Breaking Up is Not So Hard to Do, When Combining Ownership of Property as a Single-Member LLC with a Tenant-in-Common Agreement

Limited liability companies are young creatures recently created by state statutes. By contrast, the law of tenants in common is centuries old, with much of it dating back to English law. In a May-December romance, these are wed into what is often the best structure for holding multiple-owner investment properties.

Potential Issues of an LLC

The limited liability company is the usual vehicle for holding real estate. These entities are easy to create and manage. They separate out the risk of owning the property, thereby protecting the other assets of the members (owners). Members can own various percentages of the LLC according to their contribution. For multiple-member LLCs, the entity obtains a federal employer identification number (EIN) and files a partnership tax return with tax incidents reported to the members on Form K-1.

However, the use of this form of ownership can create unforeseen problems when the property is sold at a gain. When real property owned by an LLC is sold at a gain, the LLC may perform a 1031 exchange at the partnership level. In that case, the LLC sells the relinquished property, and the LLC buys the replacement property in accordance with the rules of IRC Section 1031. But often, the various members of the LLC have different goals when the relinquished property is sold. They want to go their separate ways. When this situation arises, several unsatisfying solutions are tried:

1. The members who want to stay together buy out the departing members. But this takes new cash, concentrates risk in this asset for those staying in and prevents the departing members from doing their own 1031 exchanges.

2. The LLC is dissolved, and each member is deeded its fractional interest in the real property prior to sale. Then each owner decides whether or not to perform its own 1031 exchange. This is known as a “drop and swap.” But whether such 1031 exchange transactions will be honored by the IRS is an open question. These transactions require special reporting to the IRS (lines 13 and 14 of Form 1065) and the State of California is scrutinizing these transactions, questioning whether the “held for investment” requirement of all 1031 exchange transactions is met.

3. The members who want to stay together do so, maintaining the LLC as an intact entity, but with fewer members. The departing members have deeded their respective fractional interests in the real estate. The property is sold with the LLC performing a 1031 exchange, and the new co-owners of the real property cashing out and recognizing (paying) income tax. This solution creates problems if the sale doesn’t go through.

Other problems can arise when a single uncooperative member of an LLC objects to any change in LLC ownership structure. Moreover, none of these suggestions will work when an LLC is selling only one of several properties that it owns.

A Solution: Tenants-in-Common with Limited Restrictions

Under IRC Section 1031, all real property is like kind to all other real property as long as the qualified-use test is met. Necessarily, a tenant-in-common interest in one property can be 1031-exchanged into a tenant-in-common interest in another property. However, the laws governing tenants in common (also called co-tenants or co-ownership) imbues the co-owners with certain rights that are cumbersome, especially when the tenants in common are not related by blood or fealty. Tenants in common have the right to occupy the property, the right to sell or mortgage their share of the property and the right to force the sale of the whole property (partition). They are under no obligation to share in expenses unless specifically agreed. All of these rights are inimical to investors combining their funds to buy investment real property. So while tenant-in-common interests can be 1031-exchanged, their rights must be restricted so that the investment goals of the group can be met.

The IRS published Rev. Proc. 2002-22 to assist with this problem. That ruling sets forth 15 criteria by which a tenant-in-common agreement, which limits the rights of tenants in common, will be judged. If too many of the criteria are not met, then the tenants in common will be treated as having formed a partnership, will be taxed as a partnership and will be restricted to doing 1031 exchanges at the partnership level. The most important of these 15 criteria are:

  1. Each tenant in common must hold record title ownership.
  2. No more than 35 tenants in common.
  3. No filing of any partnership tax return.
  4. Tenants in common can be forced to offer their interest to the other tenants in common before offering their interests to outsiders, but they must be allowed to sell or mortgage their interests after offering to the other tenants in common.
  5. Management agreements cannot be for more than one year.
  6. Any sale, leasing or mortgaging of the whole property must be by unanimous consent of the tenants in common.
  7. Profits and losses must be shared according to fractional ownership.
  8. Tenants in common are limited to investment activity not engaged in business.

Limited Liability and the Single-Member LLC

But what about the limited liability afforded by LLCs? Tenant-in-common ownership, by itself, does NOT separate the risk of property ownership and does NOT protect the other assets of the tenants-in-common. Again, the IRS has rescued the situation be declaring that single-member LLCs are “disregarded entities” for tax purposes. By disregarded, they mean that a single-member LLC need not have an EIN nor does it need to file a separate tax return. Instead, the tax incidents of any real property owned by a single-member LLC are reported directly on the individual tax return of the member. By combining ownership of property as a single-member LLC with a tenant in common agreement, you achieve maximum 1031 exchangeability with limited liability.

When multiple owners join forces to buy real estate, they often overlook their 1031 exit strategy. To achieve limited liability with 1031 exchangeability, real property investments can be structured with several single-member LLCs as tenants in common operating under a tenant-in-common agreement that complies with Rev, Proc. 2002-22.

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