Daily Record August 24, 2007 Edition
FORM OF OWNERSHIP: PARTNER AND CO-TENANT DISTINGUISHED
By Michelle M. Cain
Tenancies-in common (TICs) have become popular as a way for a relatively large group of investors— usually unknown to each other—to exchange individual properties for a TIC interest via a tax-deferred 1031 exchange. Much more common, however, is for two or three friends, or business associates to combine funds to buy a piece of real estate without entering into a formal, written agreement. Are they co-tenants or partners? The guidelines followed by the IRS in deciding the form of ownership for tax purposes are discussed below.
A Treasury Regulation says that whether an organization will be viewed separate from its owners (e.g., a partnership) for federal tax purposes is a matter of federal law regardless of its characterization under local law (§301.7701-1(a)(1)). The next paragraph of the Regulation states that a separate entity exists for federal tax purposes if co-owners of an apartment building lease space, and in addition, provide services to the occupants either directly or through an agent. But mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purpose [301.7701-1(a)(2)]. The distinction of whether a partnership exists could be based on the level of services provided.
Contrasting Examples
In 1975, the IRS concluded that a co-ownership of an apartment building was not a partnership for federal tax purposes. (Revenue Ruling 75-374, 1975-2 C.B. 261.) The co-owners employed an agent to manage the rental units; collect rents, pay expenses attributable to the project, and provide the tenants with customary services in connection with repair and maintenance. Furthermore, the management agent furnished additional services to the tenants; one example was parking, for its own account. The ruling indicated that furnishing customary services in an apartment project will not render co-ownership a partnership. However, furnishing additional services will render the co-ownership a partnership if furnished directly by the co-owners, or through an agent. In the facts of the ruling, the additional services were not furnished by the co-owners, but by the management company acting on its own behalf.
On the other hand, even if co-owners of property engage in no activity with respect to their property, a partnership apparently will result if they surrender their rights to separately sell their respective shares in the property. For example, assume individuals A, B and C each acquire a one-third interest in a parcel of land. They neither lease the land, nor exploit it by farming, timbering, or mining but merely hold it for future appreciation. They agree the land can be sold upon the vote of two of the three co-tenants, and that no co-tenant has the right to have the land partitioned or to otherwise separately dispose of their interest in the property. On these facts, a partnership apparently results because they have agreed to divide a single profit from the land.
Planning for Co-Ownership
If two or more persons acquire investment property and wish not to be classified as a partnership for federal tax purposes, each person should take care to establish separate ownership with the right to deal with the undivided interest for his or her own financial benefit. Expenses should be prorated and separately paid if possible. Each cotenant should separately insure his or her interest.
If property management is delegated to one co-tenant or to an agent, the delegation should be revocable by any co-tenant on short notice (less than one year), and the scope of the delegated authority should be restricted to ministerial duties. Moreover, each co-tenant should retain the right to have the property partitioned, or otherwise be able to dispose of his or her interest in the property. If it is absolutely necessary to inhibit the co-owners’ ability to separately dispose of a share or to require them to follow the will of the majority, first-offer and purchase-option procedures should be adopted.
Planning for Partnership
Co-owners of investment property might wish to become partners by express intention even though their relationship otherwise might not be deemed a partnership by the IRS. However, this will not be successful if partnership status is sought for a palpable tax avoidance purpose.
For example, if two cash-method taxpayers jointly acquire investment property but conduct no activity with respect to the property and separately reserve the right to take and sell their shares of the property, they are not likely to be considered partners. As co-tenants, each is required to report his share of income and expense with respect to the property. If in order to allocate expenses disproportionately to one co-tenant, they execute a partnership agreement specially allocating the expenses under Code Section 704(b), the IRS may deny partnership status in order to prevent the special allocation.
Michelle M. Cain, CPA is a senior manager with Mengel, Metzger, Barr & Co. LLP. She can be reached at Mcain@mmb-co.com.
