Co-Ownership Structures

The two vehicles are the tenancy in common and the Delaware statutory trust. Each is governed by a single piece of administrative guidance, and in both cases the guidance is more limited than the use practitioners make of it.

21.1 The recharacterization problem

A tenancy in common is a form of direct ownership. Each co-tenant holds an undivided fractional interest in the land itself, and the regulation confirms that co-ownership is an intangible asset that is real property for section 1031 purposes.¹

The difficulty is that co-ownership can become a partnership without anyone forming one. A partnership exists for tax purposes where two or more persons join together to conduct a business and share in profits, and no filing or intention is required. Co-tenants who pool revenues, hire common management, share expenses, and act collectively can satisfy that description while believing themselves to be nothing more than neighbors on a deed.

The consequence is fatal in both directions. If the arrangement is a partnership, each participant holds a partnership interest, which is not real property.² A co-tenant cannot exchange out of it, and a taxpayer who exchanges into it has acquired something ineligible.

Revenue Procedure 2002-22 addresses the question, and understanding what it is comes before understanding what it says.

21.2 What Revenue Procedure 2002-22 actually is

It is not a safe harbor. It is a statement of the conditions under which the Service will consider a request for a private letter ruling, and its own opening says so.

The Service "ordinarily will not consider a request for a ruling under this revenue procedure unless the conditions described below are satisfied." It then adds the converse: where the conditions are not satisfied, the Service "may consider a request for a ruling under this revenue procedure where the facts and circumstances clearly establish that such a ruling is appropriate."³

Two propositions follow, and both are routinely misstated.

Satisfying the conditions does not establish that an arrangement is not a partnership. It establishes that the Service will entertain a ruling request. The substantive question remains governed by the general classification principles of Chapter 19.

Failing a condition does not establish that an arrangement is a partnership. The Service reserves discretion to rule favorably on appropriate facts, and the underlying law is unchanged by the procedure.

The conditions are nonetheless the best available statement of what the Service regards as consistent with co-ownership, and practitioners structure to them for that reason rather than because they confer protection.

One condition deserves immediate notice because of where Chapter 20 left us. Condition .03 provides that 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

That sentence is aimed squarely at the drop and swap. The Service has told practitioners, in the guidance that defines acceptable co-ownership, that it will not bless the arrangement that a drop and swap produces. It does not make the technique unlawful, and it does not create a presumption. It does tell a client what the Service thinks, and it belongs in the written advice contemplated at 20.4.

21.3 The fifteen conditions

The conditions repay reading in the original, and the following states what each requires.

Title and number. Each co-owner must hold title as a tenant in common under local law, directly or through a disregarded entity, and title to the property as a whole may not be held by an entity recognized under local law.⁵ Co-owners are limited to thirty-five persons, with a married couple counted as one person and all persons acquiring by inheritance from a co-owner counted as one.⁶

Not holding out as an entity. The co-ownership may not file a partnership or corporate return, conduct business under a common name, execute an agreement identifying the co-owners as partners, shareholders, or members, or otherwise hold itself out as a business entity.⁷

Voting. This is the condition most often violated in practice. The co-owners must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any leases, and the creation or modification of a blanket lien. And a specific list of actions requires unanimous approval: any sale, lease, or re-lease of any portion of the property; any negotiation or renegotiation of indebtedness secured by a blanket lien; the hiring of any manager; and the negotiation of any management contract or its extension or renewal.⁸ All other actions may be taken by holders of more than fifty percent. A co-owner may give a specific power of attorney for an approved action but may not give a global power of attorney.

Alienation. Each co-owner must have the right to transfer, partition, and encumber the undivided interest without the agreement or approval of any person, subject to lender-required restrictions consistent with customary commercial lending practices, and subject to permitted rights of first offer.⁹

Proportionality. Each co-owner must share all revenues and all costs in proportion to the undivided interest, and must share blanket-lien debt in proportion.¹⁰ Advances to a co-owner are permitted only if recourse and for no more than thirty-one days.

No business activities. Activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property.¹¹

Agreements and fees. Management and brokerage agreements must be renewable no less frequently than annually, the manager must disburse each co-owner's share of net revenues within three months of receipt, and manager fees may not depend on income or profits nor exceed fair market value of the services.¹² Leases must be bona fide and rent may not depend on the income or profits of the lessee, other than a fixed percentage of receipts or sales.¹³ The lender may not be related to any co-owner, the sponsor, the manager, or any lessee.¹⁴ Payments to the sponsor must reflect fair market value and may not depend on income or profits.¹⁵

The unanimity requirement is what makes the tenancy in common unattractive at scale. Thirty-five co-owners each holding a veto over every lease renewal is a governance structure that functions only where the co-owners are few and aligned.

21.4 Delaware statutory trusts

The governance problem created by unanimity is what produced the Delaware statutory trust as a replacement-property vehicle, and Revenue Ruling 2004-86 is its charter.

The mechanism is trust classification rather than co-ownership. A trust that merely holds property and distributes income, without power to vary the investment, is an investment trust whose beneficial owners are treated as owning the underlying assets directly. Where the trust holds real property, the beneficial interests are interests in that real property, and they may be acquired in an exchange.

The ruling reaches that result on facts in which the trustee's powers are severely constrained. On those facts, the trust agreement provided that the trustee's activities are limited to the collection and distribution of income, and that the trustee may not:

• exchange the property for other property;
• purchase assets other than specified short-term obligations;
• accept additional contributions of assets, including money;
• renegotiate the terms of the debt used to acquire the property;
• renegotiate the lease or enter into leases with new tenants, except on the tenant's bankruptcy or insolvency; or
• make other than minor non-structural modifications to the property, unless required by law.¹⁶

Cash reserves may be invested only in short-term government obligations or qualifying certificates of deposit, maturing before the next distribution date and held to maturity. The trustee may perform ministerial activities required to maintain the trust under local law. Each beneficial owner has a right to quarterly cash distributions and to an in-kind distribution of its proportionate share of trust property.

Practitioners call these restrictions the seven deadly sins. The label is useful shorthand and is not the Service's language, and the point that matters is structural: the restrictions are facts of the ruling, not a statutory test. A trust that departs from them is not violating a rule. It is outside the ruling, and its classification must be established on its own merits, with the risk that it is a business entity whose interests are not real property.

The binding limitation follows from the prohibition on accepting additional contributions and renegotiating debt. A DST cannot raise capital or refinance to address a distressed property. That is the structure's principal weakness and it surfaces precisely when conditions deteriorate.

21.5 Choosing between them

The two vehicles trade the same variables in opposite directions.

For a small group of partners separating after a drop and swap, the tenancy in common is generally the only workable answer, because the participants want control and are few enough for unanimity to function.

For a taxpayer with an approaching forty-five-day deadline and no identified replacement property, the DST is generally the answer, because interests are available in standing offerings and acquisition is administratively simple.

Two cautions close the chapter.

A DST interest is a security. Offerings are made under the securities laws, and a lawyer advising on the tax treatment is not thereby advising on the investment. The distinction should be made explicit to clients, who frequently do not perceive it.

Neither vehicle cures a defective exchange. Both are answers to the question of what the replacement property may be. The requirements of Chapters 12 through 18 apply to the taxpayer acquiring the interest exactly as they would to a taxpayer acquiring a building.