Safe Harbor?”: Tenancies-in-Common in Section 1031 Tax-Deferred Exchanges Explained

In recent years, a number of Revenue Rulings, private letter rulings and Revenue Procedures issued by the Internal Revenue Service (the Service) have provided guidance on special situations related to tax-deferred exchanges, including reverse exchanges and tenancy-in-common transactions.

IRS Provides Guidance

In recent years, a number of Revenue Rulings, private letter rulings and Revenue Procedures issued by the Internal Revenue Service (the Service) have provided guidance on special situations related to tax-deferred exchanges, including reverse exchanges and tenancy-in-common transactions. Revenue Procedure 2002-221 provides guidance for taxpayers seeking to take advantage of Section 1031 of the Internal Revenue Code (the Code) by trading into tenancy-in-common interests in real property, and helps resolve the uncertainty regarding whether tenancy-in-common interests would be classified as partnership interests by the Service.

Background on Section 1031 Exchanges

Section 1031 of the Code is considered by many to be one of the most generous, widely available provisions of the Code, as it creates an exception to the general rule set forth in Section 1001(c) of the Code. Section 1001(c) of the Code provides that the entire amount of gain or loss from the sale or other disposition of property shall be recognized unless otherwise provided by the Code. Thus, unless another section of the Code creates an exception, when a taxpayer sells property for more than its tax basis in that property, the gain recognized by such taxpayer is taxable (generally as a capital gain) in the tax year in which the sale occurs. Section 1031 of the Code allows the taxpayer to defer the capital gains tax related to such sale provided that the taxpayer meets certain requirements.

The threshold requirement for a taxpayer seeking to take advantage of Section 1031 is that the taxpayer exchange property currently held for investment or productive use in a trade or business for like-kind property. This requirement has led to the coining of the common name of transactions under Section 1031–so-called “Like-Kind Exchanges”–and it underlines the basic legislative rationale behind the adoption of the provision, namely that the capital gains on such transactions, if reinvested in “like-kind” property of equal or greater value, represent a continuing investment by the taxpayer which is not subject to taxation at the time of the exchange.

Section 1031 of the Code and Treasury Regulation Section 1.1031 set forth the like-kind exchange requirements, providing “safe harbor” rules for taxpayers evaluating whether a transaction will qualify for tax-deferred treatment under Section 1031. The “safe harbor” rules establish the mechanical requirements for Section 1031 exchanges, which amplify Section 1031’s original focus on the type of property being exchanged.

Partnership Interests are Not Like-Kind Property

While real property and certain classes of personal property are eligible for Section 1031 exchanges, several properties or classes of properties are listed as being specifically ineligible for Section 1031 exchanges. Among those classes of properties specifically excluded from eligibility for Section 1031 exchanges are partnership interests.2

Revenue Procedure 2002-22 Ruling Guidelines

The following is a general, non-exhaustive overview of the guidelines set forth in Revenue Procedure 2002-22:

  1. “Each of the co-owners must hold title to the property (either directly or through a disregarded entity) as a tenant in common under local law. Thus, title to the property as a whole may not be held by an entity recognized under local law.” 2002-14 IRB 733 § 6.01.

  2. The number of co-owners must be limited to no more than 35 persons.

  3. 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 of a business entity, or otherwise hold itself out as a partnership or other form of business entity. The Service generally will not issue a ruling under this Revenue Procedure if the co-owners held interests in the property through a partnership or corporation immediately prior to the formation of the co-ownership.

  4. The co-owners may enter into a limited co-ownership agreement, running with the land and providing among others that a co-owner must offer the TIC interest for sale to the other co-owners at fair market value before exercising any right to partition or sever the respective ownership interests of the co-owners.

  5. The co-owners must retain the right to approve, by unanimous approval, 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. All other actions may be approved by the vote of those holding more than 50 percent of the TIC interests in the property and may be delegated (subject to restrictions) as set forth below.

  6. Except as provided above or elsewhere in the Revenue Procedure (with regard to rights of first refusal and typical, commercially reasonable rights in favor of lenders), each co-owner must have the rights to transfer, partition and encumber its TIC interest in the property without the agreement or approval of any person.

  7. Upon the sale of the property, the net proceeds following the satisfaction of any liens or other liabilities affecting the entire property must be distributed to the co-owners.

  8. Except as otherwise provided, each co-owner must share in all revenues generated by the property and all costs associated with the property pro rata based on its respective percentage TIC interest.

  9. Each co-owner must share in all debt secured by blanket liens on the property pro rata based on its respective percentage TIC interest.

  10. A co-owner may issue an option to purchase its TIC interest so long as the exercise price for such option reflects the fair market value of the property determined as of the time the option is exercised.

  11. The co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property. Activities will be treated as customary activities for this purpose if the activities would not prevent an amount received by an organization described in I.R.C. § 511(a)(2) from qualifying as rent under I.R.C. § 512(b)(3)(A) and the regulations thereunder.

  12. The co-owners may enter into management or brokerage agreements with a manager and/or agent (subject to certain restrictions), which may be renewable no less frequently than once a year. Such management agreement may delegate certain responsibilities to the manager, including maintaining a common bank account for the collection and deposit of rents, offsetting expenses associated with the property against any revenues before disbursing each co-owner’s share of net revenues (provided that the manager must disburse to the co-owners their shares of net revenues within three months from the date of receipt of those revenues), preparing statements for the co-owners showing their shares of revenue and costs from the property, obtaining or modifying insurance on the property, and negotiating changes to the terms of any lease or any indebtedness encumbering the property (subject to the approval of the co-owners).

  13. All leases must be bona fide leases for federal tax purposes. Rents paid by a lessee must reflect the fair market value for the use of the property and must not depend, in whole or in part, on the income or profits derived by any person from the property leased.

  14. The lender with respect to any debt that encumbers the property or with respect to any debt incurred to acquire a TIC interest in the property may not be a related person to any co-owner of the property or certain other restricted persons or entities.

The Tenancy-In-Common Problem

The distinction between eligible properties (e.g., real property) and ineligible properties (e.g., partnership interests) can become blurred, however, due to a common form of ownership of real property. Real property may be owned as undivided fractional interests by two or more persons or entities. This form of ownership in which two or more persons or entities each own a percentage of the whole of a parcel of real property, rather than a separately identifiable portion such as a certain acre or a building, is a tenancy-in-common (TIC). The TIC form of ownership is a natural fit for taxpayers attempting to identify replacement property to complete Section 1031 exchanges, due in part to the short period (45 days) provided for the identification of replacement property following the transfer of the relinquished property. Taxpayers finding it increasingly difficult to identify replacement property within 45 days that (i) would satisfy the requirements of Section 1031 and Treasury Regulation Section 1.1031 and (ii) could be owned 100 percent by such taxpayers, are drawn to TIC interests that can be tailored to the exact needs of each taxpayer. In theory, such taxpayers can simply acquire as replacement property an undivided TIC interest in a parcel of real property in the percentage of ownership (especially with regard to amount of debt and equity allocable to such taxpayer) that would satisfy the requirements of Section 1031 and Treasury Regulation Section 1.1031. Again in theory, the search for a property of virtually the same value as the proceeds from the sale of the relinquished property can be replaced with a search for property of greater value than the relinquished property, which can then be carved into TIC interests to accommodate the needs of individual taxpayers.

The problem is that in practice, TIC interests often look very much like partnership interests, no matter what name is attached to them. When two or more persons or entities own an operating parcel of real property, as opposed to raw or unimproved land, in a TIC, they are setting themselves up for future disputes if they do not enter into a written agreement setting forth the conditions of the ownership and operation of the property. Such written agreements would naturally include a recitation of the ownership percentages of each party and the terms under which the parties would provide for the repair and maintenance and even the leasing and/or operation of the property. Unfortunately, if such agreements, written or not, have the net effect of having the co-owners engage in business operations together, essentially creating a business or enterprise in which the parties share in the profits and losses from the operation of the property, then the Service might rely on a well-settled body of law to classify the business or enterprise as a partnership.3 Since partnership interests are ineligible for Section 1031 exchanges, a taxpayer whose acquisition of a TIC interest as replacement property is determined by the Service to be the acquisition of a partnership interest will not be entitled to defer capital gains taxes under Section 1031 of the Code.

Guidance from the Service on TIC Interests in Section 1031 Exchanges

Attorneys and tax planners for taxpayers who were aware of the fine line between TIC interests and partnership interests began seeking private rulings from the Service regarding whether TIC interests in real property were in fact interests in partnerships and thus ineligible for Section 1031 exchanges. In Revenue Procedure 2000-46,4 however, the Service (i) refused, for the time being, to issue further rulings letters on whether TIC interests were partnership interests and whether such TIC arrangements constituted separate legal entities for federal income tax purposes, and (ii) stated its intention to give guidance on such questions in the future. As a result, taxpayers were left to wonder whether the acquisition of TIC interests in real property would qualify for capital gains tax deferral under Section 1031 of the Code without any guidance from the Service.

In Revenue Procedure 2002-22, the Service superseded Revenue Procedure 2000-46 and finally detailed guidelines for requesting private rulings of whether TIC interests in real property will constitute partnership interests ineligible for Section 1031 exchanges. The Service provided that the guidelines were merely to assist taxpayers in preparing their requests for rulings and that the guidelines should not be taken as substantive rules or requirements. The guidelines set forth in Revenue Procedure 2002-22, the Service cautions, should not be interpreted by taxpayers to provide a “safe harbor” with respect to TIC interests. In other words, even if all of the guidelines are satisfied in a request by a taxpayer for private ruling by the Service, the Service might still refuse to issue such ruling depending on the facts of the case. Mere satisfaction by a taxpayer of the guidelines in Revenue Procedure 2002-22 will not prevent the Service from classifying a TIC interest as a partnership interest and disallowing the capital gains tax deferral sought by a taxpayer under Section 1031 of the Code. Nevertheless, tax practitioners and taxpayers alike have come to see the guidelines set forth in Revenue Procedure 2002-22 (see previous page) as a “safe harbor” for the structuring of TIC interests in real property to be acquired as replacement property in Section 1031 exchanges.

The Guidelines Alleviate Some of the Confusion

The long-standing refusal of the Service to issue private rulings on whether TIC interests would be deemed to be ineligible partnership interests created confusion among tax practitioners and taxpayers and chilled the use of TIC interests in Section 1031 exchanges. Revenue Procedure 2002-22 resolves much of that confusion by providing relatively clear guidelines for submission of requests for private rulings from the Service on TIC interests. There is still uncertainty that will continue to cause concern until there is more guidance from the Service or from the courts on the use of TIC interests in Section 1031 exchanges. In the meantime, Revenue Procedure 2002-22 provides tax practitioners with a practical set of rules for structuring TIC interests for Section 1031 exchange purposes.


  1. 2002-14 I.R.B. 733. 

  2. I.R.C. § 1031(a)(2)(D). 

  3. See generally Luna v. Comm’r, 42 T.C. 1067 (1964) (finding that the existence of a partnership depends on the evaluation of certain factors, including, among others, the agreement of the parties, the parties’ actions in executing the terms of such agreement, the contributions made to the venture by each party, the parties’ respective control over the income and capital of the venture, and the rights of each party to make withdrawals of income and capital); Treas. Reg. § 301.7701-1(a)(2). 

  4. 2000-2 C.B. 438. 

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