When does a TIC Agreement Create a Partnership?
When does a TIC Agreement Create a Partnership?
IRS Provides Guidance for Taxpayers seeking to engage in 1031 Exchanges of Fractional Interests
On May 27, 2016, the Internal Revenue Service (the "IRS") released Private Letter Ruling 201622008 (the "PLR") providing helpful guidance on when tenants-in-common ("TIC") agreements may be construed as creating a partnership between co-owners. The letter ruling concludes that a TIC and related agreements among co-owners will not create a partnership, even if one of the owners enters into an option agreement to sell a fractional interest to the future tenant-in-common prior to the creation of the TIC. The key, it appears, is timing – the IRS will take a snapshot of the various agreements (including the TIC agreement) and determine whether, in the aggregate, they create a partnership.
For more than a decade, taxpayers and their counsel have prepared TIC agreements relying on Rev. Proc. 2002-22 and hoping that their agreements will not be construed as creating partnerships between the co-owners. The goal, of course, has been to allow the co-owners to engage in like-kind-exchanges under Internal Revenue Code ("IRC") § 1031 of their respective interests. Rev. Proc. 2002-22 allows taxpayers to obtain an IRS ruling on whether the particular co-ownership agreement creates a partnership. However, until the release of PLR 201622008, no taxpayers had apparently sought written confirmation from the IRS that their TIC agreements were within the safe harbors provided in section 6 of Rev. Proc. 2002-22. PLR 201622008 finally provides a valuable reference point, because the IRS ruled that the TIC and related agreements in the PLR did not create a partnership between the co-owners.
PLR Facts – Multiple Agreements
The PLR analyzes various agreements between a landlord and tenant that might evolve into a TIC relationship. Specifically, the IRS considered a TIC agreement (the "Co-Ownership Agreement") and related management agreement (the "Management Agreement") that would take effect only after the two parties had entered into a lease for the property (the "Lease Agreement") and call/put option for the lessee to purchase a portion of the property (the "Option Agreement").
The Initial Agreements
The taxpayer seeking the PLR owned a commercial office building (the “Property”) through a single member LLC. The taxpayer and proposed co-owner (the “New Co-Owner”) planned to enter into a Lease Agreement and Option Agreement contemporaneously. Importantly, these two agreements did not create (and the IRS did not assert that they created) co-ownership of the Property.
The Lease Agreement was to be a triple net lease between the Taxpayer and the New Co-Owner's single member LLC, with rents at the fair market value for the use of the Property. The rent paid would not be determined in whole or in part based on the income or profits derived by any person from the Property.
At the same time the Taxpayer and New Co-Owner entered into the Lease Agreement, they also signed an Option Agreement. The Option Agreement would allow the Taxpayer to sell any or all of its interest in the Property to the New Co-Owner at any time prior to the fifth anniversary (the "Put") of the Option Agreement, including the sale of a TIC interest in the Property. Additionally, the New Co-Owner could acquire interests in the Property beginning on the seventh anniversary of the Option Agreement (the "Call"). The purchase price for the Put or the Call would be based on the fair market value, increased by a reasonable annual appreciation factor.
The Co-Ownership Agreement and Management Agreement
If the Taxpayer did end up selling an undivided/TIC interest to the New Co-Owner, the PLR indicates that they would enter into the Co-Ownership Agreement that would run with the land as well as the Management Agreement. As part of the sale, neither the Taxpayer nor the New Co-Owner would provide financing to the other. Additionally, the Taxpayer and the New Co-Owner would refinance the property so that any debt encumbering the Property would be proportionate to their interests. The Management Agreement provided that if the Property was sold, any lien would be satisfied in proportion to the co-owners interest, and all revenues and costs generated from the Property would be shared proportionately.
The Co-Ownership Agreement would explicitly provide that the Taxpayer and New Co-Owner would not file a partnership tax return, or otherwise hold themselves out as members of a common business entity. Each co-owner would also be free to partition its interest in the Property, create a lien upon its own interest without the agreement or approval of any person (provided it would not create a lien on any other co-owner’s interest), and decisions under the Co-Ownership Agreement would be made by unanimous or majority voting.
In addition to the Co-Ownership Agreement, the Taxpayer and Co-Owner could also enter into a Management Agreement with a third party to administer the Property. The Management Agreement would last for only one year, and could be automatically renewed (unless the parties gave written notice 20 days before the expiration date). The manager could maintain a common bank account for the Taxpayer and New Co-Owner and deposit rents as well as offset expenses from this account, based on the two owners' pro rata interests. The manager could also obtain insurance on the Property, negotiate leases (subject to co-owner approval), and the manager’s fees would be a percentage of gross revenue received by the respective co-owners.
IRS Analysis of Rev. Proc. 2002-22 Criteria
PLR 201622008 provides that, if the Taxpayer were to exercise his option and sell a TIC interest to the New Co-Owner, the relationship created by the Co-Ownership Agreement and Management Agreement would not be considered a partnership. As a consequence, each co-owner could sell his undivided interest in the Property in an IRC § 1031 exchange.
The IRS reached its conclusion by finding that the Co-Ownership Agreement and Management Agreement satisfied all the conditions of Rev. Proc. 2002-22. Notably, the IRS highlighted the application of subsections 6.05 and 6.10 through 6.12 of Rev Proc. 2002-22 to the two agreements.
Regarding Rev. Proc. section 6.05 (Voting), the IRS analyzed whether major decisions under the Co-Ownership Agreement (like sales, leases, and liens) required unanimous vote, and other decisions required majority vote. The IRS found that the Co-Ownership Agreement met the general voting requirements of the Rev. Proc. and noted that the 20 day termination provision by the parties to the Management Agreement satisfied the unanimous vote requirement for annual extension or renewals set forth in the Rev. Proc.
Timing, it appears, was critically important in the IRS's analysis of section 6.10 of the Rev. Proc. (Options). In general, Section 6.10 of the Rev. Proc. provides that a co-owner cannot acquire an option to sell an undivided interest to a co-owner or lessee. Based on the facts of the PLR, the Taxpayer did appear to have a right to sell a TIC interest to the New Co-Owner – at least at the time the New Co-Owner was a lessee (under the terms of the Lease Agreement). But the IRS properly reasoned that the Taxpayer and New Co-Owner satisfied this requirement, because the Taxpayer's Put was not an option to sell an existing undivided interest.
Rather, the Put was an option to sell property held by the Taxpayer prior to entering into the Co-Ownership Agreement and the Management Agreement. In other words, had the Taxpayer and New Co-Owner first entered into the Co-Ownership Agreement (through a sale of an undivided interest) and then entered into the Option Agreement with the Put for a third party, the Put would likely have run afoul of Section 6.10 of the Rev. Proc. and potentially created a partnership between the co-owners.
With respect to section 6.11 of the Rev. Proc. (No Business Activities), the IRS reviewed whether the co-owners' activities were limited to the maintenance and repair of rental real property or involved other business activities. In this case, Taxpayer, New Co-Owner, and potential manager’s activities were all limited to those that are customarily performed in connection with the maintenance and repair of rental property.
PLR 201622008 provides the first IRS published guidance on how to structure TIC agreements so that taxpayers' ownership interests meet the requirements of Rev. Proc. 2002-22 and may qualify for like-kind exchange treatment under IRC §1031. Taxpayers should pay particular attention to any voting, management, option, and business activity arrangements as described in the PLR. In addition, taxpayers should carefully time the execution of their various agreements – a put option to a lessee may be permissible if entered into at the appropriate time, notwithstanding the general prohibition on such arrangements in Rev. Proc. 2002-22.
Taxpayers with questions about tenants-in-common agreements or like-kind-exchanges should contact the Real Estate Group or Tax Practice Group at Hanson Bridgett LLP.