Fractionals Help Resolve 1031 Challenges

June 1, 2002

If you’ve ever thought about recommending fractional 1031 investments to your clients but wondered how the IRS would view them, it’s time to start thinking about them again.

Earlier this year, the IRS issued a Revenue Procedure (2002-22) that answers many of the questions property owners and investors have had about how these novel investments should be structured.

Sponsored fractional real estate interests offer a way to resolve some of the challenging aspects of 1031 tax-deferred exchanges. In a 1031 exchange, owners defer taxes on the sale of their property by exchanging it for a like-kind property. One of the hurdles to a successful exchange is identifying a suitable property in the required 45-day window.

Fractional interests help address that challenge by enabling owners to exchange their property for a prepackaged interest in a larger, institutional-grade property. Say your client owns a $1 million retail property. The client can exchange it for a 10 percent ownership interest in a $10 million property.

There’s a host of benefits to fractional interest exchanges. For example, your investor clients may be able to buy into properties of a size and quality they couldn’t otherwise afford—with the potential for more income and greater resale value. There’s also the chance to trade their management responsibilities for ownership interests in a professionally managed property.

For you, fractional investments represent a good source of referral income. Investment sponsors typically pay a negotiable referral fee based on the amount of equity value your clients place in the deal.

For this type of investment to qualify for tax-deferred status, the investors’ participation must be structured as tenancy-in-common. Investors receive a deed for their share of the property rather than a share of a partnership that owns the property.

To date, the IRS hasn’t issued a private letter ruling on the tax-deferral qualifications of any specific fractional-interest investment program. But now, with the guidelines out, program sponsors can request that the IRS review a proposed investment structure, before it’s completed, against the guidelines.

The IRS doesn’t establish a safe harbor provision as to what qualifies for a tax deferral through this Revenue Procedure. However, it does spell out some requirements for tenancy-in-common interests to qualify as co-ownership interests. Sponsors selling these investments can structure their offerings to comply with the new guidelines.

Here are a few of the key points in the IRS guidelines:

  • The maximum number of tenants in common is 35.
  • Once owners decide to sell fractional interests in a property, the owners must sell all the interests within six months.
  • Owners of the interests must unanimously agree to material or economic changes to the property or its ownership structure.
  • Management agreements must be at market rate and renewable annually.

At a time when more investors are taking an interest in exchanges, these guidelines can help you and your clients investigate whether a particular fractional program is right for them.

Ron Raitz, CCIM, is president and owner of Real Estate Exchange Services, Marietta, Ga. You can reach him at 770/579-1155, Ext. 10. Information on 1031 exchange transactions is available at www.rees1031.com.

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