Internal Revenue Procedure 2002-22
On March 19, 2002, the IRS issued Revenue Procedure 2002-22, specifying 15 conditions that must be satisfied in order for a co-ownership structure of real estate to be considered real estate, and not an interest in a business entity. This landmark guidance legitimized the Tenants-in-Common (TIC) structure for 1031 exchanges and launched a whole new industry.
Although Revenue Procedure 2002-22 is a guideline and not an actual law, TIC sponsors follow it closely to minimize the risk of a challenge by the IRS. The following is a summary of the 15 guidelines in Revenue Procedure 2002-22:
- Co-owners must hold legal title to the property as tenants-in-common directly or indirectly through a disregarded entity (such as a single member limited liability company).
- The number of co-owners may not exceed 35 (a husband and wife may be treated as a single co-owner).
- The co-ownership structure must not resemble a partnership. As such it may not file a partnership or corporate tax return, may not conduct business under a common name, may not execute a partnership or limited liability company agreement and may not otherwise hold itself out as a partnership or other form of business entity.
- Co-owners may enter into a limited co-ownership agreement.
- The co-owners must approve major decisions such as sale, lease, refinancing and the appointment of managing agents unanimously. Most other decisions require a majority vote of co-owners.
- Each co-owner must have the right to sell, partition and encumber (mortgage) his or her undivided interest in the property. However, restrictions required by a lender will generally not be prohibited. In addition, granting of a right of first offer prior to a sale to other co-owners, the program sponsor or the lessee of the property will be permitted. Finally, while co-owners must have the right to partition the property, this right may be made subject to a prior right of first offer (to other co-owners, the program sponsor or the lessee) at fair market value.
- Upon sale of the property, any mortgage debt must be satisfied and the remaining proceeds must be distributed to co-owners in accordance with their undivided interests in the property.
- Co-owners must share in all revenues and expenses of the property in proportion to their undivided interests. Except for short-term loans, loans among co-owners, or from the program sponsor, are not permitted.
- Mortgage debt generally must be shared in accordance with the co-owners' undivided interests.
- A co-owner may issue a call option to purchase its undivided interest as long as the exercise price is at fair market value at the time that the option is exercised (fair market value is determined with reference to the market value of the property as a whole, multiplied by the co-owner's undivided interest). A co-owner may not have the right to put its interest in the property to the program sponsor, another co-owner, lessee, lender or any person related to any of the foregoing.
- The activities of co-owners must be limited to those customarily performed in connection with the maintenance and repair of passive rental real estate.
- Co-owners may enter into property management and brokerage agreements, but such agreements may not subsist for more than one year (although they can be renewed). Management and brokerage agreements may be entered into with the program sponsor or another co-owner, but not a lessee of the property. The management agreement may authorize the manager to maintain a bank account for the collection of revenues and payment of expenses on behalf of all of the co-owners. Net revenues must be disbursed at least quarterly. The manager may also be given responsibility for certain accounting functions, as well as the responsibility for such matters as insurance, leases and mortgages (subject to the approval of co-owners). Fees paid to the manager must be market-based and may not be dependent on the income or profits from the property.
- All leases must be true leases for Federal tax purposes (rents must reflect the fair value for the use of the property). Percentage rents are generally prohibited, except for those that are based on a fixed percentage of a tenant's receipts or sales.
- The mortgage lender may not be related to any co-owner, program sponsor, property manager or lessee of the property.
- Payments to the program sponsor must reflect the fair market value of the acquired co-ownership interest and may not depend upon the income or profits derived from the property.