Introduction

            Sellers of rental property intending to effect tax-deferred exchanges pursuant to IRC Section 1031 (“Exchangors”) frequently seek to acquire other properties (“Replacement Properties”) which entail little or no active management. In this respect, triple net lease properties can be ideal Replacement Properties. Frequently, however, such properties are too expensive for individual Exchangors. Furthermore, many Exchangors are deterred by the perceived risk of putting all of their eggs into a single tenant basket. 

            As a result, an entire industry recently has sprung up offering undivided fractional interests (“UFIs”) [1] in triple net lease properties. Typically, a person or entity (the “Sponsor”) purchases or options a number of properties, divides each of them into UFIs and then sells the UFIs. (The purchasers of the UFIs are referred to as the “Co-owners.”) In this way, Exchangors are able to acquire interests in one or more triple net lease properties, in percentage amounts that fit their budgets and on schedules that meet their timetables. 

            However, the structuring of many UFIs leaves them at risk of being characterized as disguised partnership interests by the IRS, which would result in the Co-owners being treated as partners. Since real property may not be exchanged for a partnership interest[2] such a re-characterization could be disastrous for Exchangors owning those UFIs.

            Understandably, Sponsors would like to eliminate this risk by obtaining advance rulings from the IRS that the UFIs will not be treated as partnership interests. Prior to October 11, 2000, the IRS issued such rulings.[3] On that date, however, the IRS announced that it would no longer do so.[4]

            Recently however, the IRS has announced, in Rev. Proc. 2002-22,[5] that, once again, it will issue advance rulings as to the tax classification of UFIs. This revenue procedure lists the documents which must be supplied and the tests which must be met in order to obtain such rulings. Of course, even if UFIs fail to meet one or more of those tests, they will not necessarily be deemed to be partnership interests by the IRS on audit or, if such disputes are litigated, by the courts. It only means that advance rulings cannot be obtained.

The Background of Rev. Proc. 2002-22

            Rev. Proc. 2002-22 lays out the ways in which the IRS and the courts have categorized UFIs in the past. The IRS’ own regulations state that mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity (such as a partnership) for federal tax purposes.[6] Furthermore, in 1975, the IRS issued a very liberal ruling,[7] which held that a particular two person co-ownership of an apartment building did not constitute a partnership for tax purposes despite the fact that:

…the co-owners employed an agent to manage the apartments on their behalf; the agent collected rents, paid property taxes, insurance premiums, repair and maintenance expenses, and provided the tenants with customary services, such as heat, air conditioning, trash removal, unattended parking, and maintenance of public areas. … .the agent’s activities in providing customary services to the tenants…were not sufficiently extensive to cause the co-ownership to be characterized as a partnership.[8]

            By contrast, an important Ninth Circuit Court of Appeal case, Bergford v. Commissioner,[9] held that a particular ownership structure did constitute a partnership for tax purposes. That case involved 78 investors who purchased UFIs in net leased computer equipment:

…the co-owners authorized the manager to arrange financing and refinancing, purchase and lease the equipment, collect rents and apply those rents to the notes used to refinance the equipment, prepare statements, and advance funds to participants on an interest-free basis to meet cash flow. The agreement allowed the co-owners to decide by majority vote whether to sell or lease the equipment at the end of the lease. Absent a majority vote, the manager could make that decision. In addition, the manager was entitled to a remarketing fee of 10 percent of the equipment’s selling price or lease rental whether or not a co-owner terminated the agreement or the manager performed any remarketing. A co-owner could assign an interest in the co-ownership only after fulfilling numerous conditions and obtaining the manager’s consent.[10]

            Thus, some but not all UFIs constitute partnerships under federal tax law. Partnerships are created where parties join together with the intent of conducting a business and of sharing profits and losses, especially if the economic benefits to the participants are not proportional to the UFIs.[11]

Information to be Submitted

            Rev. Proc. 2002-22 sets forth an extensive list of documentation that must be provided to the IRS for it to consider issuing a ruling.[12] This includes information as to the relationships among the Sponsor, lessee, manager and lender; all promotional documents relating to the sale of UFIs; all lending documents; the lease agreement, purchase and sale agreement, property management agreement and brokerage agreement; and all agreements among the Co-owners.

Conditions for Obtaining Rulings

            Fifteen conditions must be satisfied before the IRS will issue an advance ruling. Some of those conditions are uncontroversial, such as the requirement that the Co-owners must hold title to the property as  tenants-in-common under local law[13] and that the co-ownership may not conduct business under a common name or file a partnership or corporate tax return.[14]

            Some of the conditions arguably are even more liberal than is justified by existing law. For example, the co-ownership agreement may permit certain decisions to be made by a majority vote of the Co-owners.[15] It also may require each Co-owner to give the other Co-owners, the Sponsor or the lessee a right of first refusal before either selling his UFI or filing a partition action.[16] The Sponsor may be given a call option as to each UFI (i.e., an option to compel Co-owners to sell their UFIs to the Sponsor.)[17] Finally, the Sponsor and its affiliates may own UFIs and they are permitted to act as manager of the property and as real estate broker in the sale or leasing of the property.[18]

            Nonetheless, Rev. Proc. 2002-22 is likely to be anathema to many Sponsors because of several of the conditions that it imposes. First, the number of Co-owners is limited to 35 persons.[19] The IRS easily (and justifiably) could have chosen a less restrictive limitation on the number of Co-owners, such as 75 (as allowed for “small business corporations”)[20] or 100 (as permitted for entities called “electing large partnerships”).[21] In fact, there is no compelling need under existing law for there to be any numerical restriction.

            Even more significant, the Co-owners must retain the right to approve the hiring of any manager, the sale or other disposition of the property, the leasing of the property, and the creation or modification of any lien against the property. Furthermore, none of these actions can be taken without the unanimous approval of the Co-owners.[22]  Sponsors are specifically precluded from circumventing these voting requirements by obtaining blanket powers of attorney.[23]

            In addition, significant controls must be placed as to the management of the property. The manager must disburse to the Co-owners their shares of net revenue every quarter.[24] Fees paid to managers may not be determined in any way by any Co-owner’s income or profits. All management and brokerage agreements must be renewable no less frequently than annually.[25]

            Furthermore, Co-owners must share in all revenues and all costs of the property in proportion to their undivided interests in the property.[26] This prevents Sponsors from acquiring UFIs as promotional interests. Co-owners also must be responsible for their pro-rata share of all blanket indebtedness against the property.[27]

            Finally, payments and fees paid to Sponsors may not depend in any way on the income or profits derived by any Co-owner.[28] This precludes compensating the Sponsor with fees subordinated to a return of capital to the Co-owners.

Conclusion

            Now that Rev. Proc. 2002-22 has been issued, Exchangors should steer clear of  UFIs which have not been pre-approved by the IRS.[29] By acquiring only UFIs as to which Sponsors have obtained advance rulings, Exchangors can eliminate a significant tax concern.

            Sponsors who are unable to meet the conditions of Rev. Proc. 2002-22 probably will argue that both the IRS (on audit) and the courts (in legal actions against the IRS) are likely to take a far more liberal position than does Rev. Proc. 2002-22. Although this may turn out to be the case, why should any Exchangor take that risk?