An increasingly hot topic in the exchange industry is the use of undivided interests to complete tax-deferred exchanges. Also called a tenant in common interest or "TIC," an undivided fractional interest is the ownership of an undivided percentage of property with other owners.

With a tax deferred exchange, "like-kind" replacement property is to be identified within 45 days from the transfer of the relinquished property and acquired by the earlier of 180 days from the same transfer date or the due date of the investor's tax return for the year in which the relinquished property is sold. Because of the short time frame to identify suitable replacement property, TIC interests are being offered as options to complete exchanges. Rather than selecting an entire property, an investor can participate in property that may be financially unobtainable otherwise.

Real property is generally like kind with all other real property, regardless of whether it is a fee interest or an undivided ownership interest. When acquiring a TIC interest, it is critical that it be classified as real property and not an interest in a partnership or business entity. Why? Section 1031 specifically excludes "partnership interests" from tax deferral treatment. If the IRS considers the TIC replacement property to be a partnership interest, then, even if local law would consider it real property, the exchange will not qualify for tax deferral.

By definition, a partnership is an association of two or more people with the intent of conducting a business and sharing the profits and losses. In other words, an investor who exchanges real estate for a TIC interest may not receive tax deferral if the IRS treats the TIC co-owners as partners. The IRS would conclude that the investor has sold real estate and acquired non-like kind property, a partnership interest, even if the investor received a deed! While TIC co-owners may not intend to create a partnership, a partnership or business entity may be created for federal tax purposes if their activities go beyond very basic functions of co-owners.

To clarify its position for sponsors of TIC ownership programs, the IRS issued Revenue Procedure 2002-22 that set out 15 conditions which must exist in order to apply for an opinion as to whether a particular TIC interest is "real property" and not a business entity or partnership.

Some of these conditions include that each co-owner must hold title to the property as a tenant in common under local law. The maximum number of co-owners is limited to 35 with some exceptions for spouses and heirs. The co-ownership must not file a joint partnership or corporate tax return, conduct business under a common name, sign 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 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 of a blanket lien. The co-owners must share in any indebtedness secured by the blanket lien in proportion to their undivided interests.

If Rev. Proc. 2002-22 sets out criteria to clarify that a TIC interest is real property, why is there still an issue? First, Rev. Proc. 2002-22 is not a safe harbor, but rather, a guideline to obtain an IRS ruling as to the merits of a particular TIC ownership program. Second, many TIC arrangements were set up and formalized prior to issuance of the Rev. Proc. Third, as a practical matter, it is very often difficult, if not impossible, to comply with all 15 conditions and still have a viable project. Most TIC experts believe that it is possible to follow the intent of the Rev. Proc. without exactly complying with all 15 conditions. Finally, the timing of TIC projects often does not allow for receipt of an IRS opinion prior to marketing and sale of the interests.

As a result, very few of the TIC sponsors obtain an IRS opinion concerning the project's status. Rather, the TIC sponsors will obtain a legal opinion on how their project may survive IRS scrutiny. As a result, each investor of a TIC interest is left to make an independent judgment as to the project's qualification.

It is also important to know that federal securities laws govern the marketing of TIC interests in many, if not all, cases. The federal code and regulations define a "security" to be more than just the standard stocks and bonds that we generally consider to be "securities." A registered representative of a securities broker-dealer is used in these transactions.

Since the issuance of Rev. Proc. 2002-22, the interest in TIC programs has intensified. At a TIC symposium in Salt Lake City, Utah held in 2004, it was estimated that $1.2 billion dollars were invested in TIC properties in 2003, up from $500 million for the prior year. Some of the benefits of investing in TIC programs are described as fewer management headaches, better cash flow, diversification, and minimum equity requirements. Some of the risks include liquidity and exit strategies.

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All information contained herein is provided as a matter of courtesy to our clients. First American Exchange Company, its officers and agents make no representations as to the completeness and applicability of the information contained herein to each individual taxpayer. As a Qualified Intermediary, First American Exchange Company is precluded from providing tax or legal advice to its clients. Please consult your own independent tax or legal advisor regarding your specific circumstances.