Tax Opinions in TIC Offerings and Reverse TIC Exchanges

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1 Brooklyn Law School From the SelectedWorks of Bradley T. Borden March 7, 2007 Tax Opinions in TIC Offerings and Reverse TIC Exchanges Brad Borden Todd D. Keator Available at:

2 TIC Offerings and TIC Exchanges 1 TAX OPINIONS IN TIC OFFERINGS AND REVERSE TIC EXCHANGES 23 REAL ESTATE J. 88 (March 7, 2007) Bradley T. Borden Todd D. Keator * TABLE OF CONTENTS I. INTRODUCTION... 2 II. DEVIATIONS FROM THE REVENUE PROCEDURE... 2 A. Common Deviations Deemed Consent Investor Loans Sponsor Guarantees Sponsor Bridge Loans B. Significant Deviations Multiple Properties Non-Pro Rata Debt Construction Activities Sponsor-Retained Interests III. REVERSE EXCHANGES INVOLVING TIC INTERESTs A. Securities Issues B. Contractual Issues C. Lender Approval IV. CONCLUSION * Bradley T. Borden is an associate professor at Washburn University School of Law in Topeka, Kansas. Todd D. Keator is an associate with Thompson & Knight LLP in Dallas, Texas Bradley T. Borden and Todd D. Keator.

3 2 Bradley T. Borden I. INTRODUCTION Tenancy-in-common ( TIC ) investments offer investors the ability to own small pieces of high-grade properties that do not require active management by the investors. Moreover, TIC investments, as undivided interests in real property, generally qualify as like-kind replacement property under Code Section For these primary reasons, the TIC marketplace has exploded. Investors seeking tax deferral, quality real estate, and passive involvement have flooded the market with approximately $11 billion of equity over the past four years. 2 Investors and their advisors tend to pay the most attention to analyzing the economics of the investment, with the tax nuances of the deal sometimes taking a back seat. With significant potential tax dollars at stake, however, investors and their advisors must understand the tax issues involved. This Article discusses two prominent issues arising in TIC offerings today: (1) deviations from Revenue Procedure , 3 and (2) the use of TICs as replacement property in reverse exchanges. II. DEVIATIONS FROM THE REVENUE PROCEDURE Everyone in the TIC industry is familiar with the Revenue Procedure (herein so called) that is, Revenue Procedure wherein the IRS set forth the conditions under which it will consider a request for a ruling that an undivided fractional interest in rental real property is not an interest in a business entity (such as a tax partnership). Commentators have discussed the conditions in the Revenue Procedure ad nauseam, 4 some of whom have been critical of the Revenue Procedure See Rev. Rul , C.B All references herein to the Code refer to the Internal Revenue Code of 1986, as amended. 2. OMNI Brokerage, TIC Talk (2nd Quarter 2006) C.B The 15 conditions generally are: (1) tenancy-in-common ownership; (2) no more than 35 co-owners; (3) no treatment as a business entity; (4) tenancy-in-common agreement; (5) unanimous consent for material decisions; (6) right to transfer, partition and encumber a tenancy-in-common interest, subject to certain exceptions; (7) sharing proceeds and liabilities upon sale of the property; (8) proportionate sharing of profits and losses; (9) proportionate sharing of debt; (10) fair market value call options, and limitations on put options; (11) customary activities, no business activities; (12) management and brokerage agreements; (13) bona fide leasing arrangements; (14) loan agreements; and (15) fair market compensation to sponsor. For a detailed discussion of the conditions, see Bradley T. Borden, Exchanges Involving Tenancy-In-Common Interests Can Be Tax Free, 70 PRAC. TAX STRATEGIES 4 (January 2003); Richard M. Lipton, New Rules Likely to Increase Use of Tenancy-in- Common Ownership in Like-Kind Exchanges, J. OF TAX N (May 2002); Terence Floyd Cuff, Rev. Proc and Section 1031 Exchanges Involving Tenancies-in-Common, REAL ESTATE TAX N (3rd Quarter 2002). 5. See, e.g., Terrence Floyd Cuff Rev. Proc and Section 1031 Exchanges Involving Tenancies-in-Common, 29 REAL ESTATE TAX N 148 (3d Quarter 2002); Bradley T. Borden, The

4 TIC Offerings and TIC Exchanges 3 Criticisms are twofold: First, the Revenue Procedure does not state substantive law in fact, it ignores substantive law. Second, because the Revenue Procedure merely provides ruling guidelines, it does not specify safe harbor rules for structuring TIC arrangements. It is, however, part of the public domain and tax advisors consider it. 6 Due to the relatively lengthy period of time required to obtain a letter ruling under the Revenue Procedure, almost all TIC deals are offered on the basis of a private tax opinion rendered by reputable tax counsel to the sponsor of the offering. The Revenue Procedure is by no means a safe harbor; however, attorneys representing TIC sponsors generally strive to adhere to it because, in the event of an examination by the IRS, it is likely that the IRS would consider the Revenue Procedure guidelines, together with existing cases and rulings, to determine whether the undivided interests under examination are interests in real estate or partnership interests for Federal income tax purposes. Further, tax counsel prefers to conform to the Revenue Procedure because deviations from it are likely to be considered material information that must be disclosed to investors, which can affect the TIC arrangement s marketability. Thus, the important question facing tax counsel is just how far from the Revenue Procedure may a TIC arrangement deviate? Is satisfying fourteen of the fifteen conditions sufficient? What about ten of the fifteen? Are certain factors more important than others? Answering questions such as these requires the judgment of tax counsel and affects the level of opinion given. The Revenue Procedure provides that the IRS may rule on a TIC arrangement that does not satisfy all of the conditions. The facts and circumstances must, however, clearly establish that such a ruling is appropriate. 7 Thus, a TIC arrangement need not meet all of the conditions in the Revenue Procedure to obtain a favorable ruling from the IRS. Tax counsel takes this flexibility into consideration when drafting opinion letters. An offering that meets all of the major conditions generally will warrant a should level opinion. Some opinion writers will provide a should opinion even if a TIC arrangement does not satisfy all of the Federal Definition of Tax Partnership, 43 HOUS. L. REV. 925 (2006), available for download at 6. See MCKEE, NELSON & WHITMIRE: FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS, 3.03[5] (2006) ( [The] ruling guidelines [of the Revenue Procedure] explicitly are not intended to be substantive rules and are not to be used for audit purposes. Nevertheless, given the pervasive uncertainty in this area and the critical nature of this distinction, particularly in the context of 1031 exchanges, it is predictable that practitioners as well as revenue agents will give great deference to these guidelines in planning and auditing transactions. While some of the guidelines may be viewed as not justifiable as a matter of substantive law, impossible to comply with in various circumstances, or simply too trivial to be relevant, the guidelines include a number of helpful rules and positions which practitioners will certainly cling to in planning and defending transactions.... ). 7. Revenue Procedure at 6.

5 4 Bradley T. Borden conditions. An offering that fails to satisfy certain conditions, however, may receive only a more likely than not tax opinion. 8 TIC arrangements that fail to satisfy all of the conditions of the Revenue Procedure deviate from it. We refer to deviations from the Revenue Procedure that do not prevent tax counsel from rendering a should level opinion as common deviations. We refer to deviations that may reduce the level of opinion as significant deviations. Because the Revenue Procedure neglects substantive tax law in a significant way, the Article also focuses on whether the deviations are significant from a substantive tax law standpoint. Regarding TIC arrangements, substantive tax law is concerned about whether an arrangement is a tax partnership or a tenancy in common. Numerous cases and rulings have addressed this issue, 9 but do not provide a uniform definition of tax partnership. They do, however, indicate that courts and the IRS traditionally look to the common law definition of partnership to determine whether an arrangement is a tax partnership. 10 This reliance on the common law definition of partnership has contributed to confusion regarding the definition of tax partnership. The common law definition of partnership causes confusion in tax law because the common law definition does not consider tax policy and it has no legal significance in itself. Its legal significance derives from many legal issues. Owner liability and alienability of an interest in co-owned property are two fundamental issues that give the common law definition of partnership legal significance. Members of a partnership are jointly and severally liable for the debts of the partnership; co-owners are not jointly and severally liable for the debts of the TIC arrangement. Thus, if a creditor of co-owned property wishes to bring a collection action against one or more of the owners, the creditor may claim that the arrangement is a partnership. If the arrangement is a partnership, then each co-owner is jointly and severally liable for the debts of the partnership. The co-owners may, however, be able to avoid liability by successfully claiming that the arrangement is a tenancy in common. 8. Sponsors offer the majority of TIC deals on the basis of a should level opinion. More likely than not opinions carry more tax risk and generally are not favored in the industry, unless the rate of return is sufficient to justify the increased risk. 9. Even more have addressed the tax partnership question in general. See Borden supra note 5 (estimating that the question has been at issue in at least 150 cases and rulings). 10. We use the term common law definition of partnership to refer generally to the definition of partnership that originated in common law and has since been incorporated into the definition of partnership in the Uniform Partnership Act, which all fifty states have adopted in some form. The definition in the Uniform Partnership Act is an association of two or more persons to carry on as coowners a business for profit.... Uniform Partnership Act, 101(6).

6 TIC Offerings and TIC Exchanges 5 Tenants in common may sell their interests in co-owned property and creditors of a tenant in common may acquire the tenant in common s undivided interest in the property through foreclosure. Members of a partnership may not sell interests in the partnership s property. Thus, a coowner wishing to dispose of an interest in the co-owned property will argue that the arrangement is a tenancy in common. To prevent the sale, the other co-owners may argue that it is a partnership. Similarly, creditors of the tenancy in common will argue that the arrangement is not a partnership to proceed against an interest in the property. The resolution of these issues (owner liability and alienability of interests) turns on whether the arrangement is a common law partnership or a tenancy in common. Courts rely upon the definition of partnership to make that determination. In the Revenue Procedure, the IRS turns the analysis on its head in many respects. Many of the ruling conditions contained in the Revenue Procedure are not part of the definition of partnership, but instead reflect the legal consequence of the partnership classification. For example, a condition of the Revenue Procedure is that each co-owner must have the right to freely dispose of its undivided interest. 11 The presence of such right turns upon whether the arrangement is a common-law partnership. It is not part of the definition of partnership. Thus, relying upon the conditions in the Revenue Procedure to determine whether an arrangement is a tax partnership is problematic, as more fully explained below. A. Common Deviations As the term implies, TIC arrangements often possess common deviations from the Revenue Procedure. The cause of such deviation is the impractical nature of many of the conditions. Business exigencies (e.g., the practicality of obtaining investor consents, sponsor-retained purchase options, or sponsor-provided bridge financing) often require that sponsors structure TIC arrangements in a manner that cannot satisfy all of the conditions of the Revenue Procedure. Common deviations generally will not prevent tax counsel to the sponsor from rendering a should level tax opinion. 1. Deemed Consent Two conditions of the Revenue Procedure address consent. First, the Revenue Procedure provides that certain material decisions (i.e., decisions to lease, sell or refinance the property, or to hire a property manager for the property) require unanimous consent. 12 Second, all other 11. Rev. Proc , Rev. Proc , 6.05.

7 6 Bradley T. Borden decisions may require consent of tenants in common holding more than fifty percent of the undivided interests in the property. 13 The Revenue Procedure is, however, silent regarding the manner in which the parties must provide consent. TIC arrangements often involve up to thirty-five investors, scattered about the country, with varying levels of sophistication and willingness to respond. When the sponsor notifies investors that a decision must be made (such as to sell the property or to renew the property management agreement), most investors will reply, but some may not. To account for such investors, standard TIC agreements contain a deemed consent provision, such as the following example from a standard TIC agreement: Whenever in this Agreement the consent or approval of the Tenants in Common is required or otherwise requested with respect to any decision, each Tenant in Common shall have a period of time (the Approval Period ) ending on the date that is seven days after the date the request for such consent or approval is given in which to give written notice of its approval or disapproval of such decision. Each Tenant in Common agrees to use its best efforts to timely respond to any request for consent or approval. If a Tenant in Common does not give written notice of its disapproval of such decision within the Approval Period, such inaction shall constitute approval of such decision by the Tenant in Common. It is unclear whether such deemed consent (or consent via inaction) satisfies the consent requirement of the Revenue Procedure. 14 If the Revenue Procedure requires actual consent, deemed consent provisions deviate from it. Opinion writers take the position that deemed consent is a common deviation because each co-owner retains the unfettered right to take action and thereby withhold consent. Moreover, two private letter rulings in recent years have endorsed the use of deemed consent provisions Id. 14. Deemed consent should, however, be legally binding. See Second Restatement of Contracts, 69(1)(c) ( where, because of previous dealings or otherwise, it is reasonable that the offeree should notify the offeror if he does not intend to accept ). 15. See P.L.R (March 7, 2003) ( Although not an affirmative consent, the notice requirement in Company s management agreement containing the right of any Co-owner to terminate the agreement at any time with just 60 days notice satisfies the conditions in 6.05 and 6.12 of Rev. Proc ); P.L.R (May 1, 2005) (noting that the deemed consent procedures allow each Co-owner to exercise the right of an owner of real property to control the use of the Property. ).

8 TIC Offerings and TIC Exchanges 7 Therefore, opinion writers generally provide a should opinion, even if a TIC agreement contains a deemed consent provision. If the period for response becomes unrealistically short (e.g., one day), however, the ability to consent may be considered illusory and will adversely affect the level of opinion. The origin of the Revenue Procedure s consent conditions is unclear. The common law definition of partnership does not speak to this. Common consent is the antithesis of centralized management. Common consent requires each owner to participate in decision-making. Under a centrally-managed arrangement, owners delegate management and decision-making authority. Centralized management was a condition courts considered in determining whether an arrangement was a tax corporation, 16 but it does not appear to be a part of the tenancy-in-common or tax partnership jurisprudence. Partnerships may require common consent for certain actions and partners may retain some management authority (all partners may participate in the management of a general partnership) or may delegate the decision-making authority (limited partners delegate much of their decision-making authority). Apparently the IRS incorporated an old tax corporation characteristic, which does not appear to have significance in the tax partnership context, into the Revenue Procedure. Because substantive tax law does not appear to prohibit management delegation among co-owners, an arrangement s failure to satisfy the common-consent condition should not weaken the tax opinion writer s position. 2. Sponsor Purchase Options In contrast to the consent conditions, the Revenue Procedure allows co-owners to individually grant call options on their undivided interests in the property, provided the strike price reflects fair market value. 17 This empowers the holder of the call option to unilaterally decide whether to purchase the optioned interest. Some TIC offerings come equipped with sponsor purchase options enabling the sponsor to purchase the undivided interests of all tenants in common at some point in the future for fair market value. The options, when viewed together, effectively give the sponsor the right to purchase the entire property from the tenants in 16. See United States v. Kintner, 216 F.2d 418 (9th Cir. 1954); Treas. Reg (2)(c) (as amended in 1960) (referred to as the Kintner Regulations ). 17. See Rev. Proc , 6.10 (permitting co-owners to issue call options on their undivided interests at fair market value the fair market value of the property multiplied by the owner s interest in the property determined at the time the option is exercised). Where the strike price does not reflect fair market value (e.g., a pre-set formulaic strike price that is unable to take into consideration market factors), the option may be construed as a back-end profit sharing arrangement for the sponsor. Tax opinion writers are concerned that such profit sharing may cause the arrangement to look more like a tax partnership.

9 8 Bradley T. Borden common without their unanimous approval, which appears to be a violation of the unanimous voting requirement for property dispositions. 18 Nonetheless, these options will not prevent the tax opinion writers from giving a should opinion. Tax opinion writers who rely upon the Revenue Procedure generally do not fret about the inconsistency the IRS created. The Revenue Procedure allows co-owners to sell call options on their undivided interests at fair market value. Tax opinion writers who rely upon the Revenue Procedure should be able to assume that the IRS anticipated this inconsistency and specifically allowed it. Moreover, substantive tax law does not prohibit tenants-in-common from issuing call options on their undivided interests in the property. In fact, if an arrangement is a tenancy in common, the co-owners would have the right to dispose of their property and to issue a call option on it. Thus, the potential violation of the consent conditions should not be a concern to the tax opinion writer. 3. Investor Loans The Revenue Procedure also requires loans between tenants in common, or from the sponsor to a tenant in common, to be with recourse to the tenant in common and, where the tenant in common is a disregarded entity, to the owner of such entity. 19 Most TIC agreements fail to comply with this later provision. Virtually all TIC deals are sold to investors through special purpose, single owner, disregarded entities ( SPEs ) that hold legal title to the undivided interests. 20 Although tenant-in-common loans generally are recourse to an investor s SPE, such loans rarely are recourse to the owner of such entity because investors generally refuse to acquire personal liability in a TIC offering. Tax opinion writers do not view this deviation 18. See Rev. Proc , Rev. Proc , Generally, these SPEs are LLCs wholly-owned by the investor, but in some states (in particular, Texas), the entities are limited partnerships wherein the investor owns 100% of an LLC that is the 1% general partner of the limited partnership, and the investor is also the 99% limited partner of the limited partnership. Either way, by using a disregarded entity, the investor may complete a valid like-kind exchange under section See Rev. Rul , I.R.B. 119 (July 29, 2004) (ruling that an eligible entity with two owners, one of which is disregarded for federal income tax purposes, by default is itself classified as a disregarded entity); P.L.R (February 13, 1998) (ruling privately that an investor who acquired replacement property through a disregarded LLC is treated as having directly acquired such replacement property for purposes of section 1031). As an aside, SPEs in Texas historically have been limited partnerships due to the Texas franchise tax. The Texas franchise tax has been replaced by a new margin tax going into effect on January 1, 2007, which has caused many in the TIC industry to believe that single-member LLCs have replaced limited partnerships as the investment vehicle of choice in Texas. We continue to believe, however, that, due to certain loop holes in the new margin tax, investors should continue to use limited partnerships as their SPEs in Texas.

10 TIC Offerings and TIC Exchanges 9 as problematic because the recourse to the owner requirement has no apparent source in substantive tax law and is contrary to the general treatment of disregarded entities. 4. Sponsor Guarantees The Revenue Procedure requires that the co-owners share in any indebtedness secured by a blanket lien on the property in proportion to their undivided interests. 21 Lenders may require the sponsor to guarantee certain nonrecourse carve-out obligations of the tenants in common. 22 If a carveout obligation is triggered and the tenant in common liable for such obligation fails to satisfy it, the lender will require the sponsor, as guarantor, to satisfy it. Some practitioners are concerned that the possibility that the sponsor would be required to repay a share of the loan, when the sponsor owns no portion of the property, could cause the loan to be non-pro rata. Nonetheless, tax opinion writers provide should level opinions despite this possibility. The sponsor guarantee does not appear to be a deviation from the Revenue Procedure, and, thus, should not create a partnership for tax purposes. 23 Guarantees are not deemed to be loans for tax purposes, unless the guarantor is more likely than not to have to repay the debt. 24 Thus, the guarantee should not cause the loan to be recharacterized as non-pro rata from the outset. 25 Moreover, as discussed further below, substantive tax 21. Rev. Proc , Non-recourse carve-outs typically include: (i) misapplication or misappropriation of rents, insurance proceeds or condemnation awards; (ii) misappropriation of personal property; (iii) waste or arson; (iv) fees or commissions paid to borrower in violation of the loan documents; (v) breach of environmental indemnities provided in the loan documents; (vi) fraud or misrepresentation, (vii) damage to or loss of any part of the property as a result of intentional waste by any borrower; (viii) criminal acts resulting in forfeiture, seizure or loss of any portion of the property; (ix) misapplication or misappropriation insurance proceeds, rent paid in advance or tenant security deposits; (x) failure to comply with the financing documents environmental requirements; (xi) the payment of fees or commissions to any tenant in common or any affiliate thereof at a time when the loan is in default; (xii) violation of the transfer restrictions in the loan documents; (xiii) any breach of the SPE covenants contained in the loan documents (other than with respect to trade payables or net worth requirements); (xiv) after an event of default, the removal of all or any portion of the personal property at the property in violation of the loan documents; and (xv) the filing of an action for partition. 23. See Joe Balestrieri & Co. v. Comm r, 177 F.2d 867 (9th Cir. 1949) (holding that a guarantee did not make the guarantor of a mining venture a tax partner). 24. See Merkel v. Comm r, 192 F.3d 844 (9th Cir. 1999) (holding that for purposes of determining section 108(a)(1)(B) insolvency a taxpayer must provide that it will be called upon to pay an obligation claimed to be a liability). 25. For analogous authority in the partnership context, see Treas. Reg (b)(6) and (f)(ex. 3) (assuming that all partners who have obligations to make payments actually perform those obligations, irrespective of net worth, and that guarantors of such obligations are not called upon to satisfy their guarantees).

11 10 Bradley T. Borden law does not require a pro rata sharing of the debt secured by the co-owned property. In fact, the idea of tenancy-in-common and alienability of property interests would support non-pro rata debt on the property. 5. Sponsor Bridge Loans The Revenue Procedure states that the lender with respect to any debt that encumbers the property or with respect to any debt incurred to acquire an undivided interest in the property may not be a related person to any co-owner, the sponsor, the manager, or any lessee of the property. Generally, with respect to the primary lender, this provision is not difficult to comply with. Problems may arise, however, with respect to sponsor bridge financing. It is quite common for a TIC offering to be under-subscribed at the first scheduled closing. In such situation, the sponsor typically looks for bridge financing to complete the purchase of the property from the third party seller. Bridge financing may come from an outside lender or from the sponsor itself. Sponsor-provided bridge financing often will be extended from the sponsor (or an affiliate) to the particular sponsor affiliate (i.e., the feeco entity) undertaking the offering to enable feeco to acquire the unsold undivided interests in the property, which it will hold until such interests can be resold. Such bridge financing technically contravenes the Revenue Procedure. 26 The Revenue Procedure probably did not intentionally target sponsor loans to a sponsor affiliate (feeco) to enable the affiliate to take down the property. Rather, it is more likely that the Revenue Procedure seeks to prevent loans from the sponsor or an affiliate to the investors to enable them to acquire their undivided interests. Therefore, sponsor bridge loans to an affiliate generally do not prevent tax counsel from rendering a should level opinion that the undivided interests constitute interests in real property and not interests in a partnership for tax purposes. B. Significant Deviations Tax opinion writers take other deviations a bit more seriously. These significant deviations may cause the tax opinion writer to provide a more likely than not opinion instead of a should opinion. 1. Multiple Properties 26. Section 6.14 of the Revenue Procedure is poorly worded. Under a technical reading, for example, a loan from a father to a son to enable the son to make an equity investment in a TIC interest also is prohibited. There is no apparent basis in the substantive law for such a prohibition.

12 TIC Offerings and TIC Exchanges 11 According to the Revenue Procedure, even if a TIC arrangement satisfies the fifteen conditions to obtain a ruling, the IRS may decline to issue a ruling whenever warranted by the facts and circumstances and whenever appropriate in the interest of sound tax administration. 27 Further, under the Revenue Procedure, where multiple parcels of property owned by the co-owners are leased to a single tenant pursuant to a single lease agreement and any debt of one or more co-owners is secured by all of the parcels, the IRS generally will treat all of the parcels as a single property. In such a case, the IRS generally will not consider a ruling request under the Revenue Procedure unless: (1) each co-owner s percentage interest in each parcel is identical to that co-owner s percentage interest in every other parcel; (2) each co-owner s percentage interests in the parcels cannot be separated and traded independently; and (3) the parcels of property are property viewed as a single business unit (generally, contiguous parcels or parcels bearing a close connection between the business use of one parcel and the business use of another parcel, such as an office building and parking garage that services the tenants of such building) (herein the Three Conditions ). 28 The Three Conditions appear to apply only to multiple property offerings where the multiple parcels of property are leased to a single tenant pursuant to a single lease and the debt is secured by all of the parcels. In such a case, the IRS will treat the parcels as a single property and will consider a ruling request only if the Three Conditions are satisfied. But what about multiple property TIC offerings where the debt is secured by all parcels but each parcel is leased to a separate tenant pursuant to separate lease agreements? As an example, how should the Revenue Procedure be applied to a situation involving TIC interests in multiple, noncontiguous apartment complexes, together subject to one blanket lien, each master-leased to a separate master tenant and sold to investors as stapled, identical percentage interests through a single offering? Based on the language of Section 4 of the Revenue Procedure, the IRS apparently would not treat such parcels as a single property because they are not leased to a single tenant pursuant to a single lease. Therefore, such an arrangement should not need to satisfy the Three Conditions in order to be eligible for a ruling. Instead, the fifteen conditions should apply separately to each property. On the other hand, the packaged-nature of the undivided interests and the blanket lien secured by all properties may cause the IRS to recharacterize the undivided interests of each tenant in common as a single interest in a partnership holding multiple parcels of property. Such recharacterization might be possible because, under the aggregate view 27. Rev. Proc , Id.

13 12 Bradley T. Borden of partnerships, a partnership interest represents an undivided interest in the partnership s assets, which is similar to bundled TIC interests in multiple properties. 29 Commentators have questioned the basis for such potential recharacterization under substantive law because substantive law does not address this issue. 30 If the IRS asserted that, due to their packaged nature, the undivided interests in the multiple parcels were partnership interests, it is possible that the multiple properties would be viewed as a single property, and thus that the argument for partnership treatment under the aggregate view of partnerships would vanish, if the Three Conditions could be satisfied. In the example above, however, it is not clear whether the arrangement satisfies all of the Three Conditions. The arrangement clearly satisfies the first two of the Three Conditions because each co-owner s undivided interest in each property is identical and the undivided interests cannot be separated and traded independently. However, it is questionable whether the arrangement satisfies the single business unit condition. On the one hand, the apartment complexes are not contiguous and are capable of operating independently, which may indicate that the properties are not a single business unit. On the other hand, if the properties are of a similar type or use, share centralized management and a common business plan, and create synergies or economies of scale, such facts may indicate a single business unit. If a TIC arrangement involving multiple properties does not clearly satisfy the Three Conditions, it is more likely that the IRS would recharacterize the undivided interests in the multiple properties as interests in a tax partnership. For these reasons, multiple property offerings that fail to meet the Three Conditions (in particular, the single business unit condition) are considered to carry more tax risk and are likely to receive a more likely than not opinion. 2. Non-Pro Rata Debt The Revenue Procedure requires co-owners to share in any indebtedness secured by a blanket lien in proportion to their undivided 29. See MCKEE, NELSON & WHITMIRE: FEDERAL TAXATION OF PARTNERSHIPS & PARTNERS, 1.02 (2006) ( Subchapter K represents a blending of two views as to the nature of partnerships. The first view is that a partnership is simply an aggregation of individuals, each of whom should be treated as the owner of a direct undivided interest in partnership assets and operations. This is sometimes referred to as the aggregate or conduit view of partnerships. ). 30. See Cuff, Research Can Prevent an Investment in a Ticky Tacky TIC, 33 J. Real Est. Tax n No. 04 (3rd Quarter 2006) ( TICs constructed with bundled tenancy interests in multiple properties (or that arguably involve bundled tenancy interests in multiple properties) might be challenged by the IRS and possibly treated as tax partnerships, although why including several noncontiguous properties in the TIC should make a difference under substantive law is unclear. ).

14 TIC Offerings and TIC Exchanges 13 interests. 31 In clear violation of this requirement, some TIC offerings use non-pro rata debt structures. The primary reason is to allow investors to customize the level of replacement debt they obtain in their Code Section 1031 exchanges. As the following example demonstrates, non-pro rata sharing of debt, alone, should not automatically create a partnership. Assume that a TIC arrangement consists of two investors, Alvin and Brenda. They acquire a piece of land for $10 million. Alvin invests $1 million cash out of his personal funds and borrows the remaining $4 million from a thirdparty lender in a loan that is secured by Alvin s share of the property. Brenda invests $2 million cash out of his own funds and borrows the remaining $3 million from a third-party lender in a loan that is secured by Brenda s share of the property. Such an arrangement would not violate the Revenue Procedure because there is no blanket lien on the property. Now assume that Anne borrows $7 million to purchase property for $10 million. Anne immediately sells a fifty percent undivided interest in the property to Bill in exchange for $2 million cash and Bill s assumption of $3 million of the loan. As a result, Anne is liable for $4 million of the loan, and Bill is liable for $3 million of the loan. Thus, Anne and Bill share non-pro rata in indebtedness that is secured by a blanket lien on the property, in violation of the Revenue Procedure. Yet, Anne and Bill s situation is economically similar to Alvin and Brenda s, which did not violate the Revenue Procedure. Substantive tax law does not provide that non-pro rata debt sharing is a factor that indicates tax partnership status. Different co-owners may have different financial risks that would affect the amount of money that lenders would lend to the respective individual co-owners. This, however, should not affect whether the arrangement is a tenancy-in-common or a tax partnership. Despite the baselessness of the pro-rata debt requirement, tax opinion writers view non-pro rata debt as a significant deviation from the Revenue Procedure that has a material impact on the economic rights and obligations of the co-owners. 32 Therefore, the presence of non-pro rata debt is likely to result in a more likely than not tax opinion. 3. Construction Activities 31. Rev. Proc , One Author has previously stated that the definition of tax partnership should reflect the policy for the partnership tax rules. Under policy, the partnership tax rules should apply only if an arrangement must compute taxable income at the partnership level for administrability reasons. See Borden supra note 5. The economic rights and obligations of the members of an arrangement become important in the tax partnership classification only if they affect the ability of the members to compute taxable income from the co-owned property individually.

15 14 Bradley T. Borden The Revenue Procedure requires that the co-owners activities be limited to those customarily performed in connection with the maintenance and repair of rental real property, and cites Revenue Ruling as an example of what constitutes customary activities (i.e., heat, air conditioning, trash removal, unattended parking, and maintenance of public areas). 34 Moreover, the Revenue Procedure provides that activities will be treated as customary activities for purposes of the Revenue Procedure if the activities would not prevent an amount received by an organization described in Code Section 511(a)(2) (i.e., a tax-exempt organization) from qualifying as rent under Code Section 512(b)(3)(A) (relating to the exclusion of rents from real property from the computation of unrelated business taxable income ) and the regulations thereunder. Thus, the Revenue Procedure specifically permits tenants in common to conduct those activities that would not prevent income received by a tax-exempt organization from qualifying as rents from real property. Construction activity clearly is not contemplated in the customary activities described in Revenue Ruling ; however, Revenue Ruling is not the extent of the substantive tax law in this area. Substantive tax law allows significant activity by co-owners, so long as it merely supports the income-producing function of the property and the co-owners do not contribute the services required by the activity. 35 In fact, the regulations provide that parties may engage in significant activity, so long as the activity is merely a cost-sharing activity. 36 Case law and rulings draw a distinction between activities that support the income-producing function and other activities. 37 If co-owners pay fair market value for services that support a property s income-producing function, those activities should not affect the arrangement s classification. 38 Thus, co C.B The no business activities test appears frequently in the case law. See Estate of Levine v. Comm r, 72 T.C. 780 (1979), aff d, 634 F.2d 12 (2d Cir. 1980) (partnership found where parties engaged in an active business, performed various services, and shared the gains and losses. ); Marinos v. Comm r, 58 T.C.M. 97, 100 (1989) ( [T]he distinction between mere co-owners and co-owners who are engaged in a partnership lies in the degree of business activity of the co-owners or their agents. ); McShain v. Comm r, 68 T.C. 154 (1977) (leasing under a net lease not sufficient activity to make coowners tax partners); Gabriel v. Comm r, 66 T.C.M (1993) (finding that an arrangement with little or no business activity was not a tax partnership). Nonetheless, the degree of activity is a weak test that has no real utility. See Borden supra note 5 (forthcoming) (concluding that the type and source of activity have more relevance in tax partnership classification than does the degree of activity). 35. See Gilford v. Comm r, 201 F.2d 735 (2d Cir. 1953); Estate of Appleby v. Comm r, 41 B.T.A. 18 (1940). 36. See Treas. Reg (a)(2) (providing that a joint undertaking merely to share expenses does not create a separate entity for federal tax purposes. ). 37. See Borden supra note See id.

16 TIC Offerings and TIC Exchanges 15 owners improving property to enhance its rental-income-producing function should not cause the arrangement to be a tax partnership. Buying, improving, and selling property indicates that the property owner is a dealer in real property. 39 Co-owners who are dealers would likely be engaged in a business for profit and be partners under substantive tax law. 40 Moreover, co-owners who construct property at the behest of a tenant, in exchange for a construction fee, also would likely be engaged in a trade or business of constructing property, which they should be able to separate from the ownership function. The Tax Court, however, has specifically held that co-owners who demolished a building, constructed a parking garage to maximize income, and leased it are not partners. 41 The court stated: The evidence shows that the garage was not operated by the taxpayers, and the postulate of the Commissioner s determination is not correct. They built it at the suggestion of two automobile dealers, for the purpose of leasing it to them, and the lessees operated it. Petitioners were merely the owners of the property, which was improved and rented primarily to defray the taxes. 42 Thus, under substantive law, co-owners who construct improvements on co-owned property in order to maximize the income-producing function of the property should not be tax partners. Moreover, the authorities interpreting Code Section 512(b)(3)(A) generally permit tax-exempt organizations to engage in real estate development activity without such activity tainting the status of the rental income derived from such property. For example, in G.C.M , 43 the 39. See Suburban Realty Co. v. United States, 615 F.2d 171(5th Cir. 1980). 40. See Podell v. Comm r, 55 T.C. 429 (1970) (purchase, renovation and resale of 14 buildings over two year period constituted trade or business). 41. Estate of Appleby v. Comm r, 41 B.T.A. 18 (1940). 42. Id. See also Powell v. Comm r, 26 T.C.M. (CCH) 161 (1967) (finding that arrangement among co-owners of property did not amount to a partnership even where the activities of the coowners with respect to the property involved demolishing walls); Jerry Hall, 65 T.C.M (1993) (finding no partnership where taxpayer purchased property and transferred a thirty percent undivided interest in the property to a carpenter in exchange for the provision of restoration services on the property). If co-owners construct improvements and use the property to produce something and distribute it to the co-owners in kind, such activity may be deemed sufficient to create a tax partnership. See Madison Gas & Electric Co., 72 T.C. 521 (1979), aff d, 633 F.2d 512 (7th Cir. 1980) (holding that construction and operation of nuclear power plant by co-owners was a tax partnership); TAM (August 21, 1979) (determining that a co-ownership arrangement to construct and operate a pipeline was a tax partnership); P.L.R (March 31, 1979) (ruling privately that a co-ownership to construct and operate a coal conversion plant was a tax partnership). 43. January 6, 1975.

17 16 Bradley T. Borden Estate, a tax exempt entity under Code Section 501(c)(3), in an effort to increase its return on an investment in land, conducted an ongoing program of real estate development and leasing. At issue was whether the substantial amount of leasing and land development activities engaged in by the Estate is a sufficient basis for revocation of its exempt status. 44 According to the IRS: At issue in the instant case is the taxability of income derived by the Estate from property that it owns and actively develops. Technically stated, the issue is whether the income derived from land owned and actively developed by the Estate constitutes rents from real property within the meaning of Code 512(b)(3)(A)(i) and is therefore excluded from the Code 512(a)(1) computation of unrelated business taxable income, upon which a tax is imposed by Code 511(a). 45 After a review of the applicable law, the IRS concluded that the payments received by the Estate from its leasing and land development activities are rents in form and in substance and that it failed to discover any information indicating that the development contracts and master lease agreements thus far entered into by the Estate... are, in contemplation or in operation, either agency agreements or partnership, joint venture or other profit-sharing arrangements. 46 Because there was no indication of an intent to enter into any relationship other than that of lessor-lessee, the IRS ruled that as described by the general information thus far submitted, the rents received by the Estate fall within the Code 512(b)(3)(A)(i) modification and are therefore excluded from the tax on unrelated business taxable income Id. 45. Id. (emphasis added). 46. Id. 47. Id. See also P.L.R (January 19, 1993) (finding no unrelated business taxable income where a tax-exempt organization constructed medical offices and leased space to physicians); P.L.R (October 2, 1998) (ruling that rental income derived from property constructed by a tax-exempt entity was excludable from UBTI pursuant to Code Section 512(b)(3)). Further, in the context of real estate investment trusts ( REITs ), as one of two exclusions, Code Section 856(d)(7)(C)(ii) excludes from the definition of impermissible tenant service income any amount which would be excluded from unrelated business taxable income under section 512(b)(3) if received by an organization described in section 511(a)(2). Thus, the test under the Revenue Procedure for whether activities engaged in by tenants in common are customary is the same as the foregoing test for whether income received by a REIT is excluded from the definition of impermissible tenant service income. Numerous rulings have allowed REITs to construct and lease real property without finding that the income stream constituted impermissible tenant service income. See P.L.R (July 15, 2005); P.L.R (March 5, 2004); P.L.R (December 20, 1996). See also Rev. Rul , C.B. 252 (trustees of a REIT may make decisions and negotiate contracts with

18 TIC Offerings and TIC Exchanges 17 Under the Revenue Procedure, tenants in common likewise are permitted to engage in activities that would not prevent income received by a tax-exempt organization from qualifying as rent. Based on substantive tax law, tenants in common should be permitted to hire a contractor to construct or rehabilitate property and lease the improved property without the TIC arrangement being recharacterized as a tax partnership. 48 Despite this legal support for tenant-in-common construction activities, tax opinion writers err on the side of caution and generally do not provide more than a more likely than not opinion if the co-owners engage in construction activities on co-owned property. The reason for such conservatism is that tax opinion writers are concerned that construction activities clearly go beyond the customary activities set forth in Revenue Ruling and are not likely to be the type of activity contemplated by the IRS when it published the Revenue Procedure. Without more direct guidance regarding construction activity by tenants in common, opinion writers provide more likely than not opinions for tenants in common who construct improvements on co-owned property. 4. Sponsor-Retained Interests In addition to mandating that tenants in common engage only in customary activities, the Revenue Procedure states: 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 will be taken into account, whether or not those activities are performed by the co-owners in their capacities as co-owners. For example, if the sponsor or a lessee is a co-owner, then all of the activities of the sponsor or lessee (or any person related to the sponsor or lessee) with respect to the Property will be taken into account in determining whether the co-owners activities are customary activities. 49 respect to the construction of an office building to be held as an investment asset for the production of rental income without adversely affecting the REIT s qualification under Code Section 856). 48. It should be noted that the money to finance such construction is not likely to come from investor 1031 exchange proceeds due to the 180-day time limitation of Code Section 1031(a)(3)(B). Generally, such funds must come either from investor cash (other than 1031 proceeds), a construction loan or a combination of both. In such a case, even if the investors are found to be in a tax partnership with respect to the construction activity, they nevertheless should be considered co-owners with respect to the original, unimproved property purchased with their 1031 exchange proceeds. See Borden supra note Rev. Proc , 6.11.

19 18 Bradley T. Borden For purposes of the foregoing, a related person generally means a person bearing a relationship described in Code Section 267(b) or 707(b)(1). 50 In many TIC offerings, for economic or marketing reasons, sponsors like to keep an undivided interest in the property, thus becoming a tenant in common with the outside investors. The issue with these sponsorretained TIC interests is whether the other activities of the sponsor constitute non-customary activities that taint the interests of all investors. For example, a sponsor may retain an undivided interest through a majority-owned, single purpose entity ( SponsorCo ). The sponsor may also own a majority of the master tenant or property manager of the property ( ManagerCo ). For tax purposes, SponsorCo and ManagerCo are related persons. Therefore, if ManagerCo provides any non-customary services to tenants of the property (e.g., coin-operated laundry, vending machines, valet parking, day care service, dry cleaning service, etc.), such activities will be attributed to SponsorCo. As a tenant in common, SponsorCo will be in violation of the no business activities condition of the Revenue Procedure, which taints the interests of all tenants in common. For investors who are concerned that this condition has legal significance, they should enquire as to whether a sponsor affiliate will engage in non-customary activities. To prevent deviation from the Revenue Procedure, sponsors who retain interests should either (i) disaffiliate the entity through which the interest is retained (e.g., SponsorCo) from any other affiliate conducting business on the property (e.g., ManagerCo) 51 and require that ManagerCo separately charge the tenants for the additional services, or (ii) ensure that no person related to the sponsor conducts business activities on the property. Substantive tax law should not prohibit a co-owner from providing customary services with respect to the property, as long as the service provider is paid fair market value for the services provided. 52 Paying a coowner fair market value for customary services is analogous to paying an unrelated party to provide the services. In either case, because the service provider does not contribute services to the arrangement, the provision of 50. Rev. Proc , 4. Such relationships generally include members of a family, an individual and a corporation more than fifty percent of which is owned by such individual, two corporations that are members of the same controlled group, a corporation and a partnership if the same persons own more than fifty percent of the equity in each, two S corporations where the same persons own more than fifty percent of the stock in each, an S corporation and a C corporation if the same persons own more than fifty percent of the stock in each, a partnership and a person owning more than fifty percent of the capital or profits interest in such partnership, and two partnerships in which the same persons own more than fifty percent of the capital or profits interests. 51. Disaffiliation generally may be achieved by reducing the sponsor s (including any persons related to the sponsor) equity ownership in either the entity that will hold the undivided interest, or the entity that will conduct the non-customary activities, to under fifty percent. 52. See Borden supra note 5.