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 recogniz- ing (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. 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 prop- erty (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 invest- ment 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. ASOLUTION: TENANTS IN COMMONWITH LIMITED RESTRICTIONS
is sold. They want to go their separate ways. When this situa- tion 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 de- parting members from doing their own 1031 exchanges. 2 The LLC is dissolved, and each member is deeded its frac- tional 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” require- ment of all 1031 exchange transactions is met. 3 The members who want to stay together do so, maintain- ing the LLC as an intact entity, but with fewer members. The departing members are deeded their respective
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
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