Like Kind Exchanges And Tenancy In Common Agreements Involving Real Property
Like kind exchange transactions have increased significantly over the past several years. Substantial increases in real estate values have prompted a movement to defer built in gains when disposing of these assets. Complex rules regulating the number of identifiable properties require taxpayers to be more selective in identifying and acquiring replacement property. Taxpayers must also comply with the technical requirements of the Internal Revenue Code (the “Code”) regulating the disposition of sale proceeds.
To qualify as replacement property the property must be real property. Interests in partnerships or limited liability companies do not qualify as replacement real property. In many instances, owners who have sold real estate would like to effect a like kind exchange by purchasing an interest in replacement property that is owned by a partnership or a limited liability company. If the interest is acquired directly from the other limited partners or limited liability company members, the acquired interest is not replacement real property and the like kind exchange fails. However, an alternative structure exists which permits the owner to achieve the desired deferral. This structure involves acquiring fee simple ownership interest as a tenant in common with others.
For example, assume Newco LLC owns a desirable commercial building. Newco LLC has two (2) members as its equity owners, each with a fifty (50%) percent interest in Newco LLC. Newco LLC desires to sell a one-third (⅓) interest in the venture to Taxpayer. If Newco LLC were to distribute the existing property to its two (2) members as tenants in common, with each owning a fifty (50%) percent fee simple ownership interest, one or both of those members could then sell to Taxpayer a fee simple interest as part of Taxpayer’s like kind exchange. Lenders have become much more familiar with this structure and have been receptive to approving transactions involving tenancy in common arrangements with appropriate modifications to their loan documents.
Most taxpayers are not alert to specific IRS rules that govern tenancy in common structures. Taxpayers and their counsel pay little attention to those IRS rules and draft tenancy in common agreements that closely resemble partnership agreements. The IRS has broad latitude to construe the tenancy in common as a partnership and could deny the tax benefits associated with the like kind exchange if it decided that the replacement property was not real estate but rather a partnership interest. Factors that the IRS scrutinizes are preferred returns on contributed capital, priorities that are disproportionate to the fee ownership interest in the property, dilution provisions and other similar provisions that are traditionally seen in a partnership or limited liability company operating agreement.
Like kind exchanges involving real estate with operating businesses thereon, such as hotels and restaurants, present unique problems of their own. In these transactions “additional” services are provided by the co-owners. IRS regulations specifically provide that tenants in common “may be partners if they actively carry on a trade or business, financial operation or venture and divide the profits thereof”. The IRS has confirmed that customary services associated with simple maintenance and repair obligations will not result in the tenancy in common being deemed a trade or business but the rendering of “additional services” could result in such an adverse ruling. In particular, services rendered in managing the business, especially if shared on a pro rata basis, could result in an adverse ruling. The IRS has not been very specific in describing what “additional services” would result in such a ruling; however, it is imperative that close attention be paid to the various ownership and other operating agreements pertaining to these transactions to insure desired tax benefits are obtained.
To learn more about like kind exchange transactions and the use of tenancy in common agreements please call Martin C. Pomeroy at (617) 790-3370 or e-mail him at mpomeroy@bgblaw.com.