What is It?
It is a frequently recurring issue for those who advise the owners of rental real property, but one that is rarely raised by the owners themselves: does the ownership arrangement constitute a partnership for income tax purposes?
The question appears to be fairly straightforward – just ask any client. “We haven’t executed a partnership agreement, “ they may say, or “we haven’t filed a certificate of limited partnership, or articles of organization.” Therefore, there is no partnership.
Alternatively, they may respond that they have been filing partnership tax returns for years, on which they have been reporting the rental income and associated expenses of the “partnership.” Thus, there is a partnership.
Too often, the taxpayer-owners discover the likely consequences of their actions late in the game, when it may be difficult to redress any problems.
Why Does It Matter?
Taxpayers may be bound by the form of their agreed-upon ownership arrangement, if such form benefits the IRS.
On the other hand, the IRS is free to consider the facts and circumstances surrounding the ownership and operation of the real property for purposes of determining whether the ownership arrangement should be re-characterized as a partnership for tax purposes.
The availability of such facts and circumstances necessarily implies a history of dealings among the owners with respect to the property, on the basis of which the existence of a partnership may be determined. When this happens, it will usually be the case that the owners did not “intend” to form a tax partnership, and failed to consult with a tax adviser before engaging in such dealings.
As a result, taxpayers who believed they owned a TIC interest, the proceeds from the sale of which could be used to acquire replacement property as part of a like-kind exchange, instead find that what they owned was a partnership interest the sale of which does not qualify for like kind exchange treatment.
Fortunately, for the well-advised client, his or her adviser will be familiar with the factors on which the IRS has historically relied in establishing the existence of a partnership. Of course, this knowledge will only benefit the client if he or she consults the adviser before getting into trouble.
A recent IRS ruling describes a complex business arrangement that must have concerned the taxpayer and its advisers enough to lead them to seek the “opinion” of the IRS. [PLR 201622008]
Specifically, the taxpayer requested a ruling that undivided fractional interests in a property were not interests in a partnership for purposes of qualifying the undivided fractional interests as eligible relinquished property under the like kind exchange rules.
Taxpayer was a business entity that owned 100% of the fee title to Property. Taxpayer operated Property as a commercial rental property.
Taxpayer triple net leased Property to an unrelated third party (“Co-Owner”). Taxpayer represented that the lease for the Property was a bona fide lease for tax purposes and that the rent due under the lease reflected the fair market value (“FMV”) for the use of Property. Further, Taxpayer represented that the rent under the lease was not determined, in whole or in part, based on the income or profits derived by any person from Property.
Contemporaneously with the triple net lease, Taxpayer and Co-Owner entered into an Option Agreement under which Taxpayer had an option to sell any or all of its interest in Property to Co-Owner at any time before the fifth anniversary of the effective date of the Option Agreement (the “Put”). If Taxpayer exercised the Put with respect to a part of its interest in Property, it could exercise the Put again with respect to another part of its interest in Property and continue to do so until all interests in Property were transferred or the Put expired.
Under the Option Agreement, Co-Owner had an option to acquire the entire remaining interest then held by Taxpayer beginning on the seventh anniversary of the effective date of the Option Agreement, and ending X days later (the “Call”).
The purchase price for the exercise of the Put or the Call would be based on the FMV of Property at the time of the execution of the Option Agreement, increased at each anniversary date of such execution by Y% of the then-current exercise price, as increased by any prior Y% increases. Taxpayer represented that Y% was a reasonable appreciation factor for Property.
Within six months of executing the triple net lease and the Option Agreement, Taxpayer could exercise its right under the Put to sell a Z% tenancy-in-common (“TIC”) interest in the Property to Co-Owner. Taxpayer represented that neither co-owner would provide financing to the other to acquire a TIC interest in the Property.
When Taxpayer sold the Z% TIC interest to Co-Owner, Taxpayer and Co-Owner would either (i) refinance the existing indebtedness encumbering the Property by borrowing from an unrelated lender and creating a blanket lien on the Property, or (ii) cause the debt agreement to be amended to provide that the lien was a blanket lien and that the cost would be shared proportionately. Each co-owner would share the indebtedness on Property in proportion to that co-owner’s interest in Property.
Property would be owned by the Taxpayer and Co-Owner pursuant to a TIC agreement (the “Co-Ownership Agreement”) that would run with the land. Taxpayer represented that Taxpayer and Co-Owner would not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying the co-owners as members of a business entity, or otherwise hold themselves out as members of a business entity. The Co-Ownership Agreement would be consistent with these representations.
Under the Co-Ownership Agreement: any sale or lease of all or a portion of Property, any negotiation or renegotiation of indebtedness secured by a blanket lien, and the hiring of a manager, required the unanimous approval of the co-owners; all actions not otherwise required to be taken by unanimous consent would require the vote of co-owners holding more than 50 percent of the undivided interests in Property; there would be no buy-sell agreement; there would be no waiver of partition rights among co-owners unless required by the lender; a co-owner would be free to partition its interest in Property unless prohibited by the lender; a co-owner would be able to create a lien upon its own interest without the agreement or approval of any person, subject to the terms of the Co-Ownership Agreement, provided it did not create a lien on any other co-owner’s interest; in the event Property was sold or refinanced, each co-owner would receive its percentage interest in the net proceeds from the sale or refinancing of Property; upon the sale of Property, the co-owners would have to satisfy any blanket lien encumbering Property in proportion to their respective interests in Property; the Taxpayer and the Co-Owner would share in all revenues generated by Property and have an obligation to pay all costs associated with Property in proportion to their respective interests in Property; if either co-owner advanced funds necessary to pay expenses associated with Property, the other co-owner would have to repay such advance within 30 days of the date the expense, obligation, or liability was paid; to secure such an advance repayment obligation, each co-owner would grant each other co-owner a lien against such granting co-owner’s interest in Property and the rents and income therefrom and the leases thereof.
Taxpayer represented that the co-owners could, but were not required to, enter into a management agreement with Manager. The Co-Ownership Agreement would provide that the term of any management agreement entered into by the co-owners would be for one year, and would be automatically renewed for one-year periods unless either the Manager or any co-owner otherwise gave timely written notice to the other parties prior to the then-current expiration date.
Any such management agreement would: authorize the Manager to maintain a common bank account for the collection and deposit of rents and to offset expenses associated with Property against any revenues before disbursing each co-owner’s share of net revenues; provide that the Manager disburse the co-owner’s share of net revenues from Property within three months from the date of receipt of those revenues (subject to holding back reserves for anticipated expenses of Property, with each co-owner’s share of such reserves being proportionate to that co-owner’s interest in Property); authorize the Manager to prepare statements for the co-owners showing their shares of revenue and costs from Property; authorize the Manager to obtain or modify insurance on Property, and to negotiate modifications of the terms of any lease or any indebtedness encumbering Property, subject to the approval of the co-owners; provide that the fees paid by the co-ownership to the Manager would not depend in whole or in part on the income or profits derived from Property, and would not exceed the FMV of the Manager’s services.
Taxpayer represented that the activities of the Manager in managing Property would not result in non-customary services with respect to Property, taking into account the activities of the co-owners’ agents and any person related to the co-owners with respect to Property.
Taxpayer represented that the Co-Owner would acquire its interest in Property through the use of its own capital or through funds from an unrelated lender. Taxpayer also represented that, when the Put or Call was exercised, the Co-Owner would be required to pay the full purchase price of the interest in cash.
A Separate Entity?
Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.
A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture, and divide the profits therefrom, but the mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes.
The term “partnership” includes any joint venture or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of the Code, a corporation, trust or estate.
The IRS has enumerated certain conditions under which it would consider ruling that an undivided fractional interest in rental real property is not an interest in a business entity for federal tax purposes. The conditions relate to, among other things, TIC ownership of the property, number of co-owners, no treatment of the co-ownership as an entity, co-ownership agreements, voting by co-owners, restrictions on alienation, sharing of proceeds and liabilities upon sale of the property, proportionate sharing of profits and losses, proportionate sharing of debt, options, no business activities by the co-owners, management agreements, leasing agreements, and loan agreements.
TIC or Partnership?
The IRS determined that the Co-Ownership Agreement and Management Agreement would satisfy all of the conditions set forth above.
Regarding the condition that a co-owner may not acquire a put option to sell the co-owner’s undivided interest to another co-owner, the IRS distinguished the facts in the ruling, stating that the Put would not cause the fractional interests in Property to constitute interests in a business entity. The Taxpayer’s Put was not an option to sell an existing undivided interest that was previously acquired by the Taxpayer. Rather, the put option was an option to sell property held by the Taxpayer prior to entering into the proposed transaction.
Regarding the exercise price, and the requirement that the exercise price be the FMV at the time of exercise, the IRS found that the Y% appreciation factor adequately approximated the FMV of Property.
Regarding business activities, the IRS stated that the co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property. Activities will be treated as “customary activities” for this purpose if the activities would not prevent the amount received from qualifying only as rent, as opposed to compensation (in part) for services. In determining the co-owners’ activities, all activities of the co-owners, their agents, and any persons related to the co-owners with respect to the property are taken into account, whether or not those activities are performed by the co-owners in their capacities as co-owners.
The Taxpayer represented that the co-owners’ activities with respect to Property, conducted directly or through the Manager, would be limited to customary activities.
Based on the foregoing, the IRS concluded that, if Taxpayer sold a TIC interest in Property to Co-Owner, an undivided fractional interest in Property would not constitute an interest in a business entity for purposes of qualifying the undivided fractional interests as eligible relinquished property under the like-kind exchange rules.
Before You Act
Of course, there may be good business reasons for using an LLC; for example, a lender may require the use of a single business entity to hold the real property, or the business relationship among the owners may be such that the terms of a mere TIC agreement will not suffice.
However, it bears repeating: the mere co-ownership of real property that is maintained, kept in repair, and rented does not constitute a partnership for tax purposes. Too often, such an arrangement is formed as an LLC and is thereby treated as a partnership for tax purposes, subject to the rules and limitations applicable to such business entities.
Under certain conditions, however, an unincorporated organization may be excluded from the application of all or a part of the partnership rules. Such an organization must be availed of for investment purposes only and not for the active conduct of a business. The members of such organization must be able to compute their income without the necessity of computing partnership taxable income.
Where the participants in the joint purchase, retention, sale, or exchange of investment property: own the property as co-owners; reserve the right separately to take or dispose of their shares of any property acquired or retained; and do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange such investment property, then such group may elect to be excluded from the application of the partnership tax rules.
Any such unincorporated organization that wishes to be excluded from these rules must elect not later than the time prescribed (including extensions thereof) for filing the partnership return for the first taxable year for which exclusion from the partnership rules is desired.