Sec. 1031 and fractional property interests.

• Author: Mountain, Erin

There is a new market in the Sec. 1031 like-kind exchange arena--exchanging real property for separate, fractional property interests in replacement properties. Fractional property interests offer a more diversified investment and, if exchanged properly, escape gain recognition in a Sec. 1031 like-kind exchange.

Fractional Property Interests

In a fractional property interest, each owner of a piece of property is deemed to own a physically undivided part of the entire parcel. This relationship is a tenancy in common, in which each owner is entitled to a share of the whole parcel and the rights to a portion of the rents or profits therefrom. Co-owners have the right to transfer their interest and demand a partition of the property. However, they cannot exercise any rights that would be disadvantageous to the other tenants in common.

Sec. 1031

Under Sec. 1031 (a)(1), gain or loss on the exchange of property used in a trade or business or for investment can go unrecognized if the property is exchanged solely for like-kind property also used in a trade or business or for investment. This nonrecognition rule is popular, because it allows taxpayers to escape current gain recognition (unless boot is received).

In the past, taxpayers have generally used this provision to exchange one property for another or for a few properties. However, they can now use Sec. 1031's like-kind exchange rules to invest in several fractional property interests without significant tax consequences. Of course, all the rules on qualified like-kind replacement properties (including restrictions on the identification of multiple properties in the case of deferred exchanges) must be observed.

Prior to the IRS rulings discussed below, there was some concern that fractional-property-interest arrangements could be deemed partnerships for Federal tax purposes. Under Sec. 103 l(a)(2)(D), partnership interests do not qualify for a like-kind exchange. According to Regs. Sec. 301.7701-1(a)(2), a joint venture or contractual arrangement creates a separate tax entity, or a partnership, for Federal tax purposes, if the participants carry on a trade, business, financial operation or venture and divide the profits therefrom. Mere co-ownership of property that is maintained, kept in repair and rented or leased, however, does not constitute a separate entity for Federal tax purposes.

Rules

The IRS provided guidance in Rev. Proc. 2002-22 on whether an undivided fractional interest in real...