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									      LIKE-KIND EXCHANGES:
       UPDATE, TICs and DSTs

          Kevin Thomason
           Todd D. Keator
       Thompson & Knight LLP
         1700 Pacific Avenue
          Dallas, TX 75201

         State Bar of Texas
           July 7-9, 2005
        San Antonio, Texas

             Chapter 16
                                 K E VI N T H OMA S O N



                                 T OD D D . K EA TOR




                                                         TABLE OF CONTENTS


I.     INTRODUCTION ................................................................................................................................ 1

II.    LIKE-KIND EXCHANGES: AN UPDATE ....................................................................................... 1
       A.    Like-Kind Exchange Basics ..................................................................................................... 1
       B.    The Meaning of “Like Kind” ................................................................................................... 1
       C.    Like-Kind Exchange of Principal Residence ........................................................................... 2
       D.    Related Party Issues.................................................................................................................. 3
       E.    Reverse Exchanges ................................................................................................................... 6
       F.    TICs and DSTs ......................................................................................................................... 7

       A.   The Need for “Team” Exchanging—the Demand.................................................................... 9
       B.   The Problem with the Intuitive Solution ................................................................................ 10
       C.   TIC Syndications—a Need for Certainty ............................................................................... 10
       D.   Rev. Proc. 2002-22—The Floodgates Open........................................................................... 11
       E.   Overview of the Rev. Proc ..................................................................................................... 11
       F.   The Response of the Marketplace—Few Rulings/Many Deals ............................................. 13
       G.   Tax Issues ............................................................................................................................... 13
       H.   Lender Issues .......................................................................................................................... 13
       I.   Securities Issues...................................................................................................................... 14
       J.   Conclusion .............................................................................................................................. 14

       A NEAT, NARROW ALTERNATIVE ............................................................................................. 14
       A.   What is a DST?....................................................................................................................... 14
       B.   How is it used? ....................................................................................................................... 14
       C.   The Tax Issue ......................................................................................................................... 15
       D.   Rev. Rul. 2004-86................................................................................................................... 15
       E.   What now? .............................................................................................................................. 15

V.     CONCLUSION .................................................................................................................................. 15


Like-Kind Exchanges: Updates, TICs and DSTs                                                          Chapter 16

LIKE-KIND EXCHANGES: UPDATES, TICs                               of the taxpayer who desires to exchange his property, a
AND DSTs                                                         purchaser for the taxpayer’s property, a seller for the
                                                                 property the taxpayer wishes to acquire and an
I.   INTRODUCTION                                                intermediary that will facilitate the exchange. Special
                                                                 rules are established in Section 1031 and in Treasury
     There have been a few important developments in             Regulations § 1.1031(k) allowing deferred four-party
the like-kind exchange area over the last 12 months.             exchanges. A deferred exchange generally is that
This paper will address and summarize those                      instance in which the taxpayer first sells the
developments. However, the most dramatic action in               relinquished property through the use of a qualified
the like-kind exchange arena has been the explosive              intermediary that later buys the replacement property.
growth of the tenancy-in-common (TIC) syndications               The rules in the Treasury Regulations for deferred
of real estate. This paper will describe the tax and             exchanges are highly formalistic and care must be
business issues involved in such syndications. Finally,          taken to follow the rules. Thanks to recent Internal
a recent IRS promulgation has opened a narrow door               Revenue Service (the “IRS”) published guidance, a
for the use of Delaware Statutory Trusts (DSTs) as a             taxpayer can safely do a reverse like-kind exchange in
vehicle for providing replacement properties in a like-          which the taxpayers disposes of the relinquished
kind exchange, and we will explore that ruling and its           property after effectively acquiring the replacement
usefulness in the last portion of this paper.                    property.

II. LIKE-KIND EXCHANGES: AN UPDATE                               B.   The Meaning of “Like Kind”

A. Like-Kind Exchange Basics                                     1.   Private Letter Ruling 200450005

     A like-kind exchange is a statutory creation found                In PLR 200450005 (12/10/2004), the taxpayer
in Code Section 1031. [Unless otherwise stated, all              engaged in the business of leasing vehicles to
section references are to the Internal Revenue Code of           consumers. The taxpayer structured its vehicle leasing
1986, as amended.]. Section 1031 generally provides              operations with the intention that the disposition of a
that no gain or loss will be recognized on an exchange           vehicle coming off lease (a relinquished vehicle) by the
of property held for productive use in a trade or                taxpayer to an unrelated party and the acquisition by
business or for investment if such property is                   the taxpayer of a vehicle recently leased by a consumer
exchanged solely for property of like kind which is to           from a dealer (a replacement vehicle) would qualify as
be held either for productive use in a trade or business         a like-kind exchange under Section 1031. Regarding
or for investment. The words “like kind” refer to the            this arrangement, the taxpayer requested a ruling as to
nature or character of the property and not grade or             whether sport utility vehicles (“SUVs”) were of like
quality. The kind of real property that can be                   kind to passenger automobiles. The IRS noted that
exchanged in a like-kind exchange is broad. For our              “[t]he like-kind property standard has been
purposes, a like-kind exchange includes an exchange              interpreted more narrowly in the case of exchanges of
of the taxpayer’s fee simple interest in real property for       personal property as compared to exchanges of real
an undivided interest in real estate held as a tenant in         property.” However, according to the IRS “[e]ven
common.                                                          within the more restrictive parameters of the like-kind
                                                                 standard as applied to personal property, the
      Certain property does not qualify for a like-kind          differences between an automobile and an SUV do not
exchange. Like-kind property does not include stock              rise to the level of a difference in nature or character
in trade or other property held primarily for sale,              but are merely a difference in grade or quality.” Thus
stocks, bonds or notes, other securities or notes,               the IRS concluded that an SUV and a passenger
certificates of trust or beneficial interests, choses in         automobile were like-kind property.
action or, most importantly for our purposes, interests
in partnerships. Section 1031(a)(2).                             2.   Treasury Regulation § 1.1031(a)-2

     Rarely is a like-kind exchange done as a two-party               a. Background.        Section 1031(a) provides
exchange. As a practical matter, it is unlikely that a           generally that no gain or loss will be recognized if
taxpayer looking to sell his relinquished property in a          property held for productive use in a trade or business
like-kind exchange will find a person who not only               or for investment is exchanged solely for property of
wants to acquire the taxpayer’s property but also                like kind. Regarding personal property, Treasury
happens to own a replacement property desired by the             Regulations § 1.1031(a)-2(a) says that personal
taxpayer. Instead, the taxpayer normally will enter into         properties of a “like class” will be considered of like
a four-party exchange. A four-party exchange consists
Like-Kind Exchanges: Updates, TICs and DSTs                                                           Chapter 16

kind for purposes of Section 1031. Depreciable                    years during the 5-year period preceding the date of the
tangible personal property is of a like class to other            sale. Neither Section 121 nor Section 1031 addresses
depreciable tangible personal property if the exchanged           the application of both provisions to a single exchange
properties are within either the same general asset class         of property.
or the same product class. See Treas. Reg. §
1.1031(a)-2(b)(1).        Under prior regulations,                      Revenue Procedure 2005-14 applies only to
depreciable tangible personal properties were within              taxpayers who dispose of property in exchanges that
the same product class if they were listed in the same            satisfy both the requirements for excluding gain from
4-digit product class within Division D of the Office of          the sale or exchange of a principal residence under
Management and Budget’s Standard Industrial                       Section 121 and for avoiding gain recognition on the
Classification Manual (1987) (the “SIC Manual”).                  exchange of like-kind properties under Section 1031.
However, the SIC Manual was discontinued in 1997                  Thus the revenue procedure applies only to taxpayers
and replaced with the Office of Management and                    who satisfy the “held for productive use in a trade or
Budget’s North American Industry Classification                   business or for investment” requirement of Section
System (the “NAICS Manual”). Since that time, there               1031(a)(1). This will typically be the situation for a
has been some uncertainty concerning whether the SIC              taxpayer who owned a home as a principal residence
Manual or the NAICS Manual product classes should                 for a number of years and then converted it into a
apply in an exchange of depreciable tangible personal             rental property, or for a taxpayer who uses his home as
properties.                                                       both a principal residence and a home office. Provided
                                                                  a taxpayer meets the requirements of Code Sections
     b. Replacing SIC Manual with NAICS Manual.                   121 and 1031, the taxpayer is permitted to qualify for
Final regulations end the uncertainty by formally                 both the exclusion of gain under Section 121 and the
replacing the SIC Manual with the NAICS Manual.                   non-recognition of gain under Section 1031. The rules
See T.D. 9202 (5/19/2005). Under the new system,                  are as follows:
“property within a product class consists of
depreciable tangible personal property that is                        a.    Section 121 must be applied before Section
described in a 6-digit product class within Sectors 31,               1031.
32, and 33 (pertaining to manufacturing industries) of
the [NAICS Manual]          . . . as periodically updated.”           b.     Under Section 121(d)(6), the exclusion
Generally speaking, the NAICS Manual product                          provided by Section 121(a) does not apply to gain
classes have the same composition as the SIC Manual                   attributable to depreciation deductions for periods
product classes. However, some differences do exist,                  after May 6, 1997 claimed with respect to the
and so practitioners should consult the NAICS Manua l                 business or investment portion of the residence.
prior to undertaking an exchange of depreciable                       However, Section 1031 may apply to any such
tangible personal property. The final regulations apply               gain.
to transfers of property made on or after August 12,
2004. However, taxpayers may apply the final                          c.    In applying Section 1031, boot received in
regulations to transfers of property made on or after                 the exchange for property used in the taxpayer’s
January 1, 1997 for taxable years in which the statute                trade or business or held for investment (the
of limitations is still open. In addition, for transfers of           relinquished business property) is taken into
property made on or before May 19, 2005, taxpayers                    account only to the extent the boot exceeds the
have the option of continuing to use the SIC Manual                   gain excluded under Section 121 with respect to
product classes.                                                      the relinquished residence.

C. Like-Kind Exchange of Principal Residence                          d.    In determining the basis of the property
                                                                      received in the exchange (the replacement business
1.   Revenue Procedure 2005-14                                        property), any gain excluded under Section 121 is
                                                                      treated as gain recognized by the taxpayer and thus
     In Revenue Procedure 2005-14, 2005-7 I.R.B.                      increases the taxpayer’s basis in the replacement
(1/27/2005), the IRS clarified the treatment of gain                  business property.
qualifying for both the gain exclusion treatment
provided by Section 121 and the non-recognition of                Revenue Procedure 2005-14 gives 6 examples of its
gain provided by Section 1031. In general, Section                application. Examples 1 and 3 address the following
121 allows a taxpayer to exclude gain realized (up to             two common situations: first, where a taxpayer uses a
$500,000 for certain joint returns) on the sale or                home as a principal residence and then as a rental
exchange of property if the property was owned and                property, and second, where a taxpayer uses a home
used as the taxpayer’s principal residence for at least 2         both as a principal residence and as a home office. In
Like-Kind Exchanges: Updates, TICs and DSTs                                                         Chapter 16

both examples, “A” is a single individual.        Those        office in C's trade or business. In 2006, C exchanges
examples are reprinted below:                                  the entire property for a residence and a separate
                                                               property that C intends to use as an office in C's trade
Example 1                                                      or business. The total fair market value of C's
                                                               replacement properties is $360,000. The fair market
(i) Taxpayer A buys a house for $210,000 that A uses           value of the replacement residence is $240,000 and the
as A’s principal residence from 2000 to 2004. From             fair market value of the replacement business property
2004 until 2006, A rents the house to tenants and              is $120,000, which is equal to the fair market value of
claims depreciation deductions of $20,000. In 2006, A          the business portion of the relinquished property.
exchanges the house for $10,000 of cash and a                  From 2001 to 2006, C claims depreciation deductions
townhouse with a fair market value of $460,000 that A          of $30,000 for the business use. C realizes gain of
intends to rent to tenants. A realizes gain of $280,000        $180,000 on the exchange.
on the exchange.
                                                               (ii) Under § 121, C may exclude the gain of $100,000
(ii) A's exchange of a principal residence that A rents        allocable to the residential portion of the house (2/3 of
for less than 3 years for a townhouse intended for             $360,000 amount realized, or $240,000, minus 2/3 of
rental and cash satisfies the requirements of both §§          $210,000 basis, or $140,000) because C meets the
121 and 1031. Section 121 does not require the                 ownership and use requirements for that portion of the
property to be the taxpayer's principal residence on           property.
the sale or exchange date. Because A owns and uses
the house as A's principal residence for at least 2            (iii) The remaining gain of $80,000 (1/3 of $360,000
years during the 5-year period prior to the exchange,          amount realized, or $120,000, minus $40,000 adjusted
A may exclude gain under § 121. Because the house is           basis, which is 1/3 of $210,000 basis, or $70,000,
investment property at the time of the exchange, A may         adjusted by $30,000 depreciation) is allocable to the
defer gain under § 1031.                                       business portion of the house (the office). Under
                                                               section 4.02(1) of this revenue procedure, C applies §
(iii) Under section 4.02(1) of this revenue procedure,         121 before applying the nonrecognition rules of §
A applies § 121 to exclude $250,000 of the $280,000            1031. Under § 1.121-1(e), C may exclude $50,000 of
gain before applying the nonrecognition rules of §             the gain allocable to the office because the office and
1031. A may defer the remaining gain of $30,000,               residence are part of a single dwelling unit. C may not
including the $20,000 gain attributable to                     exclude that portion of the gain ($30,000) attributable
depreciation, under § 1031. See section 4.02(2) of this        to depreciation deductions, but may defer the
revenue procedure. Although A receives $10,000 of              remaining gain of $30,000 under § 1031. These results
cash (boot) in the exchange, A is not required to              are illustrated [on Part 2 of Attachment A appended
recognize gain because the boot is taken into account          hereto].
for purposes of § 1031(b) only to the extent the boot
exceeds the amount of excluded gain. See section               (iv) C's basis in the replacement residential property is
4.02(3) of this revenue procedure. These results are           the fair market value of the replacement residential
illustrated [on Part 1 of Attachment A appended                property at the time of the exchange ($240,000). C's
hereto].                                                       basis in the replacement business property is $90,000,
                                                               which is equal to C's basis in the relinquished business
(iv) A's basis in the replacement property is $430,000,        property at the time of the exchange ($40,000),
which is equal to the basis of the relinquished property       increased by the gain excluded under § 121
at the time of the exchange ($190,000) increased by            attributable to the relinquished business property
the gain excluded under § 121 ($250,000), and                  ($50,000). See section 4.03 of this revenue procedure.
reduced by the cash A receives ($10,000). See section
4.03 of this revenue procedure.
                                                               D. Related Party Issues
                                                               1. Teruya Brothers,         Ltd.   &   Subsidiaries    v.
Example 3                                                      Commissioner

(i) Taxpayer C buys a property for $210,000. The                    Teruya Brothers, Ltd. & Subsidiaries v.
property consists of a house that constitutes a single         Commissioner, 124 T.C. 45 (2005), involved two
dwelling unit under § 1.121-1(e)(2). From 2001 until           deferred like-kind exchanges among related parties, a
2006, C uses 2/3 of the house (by square footage) as           qualified intermediary (“QI”), and unrelated third
C's principal residence and uses 1/3 of the house as an
Like-Kind Exchanges: Updates, TICs and DSTs                                                         Chapter 16

parties. The simplified facts of Teruya Brothers are as         the IRS did not argue that Section 1031(f)(1) directly
follows:                                                        applied.    Instead, the IRS argued that Section
                                                                1031(f)(4), which states that “[t]his section [1031]
     Teruya Brothers, Ltd. (“Taxpayer”) was a Hawaii            shall not apply to any exchange which is part of a
corporation. During 1996, the taxable year at issue, it         transaction (or series of transactions) structured to
owned 62.5% of the capital stock of Times Super                 avoid the purposes of this subsection [(f)],” applied.
Market, Ltd. (“Times”). As a result, Taxpayer and               The Court began its inquiry under Section 1031(f)(4)
Times were related parties under Section 267(b).                by noting that the purpose of Section 1031(f)(4) was to
Taxpayer proposed entering into two different like-             prevent related persons from circumventing the
kind exchange transactions. In the first (“Transaction          application of Section 1031(f)(1) by using an unrelated
1”), Taxpayer proposed exchanging, through a QI, the            third party to do indirectly what they could not do
“Ocean Vista” property for replacement property                 directly. In addition, the Court noted that the non-tax
(“Replacement Property 1”) held by Times. Ocean                 avoidance exception of Section 1031(f)(2)(C) (which
Vista was valued at $1,468,500 and Taxpayer’s                   ignores dispositions by a related party within the 2-
adjusted basis in Ocean Vista was $93,270 (for a built-         year period if neither the original exchange nor the
in gain of $1,375,230). According to the plan,                  disposition had as a principal purpose the avoidance of
Taxpayer transferred Ocean Vista to the QI, which then          federal tax) must be considered in conjunction with
sold Ocean Vista to a third party for $1,468,500 cash.          any inquiry under Section 1031(f)(4): “Because this
The QI then used the cash (along with additional cash           exception [under Section 1031(f)(2)(C)] is subsumed
contributed by Taxpayer) to purchase Replacement                within the purposes of section 1031(f), any inquiry into
Property 1 from Times. Afterwards, the QI transferred           whether a transaction is structured to avoid the
Replacement Property 1 to Taxpayer to complete the              purposes of section 1031(f) should also take this
exchange. Times’s built-in gain in Replacement                  exception into consideration.”
Property 1 was $1,352,639.
                                                                     Turning to whether Section 1031(f)(4) applied,
      In the second transaction (“Transaction 2”),              the Court found that the Taxpayer’s two transactions
Taxpayer proposed exchanging, through a QI, the                 were “economically equivalent to direct exchanges of
“Royal Towers” property for replacement property                properties between [Taxpayer] and Times (with boot
(“Replacement Property 2”) held by Times. Royal                 from [Taxpayer] to Times), followed by Times’s sales
Towers was valued at $11,932,000 and Taxpayer’s                 of the properties to unrelated third parties” and that
adjusted basis in Royal Towers was $670,506 (for a              “the interposition of [QI] in these transactions [could
built-in-gain of $11,261,494). According to the plan,           not] obscure the end result.” Because Taxpayer
Taxpayer transferred Royal Towers to the QI, which              offered no explanation for structuring the exchange
then sold Royal Towers to a third party for                     transactions the way that it did, the Court concluded
$11,261,494 cash. The QI then used the cash (along              that Taxpayer “used the multiparty structures to avoid
with additional cash contributed by Taxpayer) to                the consequences of economically equivalent direct
purchase Replacement Property 2 from Times.                     exchanges with Times” and that Section 1031(f)(4)
Afterwards, the QI transferred Replacement Property 2           would apply unless the exception of Section
to Taxpayer to complete the exchange. Times had a               1031(f)(2)(C) applied.
large built-in loss in Replacement Property 2.
                                                                     With respect to the Ocean Vista transaction,
     The issues for consideration were (1) whether the          Taxpayer argued that there was no tax avoidance
two transactions were exchanges structured to avoid             purpose because Times recognized a gain on its sale of
the purposes of Section 1031(f) and, if so, (2) whether         Replacement Property 1 ($1,352,639) that was larger
Transaction 1 qualified for the exception for                   than the gain Taxpayer would have recognized
transactions not having a principal purpose of avoiding         ($1,345,169, after deduction of certain selling
federal income tax.                                             expenses) had Taxpayer sold Ocean Vista directly for
                                                                cash. However, the Court disagreed:
     Section 1031(f)(1) provides a special holding
period rule for like-kind exchanges between related             Although Times recognized a gain in the Ocean Vista
parties, i. e., that both related parties that consummate       transaction that slightly exceeded Teruya's gain
a like-kind exchange must hold the property received            deferral, it appears that Times paid a much smaller
in the exchange for a minimum of 2 years; otherwise,            tax price for that gain recognition than Teruya would
the original non-recognition treatment accorded the             have paid if it had recognized gain in a direct sale of
exchange will not be available. Because Transfer 1              Ocean Vista. On its corporate income tax return for
and Transfer 2 did not involve direct exchanges                 taxable year ending March 31, 1996, Teruya reported
between related parties (since the QI was interposed),          taxable income of $2,060,806. Consequently, if
Like-Kind Exchanges: Updates, TICs and DSTs                                                          Chapter 16

Teruya had made a direct sale of Ocean Vista, the                property for building 2. Afterwards, Buyer would own
gain recognized on that sale presumably would have               building 1, AB would own building 2, CD would own
been taxable at a 34-percent corporate income tax                replacement property, and Seller would have cash. AB
rate. See sec. 11(b)(1)(C). By comparison, on its                and CD each represented that neither would dispose of
Form 1120 for its taxable year . . ., Times reported a           its replacement property within two years of receipt of
net operating loss (NOL) of $1,043,829. Thus,                    such property. The issue was whether Section 1031(f)
although Times recognized a considerable gain on the             applied.
Ocean Vista transaction, because of offsetting
expenses, it did not incur tax on that gain. Instead, the             On the face of the transaction, Section 1031(f)(1)
only tax consequences of Times's gain recognition                was inapplicable, since AB and CD (related persons)
were reductions of its . . . NOL carryovers for                  never directly exchanged with each other and instead
subsequent taxable years.                                        exchanged with QI (an unrelated person). However,
                                                                 according to the IRS, despite use of a QI, Section
Accordingly, the Court he ld that the Taxpayer failed to         1031(f)(4) still could apply, which section prohibits
prove that tax avoidance was not one of its principal            Section 1031 exchanges that are part of a transaction or
purposes for structuring the transactions the way that it        series of transactions structured to avoid the purposes
did, and thus the transactions failed to qualify for like-       of Section 1031(f). Thus the issue became whether
kind exchange treatment by reason of Section                     Section 1031(f)(4) applied. If the QI were used to
1031(f)(4).                                                      circumvent the purposes of Section 1031(f), then the
                                                                 transaction would not qualify for nonrecognition
     Teruya Brothers is interesting for two primary              treatment under Section 1031.
reasons. The first reason is that the Court held that any
inquiry under Section 1031(f)(4) into whether a                       Ultimately, the Service ruled that Section
transaction is structured to avoid the purposes of               1031(f)(4) did not apply to the exchanges. The
Section 1031(f) must also take into account the                  decision was based principally on a finding that CD’s
exception for non-tax avoidance transactions under               subsequent disposition (in a Section 1031 exchange)
Section 1031(f)(2)(C). The second is that the Court              qualified for the exception under Section 1031(f)(2)(C)
expressed its willingness to consider, when                      for dispositions where neither the original exchange
determining whether the exception for non-tax                    nor the disposition had as one of its principal purposes
avoidance applies, not only the nominal built-in gain of         the avoidance of federal income tax. The legislative
the various properties but also the tax attributes—here          history regarding this non-tax avoidance exception
net operating loss carryovers—of the related                     indicates that it would generally apply to dispositions
exchanging parties. Practitioners should be aware of             in nonrecognition transactions. See S. Print No. 56,
these developments when structuring like-kind                    101st Cong., 1st Sess. 152 (1989). According to the
exchanges between related parties.                               Service:

2.   Private Letter Ruling 200440002                             In the present case, the only subsequent disposition
                                                                 contemplated by the parties after [AB] receives
     PLR 200440002 (10/1/2004) deals with a related              Building 2 as replacement property is the use of the
party exchange with facts similar to Teruya Brothers.            proceeds from the disposition of Building 2 by [CD] to
In the ruling, AB and CD were related parties per                acquire like-kind replacement property in another
Section 1031(f)(3). AB owned building 1, and CD                  exchange under § 1031, a nonrecognition transaction.
owned building 2. Buyer, an unrelated person, desired            Thus, because [CD] is structuring its disposition of
to acquire building 1. AB wanted to defer gain                   Building 2 as an exchange for like-kind replacement
recognition on the transfer, and therefore proposed the          property so that the gain on the transfer of Building 2
following series of related transactions: First, AB              is eligible for nonrecognition treatment under §
would transfer building 1 to Buyer pursuant to an                1031(a), § 1031(f)(4) and Rev. Rul. 2002-83 are not
exchange agreement entered into with QI, a qualified             applicable.
intermediary. Because AB would use QI to transfer
building 1, QI would be treated as selling building 1 to         Essentially, the Service concluded that the parties
Buyer. Second, QI would acquire building 2 from CD               could do indirectly what they could also do directly. If
and transfer it to AB as replacement property.                   AB and CD had first exchanged buildings 1 and 2 with
Pursuant to an exchange agreement between CD and                 each other, with CD then transferring building 1 to
QI, QI would be treated as acquiring building 2 from             Buyer through QI in exchange for replacement
CD and as transferring it to AB. Finally, QI would               property from Seller, Section 1031(f) would have been
purchase replacement property from Seller, an                    inapplicable under Section 1031(f)(2)(C). The key is
unrelated person, and transfer it to CD as replacement           that CD did not cash out its investment.
Like-Kind Exchanges: Updates, TICs and DSTs                                                         Chapter 16

                                                               Agreement with QI for an exchange of certain other
E.   Reverse Exchanges                                         property owned by the Taxpayer (“Relinquished
                                                               Property 2”). Although it is not clear from the text, it
1.   Revenue Procedure 2004-51                                 appears that the Taxpayer exchanged Relinquished
                                                               Property 1 and/or Relinquished Property 2 for
     Revenue Procedure 2004-51, 2004-33 I.R.B. 294             Replacement Property 2 in an attempt at a reverse like-
(7/20/2004) modifies Revenue Procedure 2000-37,                kind exchange. On its Form 8824 filed for the year at
2000-2 C. B. 308, by providing that Revenue                    issue, Taxpayer reported a disposition of a commercial
Procedure 2000-37 does not apply to replacement                real estate building and the acquisition of another
property held in a qualified exchange accommodation            commercial real estate building. The issue appears to
arrangement if the property was owned by the taxpayer          be whether Taxpayer’s sale and acquisition of
within the 180-day period ending on the date of                Replacement Property 1 qualified for like-kind
transfer of qualified indicia of ownership of the              exchange treatment under Section 1031.
property to an exchange accommodation titleholder.
The IRS issued Revenue Procedure 2004-51 to address                  The field attorney with the IRS (LMSB) began his
its concern that “some taxpayers have interpreted              or her inquiry with a brief review of Section 1031
[Revenue Procedure 2000-37] to permit a taxpayer to            exchange principles and a discussion of Revenue
treat as a like-kind exchange a transaction in which the       Procedure 2000-37, 2000-2 C. B. 308. Turning to the
taxpayer transfers property to an exchange                     issue at hand, the field attorney concluded that Revenue
accommodation titleholder and receives that same               Procedure 2000-37 did not apply to Taxpayer’s
property as replacement property in a purported                transaction for two reasons:          First, Taxpayer’s
exchange for other property of the taxpayer.” Thus             acquisition of Replacement Property 1 predated the
Revenue Procedure 2004-51 puts a end to transactions           effective date of the revenue procedure. Second, even
wherein a taxpayer sells or leases property (e.g., a           if the revenue procedure applied to the transaction, the
vacant lot) already owned by the taxpayer to an EAT,           field attorney concluded that “Taxpayer acquired the
directs the EAT to construct improvements on the               [Replacement Property 1] more than 180 days before
property, and then receives the improved property from         the transfer to Taxpayer” and that “there is still some
the EAT as replacement property in a like-kind                 ambiguity as to whether the [Relinquished Property 1]
exchange. However, Revenue Procedure 2004-51 is                was properly identified in the required 45 day period.”
limited to replacement property previously owned by            Thus the issue evolved into determining whether the
the taxpayer directly. Thus it would not preclude a            Taxpayer’s exchange satisfied the requirements for a
taxpayer from receiving replacement property that was          non-safe harbor reverse exchange.
previously owned by a related party.
                                                                    According to this field attorney, unless the facts
2.   LAFA 20050203F                                            demonstrated that Taxpayer was not the beneficial
                                                               owner of Replacement Property 1, then Section 1031
      In LAFA (Legal Advice issued by Field Attorneys)         could not apply to the Taxpayer’s exchange, as a
20050203F (UIL No. 1031.05-01), Taxpayer                       taxpayer cannot effectuate an exchange with himself.
undertook the following exchange transaction: On               The field attorney listed the following factors for
Date 1, Taxpayer entered into a purchase and sale              determining whether the benefits and burdens of
agreement with Seller for the acquisition of certain           ownership have passed to a purchaser:
property (“Replacement Property 1”) and then assigned
its rights under the contract to EAT and then entered          1.   whether legal title passes;
into a Real Estate Acquisition and Exchange
Cooperation Agreement (REAECA) with EAT. Under                 2.   whether the parties treat the transaction as a sale;
the REAECA, EAT agreed to acquire the Replacement
Property, construct improvements on it, and then               3. whether the purchaser acquires an equity interest
transfer the property to Taxpayer. For two years after         in the property;
EAT acquired the Replacement Property, Taxpayer
retained an option to acquire such property for the            4. whether the sales contract creates an obligation on
acquisition costs incurred by EAT. Taxpayer also               the part of the seller to execute and deliver a deed and
entered into a two-year, triple-net lease agreement with       an obligation on the purchaser to make payments;
EAT for rent of $C per month. On Date 8, Taxpayer
entered into a purchase and sale agreement with Buyer          5. whether the purchaser is vested with the right of
1 for the sale of certain business property owned by           possession;
Taxpayer (“Relinquished Property 1”).            Shortly
thereafter, Taxpayer entered into an Exchange
Like-Kind Exchanges: Updates, TICs and DSTs                                                       Chapter 16

6. whether the purchaser pays income and property             7. Whether the purchaser bears the risk of economic
taxes;                                                        loss or physical damage. Here, EAT had no risk of
                                                              loss associated with the replacement property.
7. whether the purchaser bears the risk of economic           Ultimately, since the note was guaranteed by
loss or physical damage; and                                  Taxpayer, EAT had no risk associated with any
                                                              decline in value or damage to the replacement
8. whether the purchaser receives a profit from the           property. This risk was entirely Taxpayer's. Liability
operation, retention and sale of the property.                for operating the property also rested with Taxpayer
                                                              under the terms of the lease.          Taxpayer was
This field attorney analyzed each of the above factors        responsible for obtaining liability insurance that
as follows:                                                   named EAT as an additional insured party.

1. Whether legal title passes. Here, the relevant             In addition, this field attorney noted that the rental
documents indicate that legal title passed to EAT.            payments of “$C” for Taxpayer’s lease-back were far
                                                              below market rental value of the property and that
2. Whether the parties treat the transaction as a sale.       “[t]his extraordinary disparity in the negotiated rent is
Here, as a result of the REAECA, EAT acquired the             evidence that EAT never actually received any of the
right to complete the sale, which presumably it did.          equitable benefit of owning the property.” After
                                                              analyzing the above factors, the IRS concluded “that
3. Whether the purchaser acquires an equity interest in       Taxpayer, and not EAT, was the beneficial owner of
the property. Here, Taxpayer, and not EAT, was                the property.” According to the IRS, “Taxpayer may
entitled to the equity in the replacement property for        have been the beneficial owner of the property for
the first twenty-four months beginning with the date of       federal tax purposes, even though [EAT] held the legal
acquisition. If the value of the replacement property         title. A court will look at all of the facts and
went up, Taxpayer was entitled, through the terms of          circumstances, and consider all of the factors together.
the agreement, to the difference between the                  Here, the only factors that appear to favor EAT are
acquisition cost and the fair market value of the             numbers 1 and 2. The remaining factors suggest that
property for twenty-four months beginning after the           Taxpayer is the true owner of the property.”
day EAT acquired the property. Furthermore, EAT
had no risk of loss, since the property was purchased         Thus Taxpayer’s exchange failed, in the judgment of
with borrowed funds guaranteed by Taxpayer.                   this field attorney, to qualify for like-kind exchange
4. Whether the sales contract obligates the seller to
execute and deliver a deed and obligates the                  F.   TICs and DSTs
purchaser to make payments. Presumably, in taking
legal title, EAT received the deed to replacement                  Although we will discuss TICs and DSTs more
property and was obligated to make payments to the            fully below, here follows a more detailed exposition of
seller. In actuality, however, those payments were            the major administrative developments in these areas
made from loan proceeds guaranteed by Taxpayer, not           over the last year.
EAT. Moreover, the REAECA explicitly excused EAT
from having to make any payment for replacement               1.   Revenue Ruling 2004-86
property in excess of the funds supplied by the loan
proceeds or proceeds from the sale of relinquished                 In Revenue Ruling 2004-86, 2004-33 I.R.B. 191
property. (See 2.2 of REAECA)                                 (7/20/2004), the Service ruled that a Delaware
                                                              Statutory Trust (“DST”) that owned real property was
5. Whether the purchaser is vested with the right of          an investment trust classified as a trust and not as a
possession. Here, the terms of the REAECA actually            partnership or other business entity for federal tax
gave Taxpayer the right to lease, and therefore               purposes. As a result, the Service concluded that a
possess, the property. EAT merely possessed the title         taxpayer could exchange real property for an interest in
to the property and never actually had the right to           such DST under Section 1031.
occupy it.
                                                                   The facts of Revenue Ruling 2004-86 are as
6. Whether the purchaser pays property taxes after the        follows: A, an individual, borrowed money from Bank
transaction. As a result of the triple net lease,             (for a period of 10 years) in order to purchase
Taxpayer, not EAT was obliged to pay property taxes           Blackacre (rental real property). The loan was
after the transaction.                                        nonrecourse to A. A then net-leased Blackacre to Z,
                                                              formed DST pursuant to Delaware law, and
Like-Kind Exchanges: Updates, TICs and DSTs                                                           Chapter 16

contributed Blackacre to DST. The trust agreement                all trust income attributable to their undivided
between A and DST provided that the interests in DST             fractional interests in DST, each was treated, by reason
were freely transferable, that DST would terminate on            of Section 677, as the owner of an aliquot portion of
the earlier of the expiration of 10 years or the                 DST, and all income, deductions and credits
disposition of Blackacre, and that the beneficial                attributable to such portion would be includible by B
interests in DST would be of a single class representing         and C under Section 671 in computing their own
undivided beneficial interests in the assets of DST              taxable incomes. Because the owner of an undivided
(Blackacre). Moreover, the trustee was required to               fractional interest of a grantor trust is considered to
distribute all available cash, less reasonable reserves,         own the trust assets attributable to that interest for
quarterly to each beneficial owner in proportion to its          federal income tax purposes, B and C were each
respective interest in DST and to invest cash received           considered to own an undivided fractional interest in
from Blackacre between each quarterly distribution in            Blackacre for federal income tax purposes. As a result,
short-term U.S. obligations or qualified certificates of         such undivided fractional interests were considered of
deposit. The trustee’s activities were limited to the            like kind to the tracts of real property that B and C
collection and distribution of income, and the trustee           relinquished. Accordingly, the Service ruled that the
could not exchange Blackacre for other property,                 exchange would qualify under Section 1031, provided
purchase assets other than short-term U.S. obligations           the other requirements of that section were met.
or qualified certificates of deposit, or accept additional
contributions of assets (including money) to DST.                2.   Private Letter Ruling 200513010
Moreover, the trustee could not renegotiate the terms
of the debt used to acquire Blackacre, renegotiate the                 PLR 200513010 (4/1/2005) expands upon the
lease to Z, enter into additional leases with tenants            precedent established by Revenue Procedure 2002-22,
other than Z, or make any modifications to Blackacre             2002-1 C. B. 733 (the “Rev. Proc.”), wherein the IRS
other than minor nonstructural modifications.                    set forth 15 conditions that must be met in order to
                                                                 obtain a ruling that a TIC arrangement is not a
     After A formed DST and contributed Blackacre to             partnership. In PLR 200513010, Company intended to
it, B and C exchanged Whiteacre and Greenacre,                   acquire a fee interest in certain property (the
respectively, for all of A’s interest in DST. The issues         “Property”) subject to existing triple-net leases.
considered were whether the DST was a trust or a                 Following the acquisition of the Property, Company
business entity for tax purposes and, if it were a trust,        intended to create and sell undivided fractional
whether beneficial interests in the DST were of like             interests in the Property at fair market value to no more
kind to other real property under Section 1031.                  than 35 investors (“TICs”). Each TIC would be
                                                                 required to enter into a tenancy-in-common agreement
      As to the first issue, the Service ruled that, under       governing the rights and obligations of the TICs among
Treas. Reg. § 301.7701-4(c)(1) (which provides that an           themselves and a management agreement governing
investment trust with a single class of ownership                the rights and obligations of the TICs and the property
interests, representing undivided beneficial interests in        manager (a Company affiliate).            The TIC and
the assets of the trust, will be classified as a trust if        management agreements generally complied with the
there is no power to vary the investment of the                  conditions set forth in the Rev. Proc. but deviated from
certificate holders), DST was a trust and not a business         or expanded upon the Rev. Proc. in the following
entity for tax purposes. This conclusion was based on            respects:
the following factors: (1) under Delaware law, DST
was an entity that was recognized as being separate                      Each TIC granted each other TIC a call option
from its owner; (2) under the trust agreement, the                        on its undivided interest in the Property (each
trustee could not exchange Blackacre for other                            an “Interest”) in the event that (1) there was a
property, purchase assets other than certain short-term                   proposal to sell the Property, to refinance the
investments, accept additional contributions of assets,                   Property, or to modify a lease of the Property,
renegotiate the terms of the debt used to acquire                         and the TIC voted not to proceed in
Blackacre, or renegotiate the lease with Z or enter into                  circumstances in which holders of more than
new leases, thus meaning that the trustee lacked the                      50% of the Interests voted to proceed with the
power to vary the investment; and (3) DST had only                        proposed action, or (2) the TIC provided a
one class of interests.                                                   notice of termination of the management
     As to the second issue, the Service found that B
and C were treated as “grantors” of DST under Treas.                     The management agreement was for a 12-
Reg. § 1.671-2(e)(3) when they acquired their interests                   month term renewable annually. To renew,
from A. Because they had the right to distributions of                    within a fixed window of time prior to the end
Like-Kind Exchanges: Updates, TICs and DSTs                                                        Chapter 16

        of each 12-month period, the property manager         hiring a manager, § 6.12 of Rev. Proc. 2002-22
        would provide each TIC with a notice of               provides, in part, that the co-owners may enter into
        renewal of the management agreement. Any              management or brokerage agreements, which must be
        TIC (the “objecting TIC”) would be able to            renewable no less frequently than annually, with an
        cause the management agreement to be                  agent, who may be the sponsor or a co-owner (or any
        terminated with regard to itself, and hire a          person related to the sponsor or a co-owner), but who
        manager for its own TIC interest with its own         may not be a lessee.
        funds, by providing a notice of termination
        within a certain number of days prior to the          Company's co-tenancy agreement provides that any
        end of the renewal period, but only if the            sale, lease, or re-lease of a portion or all the Property,
        notice set forth a substitute manager and the         any negotiation or renegotiation of indebtedness
        material terms under which the substitute             secured by a blanket lien, and the hiring of a manager,
        manager would be engaged. TICs failing to             requires the unanimous approval of the Co-owners.
        vote within the requisite time frames would be        All other actions on behalf of the co-ownership require
        deemed to consent to renewal. If an objecting         the vote of those holding more than 50 percent of the
        TIC provided proper termination notice, the           undivided interests in the Property. The management
        other TICs would then have a period of time in        agreement requires the Management Company to send
        which to approve or reject the substitute             a notice of renewal to each Co-owner annually at
        manager proposed by the objecting TIC. If             which time each Co-owner could exercise its right to
        any TIC vetoed the substitute manager, the            terminate the management agreement. The renewal
        non-objecting TICs would have a call option           procedures allow each Co-owner to exercise the right
        on the interest of the objecting TIC in the           of an owner of real property to control the use of the
        Property. If no TIC exercised the call option,        Property. As a result, the provisions relating to
        the objecting TIC would be released from the          changing managers and altering the management
        original management agreement and free to             agreement satisfy the requirements of §§ 6.05 and 6.12
        hire its own manager.                                 of Rev. Proc. 2002-22.

       The management agreement provided that,               In addition, Company's management agreement
        notwithstanding its requirement that TICs must        provides that Management Company may lease or re-
        unanimously approve leases or re-leases of all        lease up to [Redacted Text]% in the aggregate of the
        or part of the Property, the property manager         total leaseable space of Property based on specific
        would be permitted to lease or re-lease a             lease guidelines unanimously approved by the Co-
        specified percentage of the property without          owners. The lease guidelines will relate to the credit
        obtaining consent from the TICs. However,             worthiness and type of tenant, rental ranges, and
        any leases entered into by the property               length of lease term. The guidelines can be amended
        manager under this provision would have to            only by unanimous agreement of the Co-owners. This
        meet certain lease guidelines unanimously             arrangement to provide some limited flexibility in
        approved by the TICs.                                 managing the leasing of Property while maintaining
                                                              the owners' rights to direct and limit that flexibility
     Company sought a ruling from the IRS that the            satisfies the requirements of §6.05 of Rev. Proc. 2002-
TIC arrangement was not a business entity under the           22.
provisions of the Rev. Proc. According to the IRS:
                                                              Thus the IRS ruled that the arrangement qualified as a
Company's co-ownership arrangement satisfies all of           co-ownership rather than as a business entity under the
the conditions set forth in Rev. Proc. 2002-22.               Rev. Proc.
Specifically regarding voting, § 6.05 of Rev. Proc.
2002-22 provides, in part, that the co-owners must            III. TENANCY IN COMMON (TIC)
retain the right to approve the hiring of any manager,             SYNDICATIONS—1031 FOR THE LITTLE
the sale or other disposition of the Property, any                 GUY
leases of a portion or all of the Property, or the
creation or modification of a blanket lien. Any sale,         A. The Need for “Team” Exchanging—the
lease, or re-lease of a portion or all of the Property,       Demand
any negotiation or renegotiation of indebtedness
secured by a blanket lien, the hiring of any manager,              A broader and broader population of real estate
or the negotiation of any management contract (or any         investors has discovered the advantages of deferring
extension or renewal of such contract) must be by             disposition gain by utilizing Section 1031. For larger
unanimous approval of the co-owners. Relating to              sophisticated real estate players, products like net lease
Like-Kind Exchanges: Updates, TICs and DSTs                                                            Chapter 16

properties, credit tenant properties and other real estate         ultimate disposition of the property, no real tax risks
structures have filled the ever-increasing demand for              existed in the relationship.
quality replacement properties.
                                                                         However, as the number of TICs grew, or
      However, for real estate investors who own                   taxpayers found themselves becoming co-owners with
smaller properties, such as duplexes, working ranches,             other taxpayers that they either didn’t know or didn’t
strip centers and the like, there was, and remains, a              trust, TICs began to desire documentation regarding
limited quantity of properties which were available to             their relationship covering issues like:
utilize as replacement properties in a like-kind
exchange. Moreover, if an investor desired to get into                    Who will manage the property?
a high quality property which was professionally                          How much will that person be compensated?
managed and threw off a stable, better-than-Treasury                       How about an extra percentage of the profits
bill return, the options were often non-existent. It                       from the property as compensation for such
seemed for the longest time that such investors were                       management?
limited to reinvesting in         smaller, self-managed                   How do we restrict partition rights?
properties similar in size, if not in product type, to that               Can any liabilities secured by the property be
which they had hoped to trade out of in the first place.                   shared in a non-pro rata fashion?
                                                                          Just how much business can be done on the
B.   The Problem with the Intuitive Solution                               property? Are the co-owners limited to just
                                                                           renting the property to a tenant, or can a whole
     The intuitive solution, of course, was to simply                      array of other activities be engaged in on the
find several investors—some or all of whom were also                       property to make additional profits?
looking for replacement properties to use in completing                   Who makes the decisions regarding leasing the
like-kind exchanges—and simply partner up with them                        property, managing the property, pledging the
to acquire a large, high-quality, professionally                           property and disposing of the property?
managed property that would provide good returns to
                                                                          What restrictions can be placed on selling a
the now-passive investors. The problem with that
                                                                           TICs interest in the property? How about
approach, however, is the following provision of                           rights of first refusals? Call options? Put
Section 1031, which provides:                                              options?
(2) EXCEPTION.—This subsection shall not apply to
any exchange of –
                                                                        As TICs would become more and more entwined
                                                                   with each other in owning a property, the risk
(D) interests in a partnership . . .
                                                                   increased of the IRS recharacterizing their relationship
                                                                   as a partnership, which would be fatal to like-kind
Thus, the simple “let’s just partner up” solution was,
                                                                   exchange treatment.
and is, unavailable to taxpayers trying to find some
way to team up with other taxpayers to complete a                        Then, in the mid-1990’s a group of Southern
like-kind exchange. So, a different solution was                   California real estate syndicators realized that this
                                                                   roaring demand for replacement property could be met,
                                                                   at a profit, by tying up quality properties, finding
And was available.                                                 investors who desired good quality replacement
                                                                   properties that would be professionally managed,
C. TIC Syndications—The Need for Certainty                         selling each such investor a TIC interest in such
                                                                   property, and then managing it for them. [The set of
      Many tax professionals had dealt with this                   slides appended hereto as Attachment B illustrates how
problem on a smaller scale for years, and the solution
                                                                   this process occurs.] Thus, it became even more
had been to have the various parties who desired to
                                                                   critical to be certain that such an arrangement would be
“team up” simply acquire the replacement property as               treated as a qualifying direct ownership interest in real
“tenants in common,” which is nothing more than                    property for tax purposes.
traditional concurrent estates in land where each tenant
is deemed to own individually a physically undivided                    But certainty was hard to come by.
part of the entire parcel of replacement property.
When the property being acquired was a piece of raw                     In analyzing the case law that controls the
land to be owned by two taxpayers who trusted each                 determination of whether a particular arrangement
other enough not to feel the need for a lot of                     constitutes a co-ownership of real property (which
agreements about the ownership, operation and
Like-Kind Exchanges: Updates, TICs and DSTs                                                          Chapter 16

would qualify the arrangement for like-kind exchange
treatment) or a partnership (which wouldn’t), it became                In early 2002, the IRS issued the Rev. Proc.,
apparent that little certainty could be assured. The lead        which established guidelines for requesting a private
case, Culbertson v. Commissioner, 337 U. S. 773                  letter ruling from the IRS on the big tax issue described
(1949), stands for the proposition that the                      above. By its terms it didn’t purport to establish a
determination of whether parties had formed a                    substantive rule of law, but rather set forth certain
partnership depends on whether the alleged partners              conditions which, if met, would likely lead to a
really and truly intended to join together for the               positive ruling on this issue.
purpose of carrying on business and sharing profits and
losses or both. Luna v. Commissioner, 42 T. C. 1067              E.   Overview of the Rev. Proc.
(1964), a Tax Court case, ruled that the existence of a
partnership does not depend on the actual name given                  Before describing what the conditions are that
the relationship but instead on the presence or absence          must be met in order to obtain a positive ruling, notice
of a variety of factors such as:                                 the following provisions of the Rev. Proc.:

1.   The agreement of the parties;                                       It applies only to rental real property
                                                                         It is not to be used for audit purposes
2.  The conduct of the parties in executing such                         It provides no certainty of obtaining (or being
agreement;                                                                denied) a ruling
                                                                         Multiple properties must be a part of a single
3.  The contributions, if any, which each party has                       “business unit”
made to the arrangement;
                                                                 The 15 conditions that must be met, in summary form,
4.   The control of each of the parties over the income          are as follows (the following Section references are to
and capital of the arrangement;                                  sections of the Rev. Proc.):

5.   The form of compensation;                                   SECTION 6.01 - OWNERSHIP. Each co-owner must
                                                                 hold title to the property (either directly or through a
6.  Whether the business was conducted in the joint              disregarded entity) as a tenant in common under local
names of the parties;                                            law.

7.   The type of governmental returns filed by the                        A TIC can own its individual TIC interest in
parties and how they held themselves out to the                            a single-member LLC
persons with whom they dealt;
                                                                          In very narrow circumstances, an investor
8.   Whether the venture kept separate books; and                          can own freely transferable interests in a
                                                                           Delaware Statutory Trust. See discussion
9. The level of mutual control and mutual                                  below.
responsibilities for the enterprise
                                                                 SECTION 6.02 - NUMBER OF CO-OWNERS. No
      Even the Treasury Regulations on this topic                more than 35 co-owners.
provide multiple subjective tests by which to make this
critical tax determination. Thus, in the late 1990’s,                     Husband and wife count as one
some of the TIC program sponsors, through their
counsel, began to request rulings from the IRS on their                   All heirs inheriting from same co-owner are
proposed deal structures. Due to the complexity of the                     counted as one
issue and the diversity of the fact patterns presented,
the IRS, in Rev. Proc. 2000-46, 2002-2 C. B. 438,                SECTION 6.03 - NO ENTITY TREATMENT OF CO-
refused to rule on the issue and began an analysis of            OWNERSHIP. No filing of entity tax returns, no
the industry and this critical tax issue to determine            conducting business under a common name, no
whether it could provide some broad guidance on the              holding out as partners, no holding the business out as
topic.                                                           an entity or the co-owners as partners, etc. Co-owners
                                                                 cannot have held their property interests through a
     It did—and the world will never be the same.                partnership or corporation immediately prior to
                                                                 formation of the co-ownership—no “drop and swaps”
D. Rev. Proc. 2002-22—The Floodgates Open                        (Bolker strategies).
Like-Kind Exchanges: Updates, TICs and DSTs                                                           Chapter 16

SECTION 6.04 - TIC AGREEMENT. TIC agreements                           Advance is recourse to non-paying co-owner (and,
are allowed, with various voting provisions and                   if the non-paying co-owner is a disregarded entity, to
transfer restrictions permitted, as limited by the                its owner)
remaining Sections of the Rev. Proc.
                                                                      Very troublesome - conflicts with lender
SECTION 6.05 - VOTING. All decisions, other than                  requirement of bankruptcy-remote entity and need for
the following four (which require unanimous co-owner              non-consolidation opinions
consent), may be made by those holding more than 50
percent of the undivided interests in the property:                   What about liabilities for “bad boy” carve-outs
                                                                  and environmental liabilities?
    Sale of all or a portion of the property
                                                                      Watch out for “springing” recourse liabilities
    Lease or re-lease of all or a portion of the property
                                                                  SECTION 6.09 - PRO RATA DEBT SHARING. Co-
    Negotiation or renegotiation of a blanket lien on            owners share in liability secured by a blanket lien in
the property                                                      proportion to their individual interests

    Hiring of a manager or negotiation or any                    SECTION 6.10 - OPTIONS.
management contract. PLR 200327003 may provide
that all such consents may be obtained by sending a                   No puts allowed
notice and receiving no negative response during a
specified response time, but PLR 200513010 clearly                    Calls at FMV (% of whole property FMV) at time
allows such a mechanism.                                          of determination allowed

SECTION 6.06 - TRANSFER RESTRICTIONS. Each                           Provides a mechanism              for    eliminating
co-owner must retain the right to transfer, partition and         misbehaving co-owners
encumber his or her undivided interest without
restrictions other than--                                         SECTION 6.11 - NO BUSINESS ACTIVITIES. Co-
                                                                  owners must limit their activities to those “customarily
    Required lender restrictions consistent with                 performed in connection with the maintenance and
customary commercial lending practices                            repair of rental real property.” See Rev. Rul. 75-374,
                                                                  1975-2 C. B. 261. Activities are customary if activities
   Rights of first offer (ROFO) to co-owners,                    would not prevent an organization described in Section
sponsor or lessee before a sale                                   511(a)(2) from being deemed to be receiving
                                                                  qualifying rent under Section 512(b)(3) and related
    Note that ROFO is different from rights of first             Treasury Regulations.
refusal at FMV (% of whole property FMV)
                                                                      Activities of co-owners, their agents and affiliates
     Calls at FMV (% of whole property FMV at time               taken into account, whether on not performed in
of determination) allowed before exercising partition             capacity as co-owner. [Note, if sponsor or lessee is co-
right                                                             owner, then all activities of that party among related
                                                                  parties taken into account for partnership
SECTION 6.07 - PRO RATA LIABILITY AND                             determination.]
PROCEEDS SHARING. If property is sold, debt
secured by blanket lien must be satisfied; sales                     Six month safe harbor (maybe longer—see PLR
proceeds must be distributed pro rata to the co-owners.           200327003)

SECTION 6.08 - PRO RATA SHARING OF                                   May require sponsor to sell all leftover interests in
PROFITS AND LOSSES. Must share in revenues                        6 months
from and costs of the property pro rata. Prohibits
advances by one co-owner on behalf of another unless-             SECTION        6.12   -   MANAGEMENT           AND
                                                                  BROKERAGE AGREEMENTS. Are allowed, but
    Advance is for no more than 31 days                          commissions must be based on gross proceeds/income,
                                                                  not net, and must be FMV.

                                                                      Must renew annually
Like-Kind Exchanges: Updates, TICs and DSTs                                                           Chapter 16

    Requires unanimous consent—notice and non-                  there were right at 50, with new sponsors coming to
objection may work—see PLR 200327003 and PLR                     market every few weeks. In 2002, about $250 million
200513010.                                                       of equity was raised to do syndicated TIC deals. In
                                                                 2004, almost $2 billion of equity was raised, and 1st
    Manager may maintain a common bank account                  quarter 2005 statistics evidence a continuing upsurge in
to collect rent and pay expenses, but must distribute net        the amount of equity being attracted to this niche of the
revenues within 3 months of receipt, and may prepare             market.
statements of revenue and costs
                                                                 G. Tax Issues
    Authorizes manager to modify insurance and to
perform ministerial functions                                          There remain many unanswered tax issues in TIC
                                                                 transactions. One general fundamental question—
                                                                 whether one must meet precisely all 15 of the
    Management agent may be sponsor but not a
lessee                                                           conditions in the Rev. Proc. in order for a structure to
                                                                 qualify as a co-ownership arrangement instead of a
                                                                 partnership—has been answered in the negative by the
    Co-owner may not provide a global power of
                                                                 2 private letter rulings that have been issued to date.
attorney but may give a power of attorney with respect
                                                                 The first ruling, PLR 200327003, addressed a single
to those acts approved under the majority rule
                                                                 tenant property and a basic TIC structure and stands
                                                                 primarily for the propositions that (1) deemed consent
                                                                 provisions may be used with regard to the annual
be bona fide, FMV [problem with credit tenant leases]            renewal of the management agreement and (2) a
and any percentage rents must be based on gross, not             sponsor may retain an interest in the TIC property for
net, income.                                                     up to 18 months without having its potentially
                                                                 disqualifying activities with regard to the property
SECTION 6.14 - LOAN AGREEMENT. Lender may                        attributed to the other TICs
not be related to co-owners, sponsor, manager or
tenants. Prevents sponsor and non-pro rata financing.                 Another interesting issue arises where the lender
                                                                 requires the TICs to waive their rights to partition the
SECTION 6.15 - PAYMENTS TO SPONSORS.                             property. Query whether such a requirement is a
Amounts paid for property and fees must be FMV and               “customary commercial lending practice?”
not based on income or profits from property.
                                                                      Those of us structuring these transactions had
F.   The Response of          the   Marketplace —Few             wondered about the ability to ameliorate the problem
     Rulings/Many Deals                                          of having to obtain unanimous consent of the TICs to
                                                                 new leases by using agreed lease forms and leasing
     One would have thought that, given a clear                  parameters, but that issue seems to have been favorably
roadmap for getting a positive ruling from the IRS,              addressed by PLR 200512010 discussed in II.E.2
TIC sponsors would have flooded the IRS with ruling              above.
requests. Not so. Only 2 rulings have been issued thus
far, and not many more sought. The reasons for this                   And, finally, the requirement that the owner of a
dearth of ruling activity are (1) it takes too long—even         single-member LLC that holds the TIC interest be
given the promise of expedited attention from the                personally liable for loans made by other TICs to fund
IRS—to obtain a ruling, and (2) most deals, as required          a capital call made on that TIC has proven problematic
to be structured by market conditions or lender                  in many deals and is rarely mandated, although the
demands, wouldn’t meet all 15 of the conditions, and             Rev. Proc. makes such a provision a condition of
therefore taxpayers are pessimistic about getting                obtaining a positive ruling.
rulings. As before the issuance of the Rev. Proc., TIC
sponsors provide comfort to investors on the big tax                   This is not meant to be an exhaustive list of open
issue by obtaining “should” level opinions from                  tax issues, but the reader can clearly see that the future
reputable tax counsel.                                           holds more development of the case law surrounding
                                                                 TIC syndications.
     Notwithstanding the foregoing, the TIC
marketplace has simply exploded since the issuance of            H. Lender Issues
the Rev. Proc. At the beginning of 2002, there were 9
sponsors of TIC programs. As of the end of 2004,                      Probably the 2 most intrusive and burdensome
                                                                 requirements of lenders in TIC transactions are (1) the
Like-Kind Exchanges: Updates, TICs and DSTs                                                           Chapter 16

requirement that each TIC form a bankruptcy-remote,              interest. The discussion of this issue is usually heated
single-purpose disregarded entity (an SPE) (usually a            and provides a great example of “where worlds
Delaware LLC, although a chain of LLC and limited                collide.”
partnership structured to be disregarded for federal tax
purposes is utilized for Texas properties in order to                 Most reputable counsel agree that almost all TIC
minimize the franchise tax exposure) to hold title to the        deals constitute the sale of a security under the
TIC’s share of the property, and (2) the requirement             definitions applicable for federal and state laws. As
that the owners of such entities guarantee payment of            such, only licensed securities broker-dealers may
the otherwise nonrecourse loan pursuant to the                   receive a commission upon the sale of a TIC interest.
provisions of “carve-out guarantees.”                            However, advocates of the interests of real estate
                                                                 brokers point out, simply but correctly, that a TIC
      TIC lenders fret openly about the possibility of           interest is also an interest in real estate and that the
“serial bankruptcies,” i. e., a situation where the              applicable laws of most states provide that only
owners of TIC interests in a troubled property would             licensed real estate brokers may receive a commission
each go into bankruptcy—one at a time—leading to the             upon the sale of an interest in real estate. Because the
possibility of foreclosure stays that last for years. The        securities broker-dealers have been in the TIC market
first line of defense against this risk mandated by              longer, and frankly because the penalties for violating
lenders is that each TIC form an SPE to hold title to the        securities laws are more severe than those for violating
TIC interest, under the theory that they can control an          state laws on real estate licensure, most TIC deals are
entity better than they can control a person. If the deal        sold exclusively through NASD member licensed
is of sufficient size ($15-20 million), one or more              securities broker-dealers. However, this debate is just
independent managers may be required, with the                   heating up, and the potent real estate lobby is actively
consent of such managers being required in order to              attempting to effect statutory and administrative
put the SPE into bankruptcy or have it file a partition          changes that would clarify applicable law and rules so
action. In addition, often a nonconsolidation opinion is         as to permit real estate brokers to receive commissions
required.                                                        on the sale of TIC interests.

     The other primary protective device for the lender          J.   Conclusion
is the use of a “nonrecourse carveout guarantee.”
What this provides is that, in certain circumstances, the             The creation and evolution of the syndicated TIC
owner of the SPE, along with the SPE, can become                 market has addressed a market need—that being, the
personally liable (an instance of so-called “springing           need to create quality 1031 replacement properties for
recourse liability”) for either that TIC’s pro rata share        “the little guys.” There remains much uncertainty
of the debt or 100% of the debt upon the occurrence of           about the issues addressed above, but even so the
certain actions or the discovery of certain bad acts.            velocity and dollar volume of TIC transactions appears
The most common action that would result in the                  to be accelerating.
imposition of such personal liability is the
aforementioned bankruptcy or partition action. These             IV. DELAWARE     STATUTORY    TRUST
guarantees vary widely from lender to lender and deal                SYNDICATIONS -- A NEAT, NARROW
to deal.                                                             ALTERNATIVE

     As mentioned above, often lenders require the               A. What is a DST?
TICs and their SPEs to waive any partition rights, to
subordinate any tenant-in-common agreement to the                     Quite simply, a Delaware Statutory Trust (DST) is
loan, to provide for a central place for notices to be           a trust formed under Delaware law. The particular
sent, and to agree to fairly restrictive provisions              aspects of Delaware trust law are not as important as
regarding transfer of TIC interests (usually requiring an        the niche that a DST fills in the ongoing search for
assumption fee in the range of 1% of the loan).                  replacement property for taxpayers seeking to
                                                                 complete a like-kind exchange.
I.   Securities Issues
                                                                 B.   How is it used?
     One raging issue in the TIC world is whether,
under applicable securities law, commissions can be                    In the like-kind exchange context, a DST is
paid to real estate brokers upon the sale of a TIC               formed to hold title to real property into which an
interest—and also whether, under applicable real estate          investor wants to exchange, but which is too big for
licensure laws, commissions can be paid to anyone                that single investor to purchase alone. In that regard, it
other than a real estate broker upon the sale of a TIC           is like the TIC structure, in that it allows multiple
Like-Kind Exchanges: Updates, TICs and DSTs                                                              Chapter 16

persons to own—here beneficially as opposed to                      from committing any of the following “seven deadly
legally—an undivided interest in the replacement                    sins:”
                                                                         1. The trustee can neither renegotiate the terms
      The DST arose due to the burdensome complexity                of the existing loan nor borrow any new funds;
of forming multiple LLCs to hold title to property in
the TIC structure and, most importantly, due to the                      2. The trustee cannot reinvest the proceeds from
strident pleas of lenders to have only one borrower, as             the sale of the property;
opposed to up to 35.
                                                                         3. Once the offering of beneficial interests in
C. The Tax Issue                                                    the trust is completed, there can be no future
                                                                    contributions of funds to the DST, whether by existing
      Beneficiaries of grantor trusts are deemed, for tax           or potential future beneficiaries;
purposes, to own the assets owned by the trust.
Multiple beneficiaries of an appropriately drafted                       4. The only capital expenditures which the
grantor trust are deemed to each own a pro rata share               trustee may make with regard to the property are those
of the property owned by such trust. Thus, if a trust               for (a) normal repair and maintenance, (b) minor non-
can be structured such that its beneficiaries are deemed            structural improvements, and (c) legally required
to own pro rata portions of the property owned by the               expenditures;
trust, then each such pro rata interest can qualify as
replacement property in a like-kind exchange.                             5. Any reserves or cash held between
                                                                    distribution dates may only be invested in short term
     The challenge for tax purposes is that, in order for           debt instruments;
a trust to be treated as a trust and not as a partnership,
it must be an “investment trust.” Treasury Regulations                   6. All cash, other than necessary reserves, must
describe the difference between business trusts and                 be distributed currently; and
investment trusts, with the determinative requirement
being that in an investment trust the trustee may not                    7. Absent the insolvency or bankruptcy of a
have the power to “alter the investment.” Determining               tenant, the trustee cannot enter into new leases or
how to structure a trust so that its trustee can’t alter the        renegotiate existing leases.
investment of the trust’s assets—that is, the property
which it is hoped can be treated as being owned by its                    If you’re shaking your head at this point, you’re in
beneficiaries for Section 1031 purposes—is a difficult              good company. As issued, this revenue ruling is useful
endeavor, mainly because the required passivity of the              only for single credit tenant triple-net deals or for
trustee butts up against the need for such trustee to take          master-leased properties, and even then lenders push
actions such as leasing or re-leasing the property,                 for some kind of mechanism by which, if the property
developing the property, doing tenant-mandated                      is in trouble, they can work with the trustee to avoid
improvements, renegotiating, renewing, extending or                 foreclosure. Several mechanisms have been tried,
working out the loan securing the property, or making               including the use of so-called “springing LLCs,” but it
capital calls on the beneficiaries when cash is needed.             remains to be seen whether the discretion left to the
                                                                    trustee by such mechanisms rises to the level of giving
     However, the industry really, really wanted to be              the trustee a fatal power to alter the investment.
able to use the DST in the 1031 context, and the literal
language of the Rev. Proc. indicated that no such entity            E.   What now?
could be used. Thus, additional guidance was sought,
and the result was an important, but narrow, revenue                      The marketplace, and particularly the lending
ruling issued by the IRS in the summer of 2004.                     community, is clamoring for DST-structured deals, but
                                                                    to date very few have been done due to some of the
D. Rev. Rul. 2004-86                                                difficulties described above. Undoubtedly more will
                                                                    come down the pike, with the lenders pushing the tax
     As set forth in II.E above, this revenue ruling lays           lawyers as close to the ditch as possible—if not into
out a fairly narrow set of facts under which a DST may              the ditch.
be used to hold property which would qualify as
replacement property in a like-kind exchange. In                    V.   CONCLUSION
analyzing whether this structure will be useful in a
transaction, one must first realize that the trust must                  With few rulings and even fewer cases in the 1031
limit the powers of the trustee, prohibiting such trustee           area in recent months, the focus is on the continually
Like-Kind Exchanges: Updates, TICs and DSTs                  Chapter 16

evolving TIC and DST arenas. As more sponsors and
more law firms get involved in the industry, new
boundaries for deal structure and finder compensation
will undoubtedly be attempted, and only time, market
changes and new cases and rulings will tell whether
such attempts are inside—or outside—the legal
boundaries inside of which these transactions must

Like-Kind Exchanges: Updates, TICs and DSTs                                                                Chapter 16

                                                ATTACHMENT A

.Part 1

          Amount realized ................................................... $470,000

          Less: Adjusted basis ............................................ $190,000

               Realized gain ................................................. $280,000

          Less: Gain excluded under § 121 ........................ $250,000

               Gain to be deferred ........................................ $ 30,000

Part 2

                                               Total           2/3 residential           1/3 business
                                               property          property                property
          Amount realized                      $360,000         $240,000                 $120,000
          Basis                                $210,000         $140,000                 $ 70,000
          Depreciation adjustment              $ 30,000                                  $ 30,000
          Adjusted basis                       $180,000         $140,000                 $ 40,000
          Realized gain                        $180,000         $100,000                 $ 80,000
          Gain excluded under                  $150,000         $100,000                 $ 50,000
          § 121
          Gain deferred under                  $ 30,000                                  $ 30,000
          § 1031
Like-Kind Exchanges: Updates, TICs and DSTs                 Chapter 16

                                   ATTACHMENT B

                                  (See 5 following pages)


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