Passthrough Entities/May–June 2002
Real Estate Undivided
Fractional Interest Programs
and Rev. Proc. 2002-22: Birth
of an Industry?
By
Louis S. Weller
and
Neal D. Sacon

2002 L.S. Weller and N.D. Sacon
Louis Weller and Neal Sacon discuss the requirements for
organization of a UFI arrangement that complies with Rev.
Proc. 2002-22, explore practical questions raised by these
requirements and consider the potential impact and
consequences of the revenue procedure.
Background
Today’s 500-pound gorilla of real
estate tax planning is the like-kind
exchange under Code Sec. 1031.1
As one of the last remaining shelters for taxable gains realized on
real estate dispositions, like-kind
exchanges have become a cottage
industry among planners and real
estate professionals focused on the
needs of property owners looking
for tax-effective means of selling
assets. An entire industry of “qualified intermediaries” has arisen to
service these transactions since
the 1991 adoption of Treasury
regulations establishing constructive receipt safe harbors for the
conduct of deferred exchanges.2
More recently, as aging baby
boomers have looked to exit from
management-intensive property
types into more passive forms of
investment, a wave of triple-net
leased corporate real estate has
been marketed as replacement
property to these buyers by a burgeoning specialty niche of
brokers and principals. Although
concrete data is hard to find,
based on a survey conducted several years ago by Deloitte &
Touche, billions of dollars annually flow into like-kind real estate
exchange transactions.3
Many property owners wishing
to divest themselves of management intensive assets and move
into more passive ownership find
it difficult to find properties that
meet the economic criteria associated with Code Sec. 1031 and
Louis S. Weller is a principal in Deloitte
& Touche, LLP’s national real estate tax
services group in San Francisco,
California, where he leads the firm’s
Transactions Planning Practice.
Neal D. Sacon is a senior manager in
Deloitte & Touche, LLP’s national real estate
tax services group in Portland, Oregon.
23
Real Estate UFI Programs & Rev. Proc. 2002-22
that they can afford. It is difficult,
for example, to find triple-net
leased properties occupied by
credit-worthy tenants in today’s
market place for less than $1 million. Buying such a property
involves evaluation of complex
lease and finance documentation.
As a result, purchase of these properties has been limited largely to
the most sophisticated participants
in the real estate world, rather than
to “mom and pop.”
In an effort to change this imbalance, various entrepreneurs
have over the past few years begun to develop programs designed
ers frequently enter into agreements both among themselves and
with third parties regarding the
operation of the real property, the
core question presented in the
like-kind exchange arena is
whether a UFI arrangement should
be characterized as a partnership
under Code Secs. 761(a) and
7701(a)(2). If so, the UFI interests
would be characterized as interests in a partnership and Code Sec.
1031(a)(2)(D) will prohibit their
transfer or receipt in a Code Sec.
1031 tax-free exchange.4 If, on the
other hand, the UFI interests are
characterized as TIC interests under local law and
the activities of
the ownership
[T]he practical utility of the revenue
group do not rise
procedure is that it suggests a framework for to the level required
for
UFI arrangements acceptable to the IRS.
partnership or
joint venture
characterization under Code Sec.
to allow smaller investors to ac761, then the UFI units should be
quire portions of larger
capable of being exchanged unreplacement properties through
der Code Sec. 1031.
group acquisition and ownership.
To ensure a positive result, in the
The key to these programs is qualiabsence of specific IRS guidance
fication of the property interests
on this issue, in 1999 and 2000
being sold to investors as direct
several taxpayers sought rulings
undivided interests in real estate,
from the IRS that specific UFI arin order to take advantage of the
rangements would not be treated
principle that, for Code Sec. 1031
as partnerships for tax purposes.
purposes, an undivided interest in
These requests led to an internal
real estate is like-kind to a fee indebate within the IRS and the Treaterest in real estate. Known as
sury about what rules should
“Undivided Fractional Interests”
apply to these arrangements and,
(UFIs) or “Tenancy in Common”
as a direct result, the IRS aninterests (TIC interests), the key tax
nounced in Rev. Proc. 2000-465
hurdle over which these programs
that it would suspend issuing letmust jump is Code Sec.
ter rulings addressing whether
1031(a)(2)(D), which excludes inCode Sec. 1031 applies to exterests in partnerships from the
changes of UFI interests while it
nonrecognition treatment acexamined the issue. In describing
corded exchanges of like-kind
the issues it intended to focus
property by Code Sec. 1031(a)(1).
upon, the IRS clearly emphasized
Because real estate UFIs involve
its concern for the problem of partcommon ownership and exploitanership characterization of UFI
tion of an asset by multiple
arrangements. In a prior article
taxpayers and because UFI own-
24
published in this Journal, the authors provided suggestions on
approaches the IRS should consider in undertaking this study.6
Rev. Proc. 2002-22
The product of the Rev. Proc 200046 examination has now been
released as Rev. Proc. 2002-22,7
issued on March 19, 2002. This
release provides guidance regarding the conditions under which the
IRS will entertain a private letter
ruling request that a UFI co-ownership arrangement relating to
rental real property,8 such as a TIC
interest, will not be treated as an
entity separate from its owners
(e.g., a partnership or corporation)
under Reg. §301.7701-1(a). The
guidance clarifies the criteria that
the IRS views as distinguishing a
real estate UFI arrangement from
a partnership arrangement, and
will enable sponsors to create
rental real estate ownership structures that have ownership units
capable of being exchanged for
other interests in real estate in a
like-kind exchange.
Quite clearly and intentionally,
this guidance does nothing to address similar issues that arise in
connection with UFI arrangements for mineral properties or the
more recent rise of UFI arrangements for corporate passenger
aircraft. According to the IRS, requests for rulings on such issues
will be considered under the more
generic rule of Rev. Proc. 2002-1
and its annual successors.9
Although a number of UFI real
estate investment programs currently are being marketed, it is
likely that Rev. Proc. 2002-22 will
expand the use of these investment vehicles because it provides
clear insight into IRS thinking on
applicable criteria that distinguish a UFI arrangement from a
Passthrough Entities/May–June 2002
partnership. However, unlike the
deferred exchange regulations issued in 1991, or the reverse
exchange guidance released as
Rev. Proc. 2000-37 in September
2000,10 the government chose not
to create a “safe harbor” for UFI
arrangements through this release. By its terms, the revenue
procedure “provides guidelines
for requesting advance rulings
solely to assist taxpayers in preparing ruling requests.”11 The IRS
approach is similar in this regard
to the approach previously employed in Rev. Proc. 89-12 to
specify the conditions under
which the IRS would consider a
ruling request on classification of
an organization as a partnership
for federal tax purposes.12 The list
of information to be submitted is
quite comprehensive and, in
many cases, includes information
that will not be available to sponsors of UFI programs prior to
completion of the sale of UFI interests to ultimate co-owners.13 As
with Rev. Proc. 89-12, it can be
anticipated that the standards for
rulings contained in Rev. Proc
2002-22 will be used more often
as a basis for structuring arrangements and as a touchstone for
legal opinions than as criteria for
submitted private ruling requests.
Rev. Proc. 2002-22 contains an
essential caveat, which will doubtless engender much debate in the
tax community. Section 3 expressly
states that “[t]he guidelines set forth
in this revenue procedure are not
intended to be substantive rules
and are not to be used for audit purposes.” There are at least two ways
of looking at this statement, and it
depends on whether the cup is half
full or half empty. If the cup is half
full, the IRS clearly has recognized
that many UFI arrangements that
do not meet its advance ruling standards still do not constitute
partnerships, and planners can proceed with some confidence that
structures with which they were
comfortable before March 19,
2002, remain viable. If the cup is
half empty, planners will be concerned that IRS field agents or even
courts may be tempted to apply the
ruling standards as de facto audit
tests or even substantive rules despite the revenue procedure’s
express admonition to the contrary.
Nevertheless, the practical utility of the revenue procedure is that
it suggests a framework for UFI
arrangements acceptable to the
IRS. This article discusses the requirements for organization of a
UFI arrangement that complies
with the revenue procedure. In
addition, we explore a number of
practical questions raised by these
requirements and consider the
potential impact and consequences of the revenue procedure.
The Framework of
UFI Arrangements
Under Rev. Proc.
2002-22
Definitions
Section 4 of Rev. Proc. 2002-22
contains several important definitions, which serve as a foundation
for understanding its provisions:
■ “[C]o-owner” means any person that owns an interest in
the Property as a tenant in
common.
■ “[S]ponsor” means any person
who divides a single interest
in the Property into multiple
co-ownership interests for the
purpose of offering those interests for sale.
■ “[R]elated person” means a
person bearing a relationship described in [Code
■
■
Secs.] 267(b) or 707(b)(1),
except that in applying
[Code Secs.] 267(b) or
707(b)(1), the co-ownership
will be treated as a partnership and each co-owner will
be treated as a partner.
“[D]isregarded entity” means
an entity that is disregarded as
an entity separate from its
owner for federal tax purposes.
Examples
of
disregarded entities include
qualified REIT subsidiaries
(within the meaning of [Code
Sec.] 856(i)(2)), qualified subchapter S subsidiaries (within
the meaning of [Code Sec.]
1361(b)(3)(B)), and business
entities that have only one
owner and do not elect to be
classified as corporations.
“[B]lanket lien” means any
mortgage or trust deed that is
recorded against the Property
as a whole.
Multiple Properties
The revenue procedure contemplates that while most UFI
arrangements will involve a
single “Property,” some arrangements may involve multiple
parcels of real estate leased to
a single tenant pursuant to a
single-lease agreement, where
the multiple parcels are pledged
a collateral for a single debt. The
mere fact that multiple parcels
are involved in the arrangement
will not preclude the arrangement from receiving a favorable
ruling, but the IRS has imposed
particular conditions to these
multiple parcel arrangements:
(1) each co-owner must have an
identical percentage interest in
each parcel; (2) the co-owners’
interests in each parcel cannot
be unbundled or transferred
separately; and (3) the multiple
parcels bear a relationship to
25
Real Estate UFI Programs & Rev. Proc. 2002-22
each other such that they “are
properly viewed as a single
business unit.”14 The first two requirements will generally not be
a problem, although the “no unbundling” criteria does seem
somewhat inconsistent with the
general requirement, discussed
below, that UFI owners be free
to transfer their UFI interests.
The third requirement is more
problematic because it will require analysis in any multiple
property arrangement of what
constitutes a “single business
unit.” Rev. Proc. 2002-22 implies that this criteria generally
will be satisfied only by contiguous
properties
or
by
noncontiguous properties
“where there is a close connection between the business use
of one parcel and the business
use of another parcel.” The example given is of an office
building and a noncontiguous
parking structure that serves the
tenants of the office building. 15
Thus, it does not appear likely
that separate noncontiguous
rental properties leased to different tenants will satisfy the
single business unit definition.
Specific Criteria
Section 6 of the revenue procedure describes the conditions
that generally must be satisfied
for the IRS to consider a ruling
request. 16 The 15 enumerated
conditions can be divided into
four broad categories: (1) formation issues, e.g., the legal
structure of the arrangement, the
scope of the sponsor’s activities
and the sponsor’s exit strategy;
(2) allocation issues regarding
revenue, expenses (i.e., profit
and loss) and debt; (3) management and control issues, e.g., the
scope of the co-owners’ activities, property management and
26
leasing; and (4) co-owner exit
strategies, e.g., sale of the underlying property, puts, calls and
options. These categories neatly
describe the major business
terms of most co-ownership
agreements and section 6
thereby provides some practical
advice on where the line between a TIC and a partnership/
joint venture can be drawn.
It is important to note that the
IRS expressly acknowledges the
possibility that, under certain circumstances, failure to satisfy all
criteria of section 6 will not preclude receipt of a favorable ruling
on UFI status:
The Service ordinarily will not
consider a request for a ruling
under this revenue procedure
unless the conditions described below are satisfied.
Nevertheless, where the conditions described below are
not satisfied, the Service may
consider a request for a ruling
under this revenue procedure
where the facts and circumstances clearly establish that
such a ruling is appropriate.17
What is unknown, of course,
is how much deviation from the
section 6 criteria will be tolerated and under what facts and
circumstances.
The UFI World
According to
Section 6
Formation Issues
TIC Under Common Law. The revenue procedure makes clear that the
co-owners must hold their interests
as TICs under local law. The corollary to this is that title to the property
as a whole cannot be held by an
entity (such as a partnership) recognized under local law. 18 It
remains to be seen whether this may
also apply to trusts or other title
holding vehicles, such as Code Sec.
501(c)(2) title holding corporations.
No Swaps and Drops. Furthermore, the revenue procedure
provides that the IRS generally
will not issue a ruling under this
revenue procedure if the coowners held interests in the
property through a partnership or
corporation immediately prior to
the formation of the co-ownership. 19 Thus, taxpayers who
obtained their TIC interests via a
distribution of real property from
a partnership as part of a plan to
allow individual partners to exchange their pro rata interests in
the property will not be able to
obtain rulings relating to these
transactions, at least under this
revenue procedure.20
Maximum Number. There can
be no more than 35 co-owners.21
This number is consistent with
prior law maximum numbers for
subchapter S corporations 22 as
well as current law maximum
numbers for nonaccredited investors in a private placement
securities offering.23 For this purpose, a husband and wife are
treated as a single person and all
persons who acquire interests
from a co-owner by inheritance
are also treated as a single person.
Sponsor Fees on Purchase of
UFI Interests. The amount of any
payment to the sponsor for the
acquisition of the co-ownership
interest (and the amount of any
fees paid to the sponsor for services) must reflect the fair market
value of the acquired co-ownership interest (or the services
rendered) and may not depend, in
whole or in part, on the income
or profits derived by any person
from the property.
Passthrough Entities/May–June 2002
Revenues, Expenses, Debt and
Cash Flow Allocations
Revenue and Expense Allocation.
Each co-owner must share in all
revenues generated by and all costs
associated with the property in proportion to the co-owner’s undivided
interest in the property. This is consistent with existing law under Reg.
§1.761-2(a), which requires that all
members of an entity eligible to
elect out of treatment under subchapter K be able to separately
compute their income without the
necessity of computing partnership
level taxable income.
Debt Allocation. In dealing
with debt secured by a blanket
lien, the IRS took extremely conservative and, in the authors’
opinion, unjustified positions in
view of the lack of authority regarding debt associated with
co-ownership arrangements. According to the revenue
procedure, co-owners must share
in any indebtedness secured by
a blanket lien in proportion to
their undivided interests.24 This is
one of the most important restrictions imposed by the revenue
procedure and may be the one
with the least theoretical support,
as discussed below. Further, if the
property is sold, any debt secured
by a blanket lien must be satisfied and the remaining sales
proceeds must be distributed to
the co-owners.25
Creation of Blanket Liens. The
co-owners must retain the right to
approve creation or modification
of any blanket lien, and any negotiation or re-negotiation of any
indebtedness secured by a blanket lien must be with unanimous
approval of the co-owners.26 Parties related to the co-owners, the
sponsor, the manager or any lessee of the property may not make
loans secured by blanket liens
against the property.27
Net Revenue Distributions. If
the co-owners employ a manager
for the purpose of collecting revenue, then the manager must
disburse to the co-owners their
shares of net revenues within three
months from the date of receipt of
those revenues.28
Default Remedies. Neither the
other co-owners, the sponsor, nor
the manager may advance funds
to a co-owner (i.e., a co-owner
who fails to fund his or her pro
rata share of negative cash flow
or capital expenses) to meet expenses associated with the
co-ownership interest, unless the
advance is recourse to the coowner (and, where the co-owner
is a disregarded entity, the owner
of the co-owner) and is not for a
period exceeding 31 days.29
Property Management, Operations and Decisions
No Partnership Appearance. In
connection with ownership and
operation of a common property,
the co-owners cannot hold themselves out as constituting a
partnership or common business
entity, including filing partnership
tax returns, characterization of
themselves as partners or use of a
common fictitious or trade name.30
Scope of Co-Owner Activity.
The co-owners’ activities must be
limited to those customarily performed in connection with the
maintenance and repair of rental
real property (“customary activities”). The standards discussed in
Rev. Rul. 75-374 are specifically
referenced. Activities will be
treated as customary activities for
this purpose if the activities would
not prevent an amount received
by an organization described in
Code Sec. 511(a)(2) from qualifying as rent under Code Sec.
512(b)(3)(A) and the regulations
thereunder. 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.
Sponsor’s Activities. If the sponsor or a lessee is a co-owner, then
all of the activities of that party (or
any related person) with respect
to the property will be taken into
account in determining whether
the co-owners’ activities are “customary activities” undertaken by
owners as TICs that do not rise to
the level of partnership activities,31
but the activities of a co-owner or
a related person with respect to
the property (other than in the coowner’s capacity as a co-owner)
will not be taken into account if
the co-owner owns an undivided
interest in the property for less
than six months.32
Use of Management Agents. Coowners may enter into
management or brokerage agreements, which must be renewable
no less frequently than annually,
with an agent who may be the
sponsor or a co-owner (or any related person), but who may not be
a lessee.33 The agreement needs to
be approved unanimously by the
co-owners.34 Compensation to a
manager cannot be dependent on
the co-owners’ income or net profits and cannot exceed fair market
value for the manager’s services,
a limitation that also applies to
brokerage arrangements. 35 The
management agreement may authorize the manager to maintain
a common bank account for the
collection and deposit of rents and
to offset expenses associated with
the property against any revenues
before disbursing each co-owner’s
share of net revenues. The management agreement may also:
27
Real Estate UFI Programs & Rev. Proc. 2002-22
Authorize the manager to prepare statements for the
co-owners showing their
shares of revenue and costs
from the property.
■ Authorize the manager to obtain or modify insurance on
the property, and to negotiate
modifications of the terms of
any lease or any indebtedness
encumbering the property,
subject to the approval of the
co-owners.
The manager must, however,
disburse each co-owner’s share of
net revenues within three months
from the date of receipt or, apparently, no less frequently than
quarterly.36
Leasing. The co-owners must
retain the right to approve any
leases of a portion or all of the
property, and any sale, lease or release of a portion or all of the
property must be by unanimous
approval of the co-owners.37 All
leasing arrangements must be
bona fide leases for federal tax
purposes. Rents paid by a lessee
must reflect the fair market value
for the use of the property. The
determination of the amount of the
rent must not depend, in whole or
in part, on the income or profits
derived by any person from the
property leased (other than an
amount based on a fixed percentage or percentages of receipts or
sales), with reference to existing
standards under standards applicable to real estate investment
trusts, under Code Sec.
856(d)(2)(A), serving as the test.
Miscellaneous Management
Decisions. Except where unanimous consent is required in
connection with employing a
manager, sale, lease and financing decisions, the co-owners may
agree to be bound by the vote of
those co-owners holding more
than 50 percent of the undivided
■
28
interests in the property.38 A coowner who consents to be bound
by a majority rule action may provide the manager or other person
a power of attorney to execute a
specific document with respect to
that action, but may not provide
the manager or other person with
a global power of attorney. 39
Co-Owner Exit Strategies
Sale of Underlying Property. Coowners must retain the right to
approve the sale or other disposition of the property, and any sale
must be agreed to by 100 percent
of the co-owners. 40
Restraints on Alienation. In general, each co-owner must have the
right to transfer, partition and encumber the co-owner’s undivided
interest in the property without the
agreement or approval of any person. However, restrictions on the
right to transfer, partition or encumber interests in the property
that are required by a lender and
that are consistent with customary commercial lending practices
are not prohibited.41 In addition,
a co-owner may agree to offer the
co-ownership interest for sale to
the other co-owners, the sponsor
or the lessee at fair market value
(determined as of the time the partition right is exercised) before
exercising any right to partition.
Further, a co-owner many grant
the other co-owners, the sponsor
or the lessee a right of first offer (the
right to have the first opportunity
to offer to purchase the co-ownership interest) with respect to any
potential transfer of the co-ownership interest in the property.42 In a
parallel, but slightly different, formulation
of
permissible
arrangements, a co-owner may
also grant other owners an option
to purchase the co-owner’s undivided interest (call option),
provided that the exercise price for
the call option reflects the fair market value of the property
determined as of the time the option is exercised. For this call option
purpose, the fair market value of
an undivided interest in the property is equal to the co-owner’s
percentage interest in the property
multiplied by the fair market value
of the property as a whole.43
Absolutely prohibited by the
revenue procedure are “put” options in which a co-owner holds
a right to sell the co-owner’s undivided interest to the sponsor, the
lessee, another co-owner, the
lender or any related person.44
The Good News
What does all this mean? There is
some good, some bad and definitely
some ugly in Rev. Proc. 2002-22,
which is quickly apparent.
Definite Default Standards
The guidance does create definite
parameters for those seeking rulings and provides a coherent
explanation of current IRS/Treasury
thinking. It will, therefore, allow
organizers of UFI programs and
potential purchasers of UFI interests to proceed with increased
certainty that specific arrangements
either do or do not fit within the
ruling guidelines and, thus, do or
do not create a material risk of being characterized as partnerships.
Further, the IRS’s position is generally consistent with prior authority
relating to the subject, incorporating Rev. Rul. 75-374 and other
extant principles relating to when
co-owners will be deemed to be
conducting a business.
Limited Scope
The revenue procedure has an
expressly limited scope, which
appears to narrowly target a particular variety of UFI arrangements
Passthrough Entities/May–June 2002
and has no bearing on others. First,
the revenue procedure applies
only to rental real estate arrangements. This is important because
the special considerations that
may apply to UFI arrangements for
mineral interests or aircraft can be
the subject of further guidance or
development through the normal
ruling process without the limitations imposed by the real-estate
centric elements of this pronouncement.
Even
more
important, the revenue procedure
does not displace existing substantive rules, and field agents and
appellate conferees are expressly
admonished of this intent. In the
authors’ view, the consequence of
this is that all but the most timid
or uninformed will conclude that
a two-party TIC arrangement need
not conform to the requirements
of section 6 of the revenue procedure where under existing law
there was no real question about
the characterization of the arrangement as a co-ownership.
Related-Party Test
In looking at arrangements between co-owners and third parties
that might have partnership-like
characteristics, the IRS took a sensible approach to the problem of
related-party arrangements by incorporating the partnership rule
under Code Sec. 707(b) instead of
saying that a party related to any
TIC would create a taint, regardless of the materiality of the
interest held. Thus, loans or management arrangements with a
party related to co-owners holding less than 50 percent of the
interests in a property apparently
will not be subject to the same
taint as would apply to a co-owner
or one related to a majority in interest of the co-owners.
Recognizing that some UFI arrangements will involve more than
a single property is beneficial, although, as discussed below, the
limitation imposed by the single
business unit concept appears inappropriate at least as a substantive
guideline for UFI analysis.
Reasonable Maximum
Adoption of the maximum 35 coowner test, while perhaps not
mandated by black-letter law, is a
reasonable and quite workable limit
that will not hinder formation of
most UFI arrangements by sponsors
or have any negative effect on
nonsponsored TIC structures.
Because the IRS potentially could
have taken the position that any
collective restraint on a co-owner’s
rights with respect to his or her interest in a property was
impermissible, the allowance of reasonable restrictive and collective
management arrangements is good
news. This allowance includes the
right to adopt majority voting procedures for most operational issues
(other than leasing, sale, finance and
hiring a manager).
Transfer Restrictions
Even more reasonable are the permitted restrictions on the right to sell
a co-owner’s interest or to institute
partition actions. Despite the requirement that such rights be reserved to
each co-owner, the ability to grant
enforceable rights of first offer and
of purchase at fair market value mean
that UFI arrangements can be structured in a manner that assures
co-owners that they have some control over successor ownership in the
common property and can prevent
forced sale of the property from being instituted by dissident minority
interests, at least where there exists
the capacity to buy out the minority.
Similarly, UFI organizers will not be
put in the position of having to refuse
reasonable lender-imposed restrictions on transfer due to adverse
income tax consequences to their
UFI characterization.
The Bad News
Drop & Swap
What is good news for some will
be bad for others. One large group
of real estate UFI arrangements is
those that are created in so-called
“drop and swap” transactions.
These transactions occur when a
partnership wants to dispose of
property and partners wish to
separate, with some or all of them
wishing to undertake independent
like-kind exchanges. One technique commonly used is for the
partnership to distribute the property to be transferred to its partners
in a liquidating distribution prior
to the transfer. The former partners,
now TICs, then separately sell or
exchange their UFI interests.
Among the key issues in these
transactions are whether the UFI
arrangement will be respected or
re-characterized as a continuation
of the old partnership or a creation
of a new one.45 Apparently not
wanting to deal with validating
these transactions when other issues are almost always present
(i.e., qualified use of the property,
attribution of the sale back to the
original partnership under the
Court Holding Co. doctrine,
etc.),46 the IRS expressly excluded
UFI transactions where a partnership formerly had held the
property from the purview of the
rulings that may be sought.
Multiple Properties
While recognition that some UFI
arrangements can involve multiple
properties appears a useful provision, the revenue procedure may
cast a pall over certain attempts
to structure UFI arrangements
where interests in multiple unre-
29
Real Estate UFI Programs & Rev. Proc. 2002-22
lated properties are bundled.47
These structures do not appear to
qualify for favorable ruling reviews. The multiple property
definition has a single business
unit zinger, which apparently is
not applicable if discrete, unconnected properties are involved.
Practical Difficulty of Obtaining
Advance Rulings
The detailed information that must
be submitted with a request for a
ruling under the revenue procedure may make it impossible as a
practical matter to obtain one in
advance of the formation of a UFI
arrangement. It seems disingenuous to require applicants to name
all co-owners of a property in order to obtain a ruling because the
names of all the co-owners may
not be known until a sponsor finishes the marketing phase of
selling off UFI interests. To date,
anecdotal reaction indicates that
this requirement, as well as the
requirement that the applicant
provide copies of all transaction
documents relating to formation
of a UFI arrangement (lending,
leases, etc.), will mean that relatively few ruling requests will
actually be filed.
Avoiding Partnership
Appearances
While it may be easy enough to
avoid filing partnership tax returns
or otherwise formally denominating a co-ownership arrangement as
a partnership, it is quite common
for co-owners to use a fictitious
business name in connection with
operation of a rental property.
Common examples are the creation of the “Blueacre Operating
Account” or filing of a fictitious
business statement listing the coowners doing business as
“Blueacre Apartments” so that contracts can be signed in group name.
30
The revenue procedure appears to
bar such conveniences and officials
of the IRS appear to have confirmed
this was intended.48
Unanimous
Co-Ownership Decisions
The list of decisions in which each
co-owner must participate will
create significant problems for
many UFI arrangements and will
require creative and clever design
of these structures. Co-owners
must each approve all leases, the
selection of a property manager,
any sale of the common property
and any financing involving creation of a blanket lien, including
refinancing transactions. As a
practical matter this creates the
potential for stalemate of major
decisions by any co-owner, regardless of how small an interest
is held. Such a potential rightfully
will create anxiety in potential coowners and in lenders thinking
about financing UFI property.
Several avenues are available
to planners seeking to reconcile
a need for orderly management
of UFI property and the requirements of the revenue procedure.
One avenue is to assume that
partition is the ultimate weapon
for a stalemated TIC arrangement. If the parties cannot
unanimously agree on a core decision, then the property should
be subjected to court-ordered
sale and the proceeds divided
proportionately. Unfortunately,
this places a great deal of power
in any minority UFI owner willing to exercise the right to dissent
from a sale, financing, lease or
manager employment decision
desired by all other co-owners.
The IRS will doubtless be asked
whether a co-owner can give prior
consent to sale, leasing, finance or
management decisions that meet
pre-defined criteria. In other words,
can a co-ownership agreement to
which all co-owners are party contain provisions stating that the
owners agree in advance to a sale
at future date at a price equal to,
say, an independently appraised
property value? Can the co-owners
agree in advance that they will consent to leases of space within the
common property as long as the
leases bear minimum rents and contain other predefined terms, such as
amounts to be expended for tenant
improvements, lease duration, etc.?
In these cases, all co-owners would
be consenting to the actions, but not
contemporaneously with the timing
of the action. It remains to be seen
whether such pre-set criteria will
pass muster.
Another approach might be to
require all co-owners to invest in
a UFI property through limited liability companies in which the
sponsor or a related party is the
manager, but where the UFI owner
holds 100 percent of profits, losses
and capital interests. It remains to
be seen whether giving decisionmaking power to the sponsor in
this manner will be allowed.
Debt Allocation
As briefly mentioned above, perhaps the least justifiable
requirements contained in the revenue procedure have to do with
debt secured by a blanket lien. In
attempting to prevent partnershiplike characteristics from being
grafted into UFI arrangements via
their financing structures, the IRS
has prohibited use of economic arrangements that have nothing to do
with tax abuse. There is nothing
strange, for example, about a UFI
arrangement in which different coowners wish to utilize different
debt-equity ratios to acquire their
pro rata share of the common property. It is typical for a lender
providing financing to some co-
Passthrough Entities/May–June 2002
owners to require that such financing be secured by the entire
common property rather than an
undivided interest; this is because
the lender does not want to own an
undivided interest if forced to foreclose on its security in the event of
loan default. There is nothing
strange about nonborrowing coowners being prepared to allow
their UFI interests to serve as collateral for such a loan, so long as the
nonborrowers are fully indemnified
by the borrowers against loss as a
result of any default.
Example. Consider Dick and
Terry who wish to purchase
Blueacre for $100, with Dick
willing to put up $50 cash and
Terry able to borrow $50 from
Howard, who requires receipt
of a deed of trust to all of
Blueacre. Terry’s share of net
cash flow from Blueacre is sufficient to pay debt service on
the $50 loan. Dick is willing
to cooperate as long as Terry
indemnifies Dick against any
loss by reason of Dick pledging his interest in Blueacre to
secure the loan from Howard.
Terry should be able to service
Howard’s loan and retire it on
sale of the property (or of
Terry’s interest). If proceeds
from sale of Terry’s 50-percent
interest are not sufficient to
pay Howard, Terry must make
up the difference. This system
does not require any partnership-level computation of
income or any allocation of
debt. It should not affect characterization of Dick and Terry’s
relationship as co-owners.
Similarly, the requirement of
section 6.07 of the revenue procedure that debts secured by
blanket liens be retired on a sale
of commonly owned property
seems unnecessary. Consider the
sale of property by a TIC where
most or all of the co-owners wish
to engage in a like-kind exchange
and become co-owners of the replacement property. The holder of
a loan secured by a blanket lien
is willing to continue to extend
credit to the group and to shift the
lender’s security to the replacement property. Why should this
scenario be prohibited? Further,
in the modern world of
securitized mortgaged debt and
collateralized mortgage backed
securities (CMBS), it is not uncommon to find absolute bars to
debt prepayment for fairly lengthy
periods after a CMBS loan is initiated. The solution when a
mortgage lien must be removed
is “defeasance,” a procedure in
which cash or cash equivalent
collateral is substituted for real
estate collateral. It is not at all
clear that defeasance is allowable
under the mandate of section
6.07. The IRS’s rationale for the
requirement of blanket lien debt
payoff on a property sale simply
does appear persuasive.
While it is certainly understandable in light of various limitations
on the character of related-party
debt, the absolute limitation on related-party loans contained in
section 6.14 will require careful
vetting of the identity of co-owners and lessees. This will place UFI
sponsors in the same position as
currently applies to group investment sponsors subject to the
related-party-debt-at-risk limitation of Code Sec. 465(b)(3).
Capital Calls
A rather peculiar required element
of UFI arrangements complying
with section 6 will be the limited
remedies available to co-owners
upon default of any owner to contribute required capital. Section
6.08 allows co-owners, sponsors
and/or managers to advance funds
to meet co-owner capital calls, but
only where the advance is recourse
to the “defaulting” partner and “is
not for a period exceeding 31 days.”
It is not clear what is supposed to
happen if the advance is not repaid
within that short period. If the only
remedy of the advancing co-owners is to purchase the defaulting
partner’s interest, then the requirement of fair market value payment
appears to provide an advantage to
the defaulting party. This is inconsistent with a currently common
practice of subjecting a defaulting
party to a “hair-cut” upon mandatory sale of its interest following
default in making a required capital contribution.
Scope of Co-Owner Activity
Section 6.11 of the revenue procedure attempts to limit co-owner
business activities to those “customarily performed in connection
with the maintenance and repair
of rental real property.” According
to the revenue procedure, the activities of the co-owners, their
agents and related parties will be
taken into account. However, it is
not clear how this rule will correlate with the principle that for
attribution purposes the rule of
Code Sec. 707(b)(1) and (b)(2) will
apply, i.e., whether noncustomary
activities by a one-percent coowner will be attributed to the
entire UFI group. If so, business arrangements
involving
a
one-percent co-owner directly will
be poison, but business arrangements involving a party related to
49 percent of the co-owners will
not. This may elevate form over
substance.
Sponsor Exit Strategies
In an effort to recognize the sales
cycle of UFI arrangements, the IRS
31
Real Estate UFI Programs & Rev. Proc. 2002-22
created a six-month safe harbor
during which business activities,
e.g., those activities that rise above
the “customary activities” of Rev.
Rul. 75-374, engaged in by co-owners will not taint a UFI arrangement.
This appears to be primarily directed
at UFI sponsors who hold UFI interests as they are being sold to
unrelated co-owners. Because these
rules are not intended as substantive principles, it appears that such
limitations may apply only to UFI
arrangements seeking rulings. However, if the marketplace adopts the
six-month period as a default, this
could have significant effects on the
methods of marketing UFI arrangements. On the other hand, in most
real estate group investments a sixmonth period should be more than
sufficient time for a well-organized
sponsor to sell all UFI interests.
Adoption of fair market value
requirements for such things as
management fees,49 sponsor compensation, 50 co-owner buy-out
options,51 lease rates52 and brokerage fees53 will put a premium on
the methods used to determine
such value. This could be particularly troublesome with respect to
lease rates, because the requirement is not limited to related-party
lessees, but is apparently global in
an attempt to screen out the possibility of partnership arrangements
between co-owners and lessees.
However, the revenue procedure
is silent as to the standards that may
be employed to establish the fair
market value of lease terms.
One interesting question related
to valuation arises from the requirement of section 6.15 of the
revenue procedure that payments
to a sponsor for a UFI interest be
equal to the fair market value of
that interest “and may not depend,
in whole or in part, on the income
or profits derived by any person
from the Property.” This seems in-
32
nocuous. However, it is common
in valuing commercial real estate,
particularly net-leased real estate,
to establish fair market value by
reference to capitalized income
from the property. If the revenue
procedure admonition is taken literally, use of an income
capitalization rate system for establishing UFI unit value may not
be permissible—a very strange
result when this is exactly the system typically used by the market
to determine the value.
Another potential problem with
this requirement is its effect on variable pricing for co-ownership
interests. In any UFI arrangement,
the possibility exists that individual
UFI interests might be offered by
sponsor-sellers at different prices at
different times. This could be due
to changing property characteristics,
e.g., execution of a favorable lease
that raises property value or termination of an above market rate lease
that lowers value. It remains to be
seen whether the requirement of
section 6.15 will allow for such
variations, even though they should
have no effect whatsoever on a determination that the eventual
co-owners of a property are or are
not partners.
A minor, but potentially annoying, provision that restricts flexibility
of UFI arrangements for reasons that
do not seem compelling is mandatory distribution of co-owner net
revenue shares on a quarterly basis
if the property is managed by an
agent. While this is, in general, probably not a difficult requirement to
follow, it gives rise to the question
of whether creation of a sinking fund
or other reserve for future capital expenditures will be permitted. In
other words, can a manager retain
a share of co-owner revenues in order to create such a fund without
violating the “distribute it all” mandate of section 6.12.
The Ugly
Of all the limitations described
above, two initially stand out as
creating the largest headaches for
UFI sponsors:
■ The twin requirements of pro
rata debt allocation on debt secured by blanket liens and of
mandatory debt payoff on
transfer of property have no
substantive law support. The
first of these will make it difficult to construct UFI
arrangements capable of responding to separate debt/
equity ratio requirements on
the part of different co-owners.
■ Unanimity of TIC decisionmaking on sale, finance,
change of property manager
and leasing decisions will test
the mettle of planners. It is probably not practical or sound
business practice to allow a
one-percent owner to effectively block sale of a property
or appintment of a manager.
Planners are likely to explore
the possibility of pre-approved
terms of sale to which all owners consent in advance or other
mechanisms providing advance
assurance that a business plan
that contemplates sale of a common property at a particular
time or under particular circumstances can be carried out.
Conclusion
Rev. Proc. 2002-22 represents another effort, in a recent series of
efforts, to provide rules for taxpayers exploring various techniques
involving Code Sec. 1031. In general, it provides a reasonable
pathway for sponsors of rental real
estate UFI programs to offer these
as replacement property alternatives
in the marketplace. There are a
number of problematic elements to
Passthrough Entities/May–June 2002
this guidance, which will restrict the
number of taxpayers actually submitting requests for rulings or who
choose to comply in all respects
with standards promulgated by the
release. However, the IRS is to be
commended for tackling the issue
and attempting to create clear, concise standards for those taxpayers
that wish the certainty of private letter ruling review while at the same
time expressly acknowledging that
alternate arrangements can and will
work. With the issuance of Rev.
Proc. 2002-22, it appears likely that
the infant “industry” made up of UFI
sponsors and programs will begin
to grow and take orderly shape.
ENDNOTES
1
2
3
4
5
6
7
8
9
10
11
12
13
Although Code Sec. 1031 applies to nonreal estate assets as well, this article focuses
on real estate like-kind exchanges for reasons that will become apparent.
Reg. §1.1031(k)-1(g).
Louis S. Weller and Joyce L. Stanney, IRC
Section 1031 Exchange Market Alive, Well
and Thriving, 18 REAL EST. TAX DIGEST 10, Oct.
2000, at 359.
There are, of course, many transactional
structures to accomplish tax-deferred or taxfree transfers of partnership interests. These
are frequently the topic of discussion in this
Journal. This article does not, however, address such techniques under subchapter K.
Rev. Proc. 2000-46, IRB 2000-44, 438.
Louis S. Weller and Neal D. Sacon, Fractional Interests in Real Estate and Code Sec.
1031: Legitimate End Run or Illegal Formation, J. P ASSTHROUGH ENTITIES., Sept.-Oct.
2001, at 39.
Rev. Proc. 2002-22, IRB 2002-14, 1.
The revenue procedure is applicable only
to UFI arrangements involving rental real
property and thus inapplicable to other
transactions in which the UFI arrangement is used, e.g., aircraft and equipment
leasing, and was issued as ruling guidance only.
Rev. Proc. 2002-22, supra note 5, section 1
(last sentence).
Rev. Proc. 2000-37, IRB 2000-40, 308.
Rev. Proc. 2002-22, supra note 5, section 3.
Rev. Proc. 89-12, 1989-1 CB 798. See also
Rev. Proc. 95-10, 1995-1 CB 501, which
modified Rev. Proc. 89-12 to include classification of LLCs as partnerships.
Rev. Proc. 2002-22, supra note 5, section
5.02, reads as follows:
Required General Information and Copies
of Documents and Supplementary Materials. Generally the following information and
copies of documents and materials must be
submitted with the ruling request:
(1) The name, taxpayer identification number, and percentage fractional interest in
Property of each co-owner;
(2) The name, taxpayer identification number, ownership of, and any relationship
among, all persons involved in the acquisi-
14
15
16
17
18
19
20
21
22
23
24
25
tion, sale, lease and other use of Property,
including the sponsor, lessee, manager, and
lender;
(3) A full description of the Property;
(4) A representation that each of the co-owners holds title to the Property (including each
of multiple parcels of property treated as a
single Property under this revenue procedure)
as a tenant in common under local law;
(5) All promotional documents relating to the
sale of fractional interests in the Property;
(6) All lending agreements relating to the
Property;
(7) All agreements among the co-owners relating to the Property;
(8) Any lease agreement relating to the Property;
(9) Any purchase and sale agreement relating to the Property;
(10) Any property management or brokerage
agreement relating to the Property; and
(11) Any other agreement relating to the
Property not specified in this section, including agreements relating to any debt secured
by the Property (such as guarantees or indemnity agreements) and any call and put
options relating to the Property.
Rev. Proc. 2002-22, supra note 5, section 4.
Id.
Note that the revenue procedure as published contains two sections enumerated as
“6.” “Conditions” are described in the first
section 6. The effect of the procedure on
other documents is described in the second
section 6, which is probably properly numbered as section 7.
Rev. Proc. 2002-22, supra note 5, section
6 preamble.
Id., section 6.01.
Id., section 6.03.
See text infra note 45 for further discussion
of this issue.
Rev. Proc. 2002-22, supra note 5, section
6.02.
Code Sec. 1361(b)(1)(A) prior to 1997
amendment.
SEC Rules 505 and 506, 17 CFR
230.505(b)(2)(ii); 17 CFR 230.506(b)(2)(i).
Rev. Proc. 2002-22, supra note 5, section
6.09.
Id., section 6.07.
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
Id., section 6.05.
Id., section 6.14.
Id., section 6.12.
Id., section 6.08.
Id., section 6.03.
Id., section 6.11.
Id.
Id., section 6.12.
Id., section 6.05.
Id., section 6.12.
Id.
Id., section 6.05.
Id.
Id.
Id.
Id., section 6.06.
Id.
Id., section 6.10.
Id.
For detailed discussion of this technique, see
Charles H. Egerton and Joseph H. Wiser, Planning to Deal with the Recalcitrant Partner in
a Code Sec. 1031 Exchange, J. PASSTHROUGH
ENTITIES, Mar.-Apr. 1999, at 23-24.
The doctrine of attribution of a property sale
to an entity that agrees to sell the asset and
then distributes the asset to the entity’s owners
prior to the sale in an attempt to evade entity
level taxation. Court Holding Co., SCt, 45-1
USTC ¶9215, 324 US 331, 65 SCt 707 (1945).
See, e.g., TAM 9645005 (July 23, 1996).
At least one sponsor of such a form of UFI
arrangement has applied for a patent that
describes a format for creating unit interests
in multiple unrelated properties that are the
subject of a single master lease. See U.S.
Patent Office Patent No. 6,292,788 B1, filed
Sept. 18, 2001.
See Tax Analysts, TNT, Apr. 11, 2002, report of Apr. 10, 2002, meeting of the District of Columbia Bar Association Taxation Section comments by Jeanne Sullivan
of the IRS Office of Passthroughs and Special Industries.
Rev. Proc. 2002-22, supra note 5, section
6.12.
Id., section 6.15.
Id., section 6.06.
Id., section 6.13.
Id., section 6.12.
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33