Ownership in real estate through a partnership as opposed to mere co-ownership (tenancy-in-common) can result in vastly divergent estate and income tax consequences. Either classification may at times be preferable to the other. Rev. Proc. 2002-22 provides guidance for taxpayers seeking an advance ruling with respect to such entity classification.
For example, exchanges of co-owned real estate qualify for tax-free treatment under IRC § 1031, but the exchange of one partnership interest for another, or for an interest in real estate, is a taxable sale. The ruling is significant since it supersedes earlier IRS policy which precluded such advance rulings as to whether a fractional interest in real property would be eligible for tax-free exchange treatment under § 1031. An element of certainty in planning for § 1031 exchange treatment is now possible — at least for those willing to comply with the ruling’s sometimes onerous conditions, discussed below. Even for those not willing to comply, the advice provides helpful guidelines and insight into the Service’s view of entity classification.
Classification can have the following other tax and legal implications:
¶ Partnership interests generate greater fractional interest discounts than do co-ownership interests. See e.g., Adams v. U.S., 99-1 USTC ¶60,340;
¶ Transfer tax liabilities under state law may differ;
¶ Tort liability under state law may be more pronounced for a co-tenancy, since no separate entity exists which could provide liability insulation;
¶ Deduction of losses under § 212 may only be possible in partnership form.
A co-tenancy for tax purposes can be a somewhat ethereal concept. Rev. Proc. 2002-22 provides that the central characteristic of a tenancy-in-common is that “each owner is deemed to own individually a physically undivided part of the entire parcel of property . . . [and] is entitled to share with the other tenants the possession of the whole parcel and has the associated rights to a proportionate share of rents or profits from the property.” However, when tenants-in-common engage in extensive business activities, a partnership may emerge for tax purposes. Regs. § 301.7701-1(a)(2) adds that a separate entity (i.e., a partnership) is created if the participants carry on a trade, business or financial operation and divide the profits therefrom, but notes “the mere co-ownership of property that is maintained, rented or leased does not create a separate entity for federal tax purposes.”
To obtain an advance ruling, facts relating to co-ownership must be disclosed. The following conditions must also be satisfied:
¶ Each co-owner must hold title to property as a tenant-in-common under local law (directly or through a disregarded entity) and no more than 35 persons may be co-owners;
¶ The co-owners may not (i) file a partnership or corporate tax return; (ii) conduct business under a common name; or (iii) hold themselves out as operating through a partnership or corporation;
¶ Unanimous consent of co-owners is required for precipitous events, such as the sale, lease or re-lease of a portion or all of the property, but only a majority vote is required for more routine events.
¶ Each co-owner must have the right to transfer, partition and encumber the co-owner’s undivided interest without the agreement or approval of any person.
¶ Each co-owner must share in all net revenues and debts;
¶ Call options must not take into account any fractionalization discounts.
For tax compliance purposes, each co-owner should be issued Form 1099s, and should report income on Schedule E of Form 1040. A TIN may be required if employees are hired. Form SS-4, box 8A, should be marked “other” and “co-ownership” should be indicated.
The Regs. requirement that co-tenants not conduct business under a common name is interpreted by the ruling as barring advertising and banking transactions. This sharply limits the ruling’s practicality. Similarly, the ruling bars co-owners from taking fractionalization discounts, perhaps to discourage its use in estate planning. Nevertheless, the ruling is by its own terms inapplicable to audits, where the compliance threshold is likely to be far lower. Thus, to the extent fractionalization discounts are economically justified, the intrepid taxpayer proceeding sans ruling could well possess a meritorious legal position.
The determination of whether a co-ownership or a partnership exists is a question of federal law. For example, California’s statutory presumption that title taken in co-ownership is not partnership property would have no bearing on the federal tax determination. Taxpayers should be alert to the possible irrelevance of state law in federal tax entity classification.