In PLR 201622008, the Service ruled that an undivided fractional interest (UFI) in rental real property will not constitute an interest in a business entity under Treas. Reg. Section 301.7701-2(a) for purposes of qualification of the UFI as eligible replacement property under Section 1031(a).

Facts

Through a disregarded entity, Taxpayer holds 100% of the fee title to the Property, which it operates as a commercial office rental property. Taxpayer intends to triple net lease the Property to an unrelated third party (New Co-Owner) under a lease that Taxpayer represents to be a bona fide lease for tax purposes with rent due that reflects the fair market value for the use of the Property. Under an Option Agreement (the Put), Taxpayer will have the option to sell any or all of its interest in the Property to New Co-Owner at any time before the fifth anniversary of the contract. Taxpayer may continue to do so until all interests in the Property are transferred or the Put expires. New Co-Owner will also have an option to acquire the entire remaining interest then held by Taxpayer beginning on the seventh anniversary of the contract (the Call). The exercise price for the Put or the Call will be based on the fair market value of the Property at inception, increased by a constant fixed percentage each year that Taxpayer represents is a reasonable appreciation factor. The price will not be based in whole or in part on the income or profits derived by any person from the Property.

Within six months of executing the triple net lease and the Option Agreement, Taxpayer may exercise its right under the Put to sell a tenancy-in-common interest in the Property to New Co-Owner. Neither co-owner will provide financing to the other co-owner to acquire a tenancy-in-common interest in the Property. There will not be more than five co-owners and Taxpayer and any new co-owners will not file a partnership or corporate tax return, conduct business under a common name or otherwise associate as a common business entity.

The Co-Ownership Agreement will require that any sale, lease, or re-lease of all or a portion of the Property receive the unanimous approval of all the co-owners. The co-owners may, but are not required to, enter into a management agreement. Taxpayer represents that the activities of the manager will not result in non-customary services with respect to the Property. The fees paid to the manager will not depend in whole or in part on the income or profits derived by any person from the Property and will not exceed the fair market value of the manager's services.

Law and analysis

Treas. Reg. Section 301.7701-1(a)(2) states that a joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. However, the mere co-ownership of property that is maintained, rented or leased does not constitute a separate entity for federal tax purposes.

In Revenue Procedure 2002-22, 2002-1 C.B. 733, the IRS specifies the conditions under which it will consider a ruling request that an undivided fractional interest in rental real property, or a tenancy-in-common, is not an interest in a business entity within the meaning of Treas. Reg. Section 301.7701-2(a). The conditions relate to tenancy in common ownership of the property, number of co-owners, co-ownership agreements, voting by co-owners, proportionate sharing of profits, losses and debt, options, management and brokerage agreements, leasing agreements and loan agreements.

The Service determined that the Co-Ownership Agreement and Management Agreement will satisfy all of the conditions set forth in Revenue Procedure 2002-22. Specifically regarding voting, the co-owners retain the right, by unanimous consent, to approve the hiring of any manager, the sale or other disposition of the Property, any leases of a portion or all of the Property, or the creation or modification of a blanket lien. Further, the manager will be required to seek the approval of both co-owners for any matter outside day-to-day operational activities.

Revenue Procedure 2002-22 states that a co-owner may not acquire a put option to sell the co-owner's undivided interest to another co-owner. However, the Put option in this case will not cause the fractional interests in the Property to constitute interests in a business entity because the Property was previously acquired by the Taxpayer and, thus, the purpose of the put prohibition does not apply to this case.

Based on the facts submitted and representations made, the Service ruled that if Taxpayer sells a tenancy-in-common interest in the Property to New Co-Owner pursuant to the terms described in this ruling, an undivided fractional interest in the Property will not constitute an interest in a business entity under Treas. Reg. Section 301.7701-2(a) for purposes of qualification of the undivided fractional interests as eligible relinquished property under Section 1031(a).

Implications

PLR 201622008 is significant for at least four reasons. First, the Service has issued relatively few private letter rulings under Revenue Procedure 2002-22. See PLR 200327003, PLR 200513010, TAM 200540010, PLRs 200625009 and 200625010, TAM 200701032, PLR 200826005 and PLRs 200829012 and 200829013.

Second, the Service concluded that the Put option granted to the Taxpayer does not violate the bar on put options under Revenue Procedure 2002-22 because the Taxpayer held the Property before entering into the proposed transaction and, thus, the purpose of the prohibition on put options does not apply in this case.

Third, the Service implicitly accepted the put and call arrangement as not constituting a sale of the Property at inception for federal income tax purposes. The Service was satisfied that the put and call options exercisable at fair market value of the Property at inception, increased by a constant fixed percentage each year, adequately approximates the fair market value of the Property in future years. Moreover, the use of that same exercise price for both the put and call options was acceptable to the Service, presumably because there is a two-year gap between the end of the exercise period of the put option after five years and the beginning of the exercise period of the call option after seven years. See, e.g., Penn-Dixie Steel Corp. v. Commissioner, 69 TC 837 (1978).

Fourth, and perhaps of greatest interest, the ruling provides a roadmap allowing taxpayers to sell slices of real property, as and when they wish over a period of up to five years, as relinquished property in a series of tax-free like-kind exchanges under Section 1031. Subject to the requirement for a triple net lease and a willing and able counterparty, this ruling effectively allows the taxpayer to a replacement period of five years.

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