Tenancy-in-Common Planning and Section 761(a) Consideration for 1031 Tax-Deferred Exchanges

Real estate investors often hold real estate in a tenancy in common. A tenancy in common is a form of property ownership where two or more individuals, known as tenants in common, own real property together, but hold the property with separate, distinct ownership shares. Like any other real estate investors, restate estate investors that hold real property in tenancy in common often exchange real property through a tax-deferred exchange under Section 1031 of the Internal Revenue Code.

Section 1031 of the Internal Revenue Code permits real estate investors to defer or postpone paying federal tax on the sale of real property if proceeds from the sale of real property are reinvested into similar property within 180 days.

A tenancy in common interest in real estate can be exchanged in tax-deferred exchange. However, a partnership interest in real property cannot be exchanged in a tax-deferred exchange. Thus, individuals holding real property in a tenancy in common must not go beyond mere co-ownership of the real property and engage in business together which could be construed by the Internal Revenue Service (“IRS”) as a partnership.

In order to make it clear to the IRS that a tenancy in common cannot be classified by the IRS as a partnership, the real property owners should enter into a written Tenants in Common Agreement and record the agreement. The tenants in common agreement should contain the following verbiage:

1. Nature of Relationship Between the Co-Tenants

1.1 Tenants in Common Relationship: No Partnership. The Tenants in Common each shall hold their respective undivided tenancy tenancy in common in the Property as tenants-in-common. The Tenants in Common do not intend by this Agreement to create a partnership or joint venture among themselves, but merely to set forth the terms and conditions upon which each of them shall hold their respective interests. In addition the Tenants in Common do not intend to create a partnership or joint venture with the Property Manager. Therefore, each Tenant in Common hereby elects to be excluded from the provisions of Subpart K of Chapter 1 of the Internal Revenue Code of 1986, as amended (the “Code”), with respect to the common ownership of the property. The exclusion elected by the Tenants in Common thereunder shall commence with the execution of this agreement.

1.2 Reporting as Direct Owners and Not a Partnership. Each Tenant in common hereby covenants and agrees to report on such Tenant in Common’s respective federal and state income tax returns all items of income, deduction and credits that result from its interests. All such reporting shall be consistent with the exclusion of the Tenants in Common from Subchapter K of Chapter 1 of the Internal Revenue Code, commencing with the first taxable year following the execution of this agreement. Further, each Tenant in Common covenants and agrees not to notify the Commissioner of Internal Revenue (“Commissioner”) that it desires that Subchapter K of Chapter 1 of the Internal Revenue Code apply to the Tenants in Common.

1.3 No Agency. No Tenant in Common is authorized to act as agent for, to act on behalf of, or to do any act that will bind, any other Tenant in Common, or to incur any obligation with respect to the Property.

Co-tenant property owners should also make an election under Section 761(a) of the Internal Revenue Code. Section 761(a) provides that certain unincorporated organizations, which would otherwise be classified as partnerships, may elect to be excluded from all or a portion of the provisions of Subchapter K, which governs partnership taxation. This means that the organization, while still existing, may not be treated as a partnership for tax purposes, allowing the co-tenants to determine and report their income directly to the IRS without having to file a partnership tax return. To be eligible for a Section 761(a) election, a tenancy in common organization must satisfy the following conditions: 1) the income of the co-tentants must be determined without computing partnership taxable income; and 2) the tenancy in common organization must be for investment purposes and not for the active conduct of a business.

A Section 761(a) election must be made by the co-tenants with the IRS. The election is made by filing a partnership return containing the information required by Treasury Regulation Section 1.761-2(b)(2)(i). The partnership return must provide the following information:

1. Certain identifying information of the organization and its members of qualification for the election;
2. A statement that the unincorporated organization qualifies under Treasury Regulation Section 1.761-2(a)(1) and either Treasury Reg. Sections 1.761-2(a)(2) or (3) (taking into account revised Treasury Regulation Section 1.761-2(a)(4) as applicable);
3. A statement that all of the members of the unincorporated organization elect to be excluded from all Subpart K;
4. A statement indicating where a copy of the agreement under which the organization operates is available.

Conclusion

Section 761(a) permits co-tenants holding real property an effective way to exchange their tenancy in common interest through a tax-deferred exchange. If you are a real property investor that is or will hold real property through a tenancy in common arrangement and are considering utilizing a tax-deferred exchange, you should consult with a competent tax attorney.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.