Many property owners seek to swap management-intensive property for property requiring no active management. However, triple net leased properties – the primary candidates for passive ownership – are generally unavailable for less than $1 million. Rev. Proc. 2002-22 ameliorated this problem by permitting a group of small investors to obtain an advance ruling with respect to the acquisition of larger replacement property in a § 1031 like-kind exchange. In appropriate circumstances, the IRS will regard undivided interests in real estate not as interests in a partnership, which interests cannot be acquired in a § 1031 exchange, but as Tenancy-in-Common interests (TICs) or Undivided Fractional Interests (UFIs).
The objective of the Rev. Proc. was to prevent the owners of TICs from avoiding the requirements of section 1031 by operating a business as a de facto partnership. Thus, the Ruling provides that co-owners may not file a partnership return or hold themselves out as being a partnership. Nor could there be any restrictions on alienability as might typically be found in a partnership agreement. The business activities among the co-owners were required to be limited to those customarily performed in connection with the “maintenance and repair” of rental real estate. The guidance provided the basis for a private letter ruling; it was not a substantive rule of law nor did it provide a “safe harbor” for such transactions.
Until recently, the IRS had issued little guidance with respect to how the taxpayer could meet the seemingly endless requirements imposed by Rev. Proc. 2002-22. After relinquishing property in a like-kind exchange, the taxpayer has only 45 days in which to identify a replacement property. Accordingly, as a practical matter the taxpayer has had to rely on tax opinions of counsel. On December 4, 2004, however, the IRS issued a Private Letter Ruling involving a multi-tenant net leased property with a blanket mortgage owned by no more than 35 co-owners, which sheds some light on the issue. The Ruling has not yet been officially published.
The Ruling implies that (i) the IRS will not view the multi-tenant aspect of the building as creating a partnership; (ii) a blanket mortgage will not violate the guidelines of Rev. Proc. 2002-22; and (iii) the power of the Manager to exercise discretion when leasing without obtaining the express consent of the owners will not cause the undivided fractional interest to fail to be eligible “replacement” property. The Ruling also implies that a Sponsor could retain an ownership interest for up to six months without causing the Sponsor’s activities in selling the Undivided Fractional Interests (UFIs) to the other co-owners to be attributed to those co-owners
In another recent ruling, the IRS expanded the scope of like-kind replacement property by equating interests in a Delaware Statutory Trust (DST) – the income from which, as a “grantor trust”, is considered earned by the owners of the DST interests – with actual ownership of real property. Thus, Revenue Ruling 2004-33 provides that the exchange of real property for interests in a Delaware statutory trust (DST) which owns real estate qualifies for exchange treatment under § 1031.
In the facts of the Ruling, an A borrows money on a note and purchases Blackacre. The note is secured by Blackacre. The individual then enters into a 10-year net lease, the terms of which require the tenant to pay all taxes, insurance, repairs and utilities. A then forms a Delaware statutory trust (DST), and contributes Blackacre to that trust. Upon contribution, the DST assumes A’s rights and obligations under the note and the lease to tenant. B and C then exchange Greenacre and Whiteacre for all of A’s interest in the DST through a qualified intermediary. A does not engage in a § 1031 exchange. Whiteacre and Greenacre were held for investment and are of like kind to Blackacre, within the meaning of § 1031.
The DST agreement provides that interests in the DST are freely transferable, but are not publicly traded on an established securities market. The trustee’s activities are limited to the collection and distribution of income, and the trustee may not exchange real estate or purchase assets (other than short-term investments), and is required to distribute all available cash (less reserves) quarterly to each beneficial owner in proportion to his respective interest in the DST.
Under Subchapter J of the Code (§§ 671 et seq.), i.e., the grantor trust provisions, each certificate holder is treated as the owner of an undivided fractional interest (UFI) in the DST, and is considered to own the trust assets attributable to that UFI of the DST for federal income tax
A Delaware statutory trust (DST) is an unincorporated association recognized as an entity separate from its owners. The trust may sue or be sued, and property within the trust is subject to attachment or execution as if the trust were a corporation. Beneficial owners of a DST are entitled to the same limitation on personal liability that is extended to stockholders of a Delaware corporation.
While § 1031(a)(2) provides that § 1031(a) does not apply to an exchange of interests in a partnership, exchanges of interests in a DST do not violate this rule, since the DST is not a business or commercial trust created by the beneficiaries simply as a device to carry on a profit, and is thus not subject to reclassification for federal income tax purposes as a partnership under Regs. § 301.7701-3. The DST provides that the trustee’s activities are limited to the collection and distribution of income. Accordingly, the DST would also not be subject to reclassification under Regs. § 301.7701-4(c)(1), which provides for such reclassication by reason of the authority vested in the Manager to enable a trust to take advantage of variations in the market to improve the investment of the investors. Comm’r v. North American Bond Trust, F.2d at 546. Since the trustee has no power to vary the investment of the certificate holders, the DST is an investment trust that will be classified as a trust for federal income tax purposes.
Persons receiving DST interests in exchange for real property are considered grantors of the DST when they acquire these interests (i.e., the replacement property) from the party acquiring their real estate (i.e., the relinquished property), and they are considered to own an undivided fractional interest in the real estate owned by the DST for federal income tax purposes.89 The Ruling, in blessing this type of exchange, concludes: Accordingly, the exchange of real property . . . for an interest in DST through a qualified intermediary is the exchange of real property for an interest in Blackacre, and not the exchange of real property for a certificate of trust or beneficial interest under § 1031(a)(2)(E). Because [the relinquished real property] is of like kind to Blackacre, and provided the other requirements of § 1031 are satisfied, the exchange of real property for an interest in DST . . . will qualify for nonrecognition of gain or loss under § 1031.
The trustee is required to distribute all available cash (less reserves for expenses associated with holding the real estate) to each beneficial owner in proportion to their respective interests in DST. Section 671 provides that where a grantor is considered the owner of any portion of a trust, the grantor must report on his own tax return items of income, deduction and credits attributable to that portion of the trust considered owned by the grantor. Under § 677(a), the grantor is treated as owner of any portion of a trust whose income without the approval or consent of any adverse party is, or in the discretion of the grantor or a nonadverse party, or both, may be distributed, or held or accumulated for future distribution, to the grantor or the grantor’s spouse. Regs. § 1.671-2(e)(1) provides that a person who is considered as the owner of an undivided fractional interest of a trust is considered to own the trust assets attributable to that undivided fractional interest of the trust for federal income tax purposes.