Fractional Interests in Property

Editor: Mark G. Cook, CPA, MBA, CGMA

The high cost of real estate may make the prospect of investing in real property ownership seem impossible to many. However, it also encourages people to think creatively to surmount this obstacle. Examples of creative avenues to allowing otherwise prohibitive property investment include establishing a partnership, engaging in a joint venture with someone who has a surplus of capital, or becoming a tenant in common in a property purchase.

This item discusses a tenancy in common and what this type of ownership entails. It also addresses the effect on one owner when a co-owner sells a fractional interest in a tenancy in common and whether the sale of the fractional interest could qualify for like-kind exchange treatment.

A tenancy in common is a specific type of ownership of real property by two or more parties. It is similar to a joint venture; however, a joint venture usually is recognized as a business entity that has been established to accomplish a specific purpose. Additionally, in a joint tenancy, the joint owners have a right of survivorship, while tenants in common can bequeath their property to whomever they choose. A tenancy in common gives each owner a fractional interest in the whole property, meaning that each party’s percentage of ownership is a fraction of the value of the property. Each fractional owner shares in the income, as well as the expenses, relative to the percentage of ownership—a cost-sharing arrangement.

With a tenancy in common, each owner has an undivided interest in the purchased property, which gives each tenant in common an equal right to use the property, even if the fractional or percentages of interests are not equal among the owners. An example of an undivided interest would be purchasing a one-tenth undivided interest in 100 acres. The owner has not purchased 10 acres but one-tenth of the entire 100 acres. This entitles the co-owner to use the entire 100 acres; however, it also entitles the other owners to use the same 100 acres. In other words, each owner co-owns the entire physical property rather than controlling a specific part of it.

One reason a tenancy in common is preferable for property held for investment or rental purposes is that this form of joint ownership generally does not create a separate business entity for federal tax purposes. Regs. Sec. 301.7701-1(a)(2) provides that co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes.Similarly, Rev. Proc. 2002-22 provides that the co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property to avoid being treated as a separate business entity.

Not being treated as a separate business entity for federal tax purposes is important for a number of reasons, not least of which is to avoid having a filing requirement for both federal and state tax jurisdictions as a taxable entity separate from the co-owner’s personal filing requirement. Instead, the reporting of the income and expenses related to the tenancy-in-common property would be done directly on the owner’s personal return, avoiding the need for additional tax preparation fees and, likely, fees various taxing authorities assess to business entities. Additionally, as long as the property ownership is not treated as a separate business entity, if the owner decides to sell the property later, the sale could be structured as a like-kind exchange under Sec. 1031(a).

In a like-kind exchange, a seller of real property can defer recognizing gain on the sale, thereby deferring payment of capital gains taxes, by exchanging the property for other real property of a like kind. Typically, the exchange is not done with the buyer of the property, but the replacement property needs to be identified within 45 days of relinquishing the exchanged property and acquired within 180 days after the transfer of the exchanged property. So, if there is a gain on the sale of a tenancy-in-common interest, the seller can defer that gain by acquiring replacement property that is of like kind. The basis of the new property would be the same as the basis of the property relinquished, decreased by the amount of any money received by the seller and increased by the amount of gain (or decreased by the amount of loss) to the seller that was recognized on the exchange (Sec. 1031(d)). And while Sec. 1031 disallows exchanges of real estate for an interest in a business entity, Rev. Proc. 2002-22 specifies the conditions under which the IRS will rule that an undivided fractional interest in rental real property (a tenancy-in-common interest) is not an interest in a business entity and, therefore, qualifies for like-kind exchange treatment.

An obvious advantage to ownership as tenants in common is that it allows an owner to exchange his or her interest in a small property for a fractional ownership interest in a much larger property without having to recognize gain on the sale. On the other hand, if someone owns a large property and has trouble finding a qualified buyer, offering fractional interests in the property would open the playing field to groups of buyers that would be interested and qualified.

With a tenancy in common, the sale, lease, development, or mortgage of the property as a whole can be done only if all the co-owners agree. However, each individual owner can sell, lease, or mortgage his or her individual interest independently of a group decision, and a new owner would become the new tenant in common. The only qualifier for the individual owner to fear is that, in practice, lenders are unlikely to accept a share in co-owned property as collateral.

In summary, participating in a tenancy in common when investing in real property offers a number of advantages. The investor can purchase an interest in a larger piece of property that might otherwise be unaffordable, even though he or she will be sharing the use of the property with the other owners. Also, since the arrangement is generally a means to share income and/or expenses that are related to the property and not to actually carry on a trade, business, financial operation, or venture and divide the profits of, it does not create an entity separate from the owners for federal tax purposes. And since no separate taxable entity is created, if an owner sells a tenancy-in-common undivided fractional interest in the property, the interest sold may qualify as eligible relinquished property under Sec. 1031(a).

EditorNotes

Mark Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.