What Is Rev Proc 2002-22 for 1031 Exchanges?

Revenue Procedure 2002-22 is an Internal Revenue Service (IRS) guidance document for real estate investors. Its primary purpose is to establish the conditions under which a Tenant-in-Common (TIC) ownership structure qualifies as a direct interest in real estate, which is important for deferring capital gains taxes through a Section 1031 like-kind exchange. The procedure outlines 15 specific requirements that are widely relied on to structure co-ownership agreements. Meeting these conditions gives investors confidence that the IRS will not challenge their TIC arrangement by reclassifying it as a partnership for tax purposes.

The Underlying Tax Issue

A Tenant-in-Common, or TIC, arrangement is a form of property ownership where two or more parties hold individual, undivided interests in a single property. Each co-owner has the right to possess the entire property, and their ownership interest can be sold, inherited, or transferred independently. This structure is popular among real estate investors who wish to pool their capital to acquire larger properties while still owning a direct interest in the real estate itself.

The central tax problem that Rev. Proc. 2002-22 addresses is the risk of recharacterization. While a TIC interest is considered direct ownership in real property and is eligible for a 1031 exchange, the IRS may scrutinize the arrangement to determine if it functions more like a business entity. If the co-owners’ activities and agreements resemble the operations of a partnership, the IRS could reclassify the entire structure as a partnership for tax purposes.

This reclassification has serious consequences for an investor. Section 1031 of the Internal Revenue Code explicitly states that partnership interests are not considered “like-kind” property and are ineligible for tax-deferred exchange treatment. If a TIC is deemed to be a partnership, any attempt by a co-owner to exchange their interest would be invalidated, triggering the immediate recognition of all deferred capital gains, plus interest and penalties.

The 15 Conditions for a Favorable Ruling

Revenue Procedure 2002-22 outlines 15 specific conditions that the IRS will require to be met before it issues a favorable ruling on a TIC arrangement for a 1031 exchange. These conditions are designed to ensure the relationship between the co-owners is one of mere co-ownership of property, not the joint conduct of a business.

Ownership and Title

Each co-owner must hold title to the property as a tenant in common under local law, either directly or through a single-member LLC. The title to the property as a whole cannot be held by a separate legal entity like a partnership or corporation. The number of co-owners is limited to no more than 35 persons, and for this count, a husband and wife are treated as a single person. The co-ownership group is also prohibited from acting like a formal business entity, meaning it cannot file a partnership tax return or conduct business under a shared name.

Economic Arrangements

The conditions also address the financial relationships among the co-owners to prevent arrangements that mimic partnership profit and loss sharing.

• Each co-owner must share in all property revenues and costs in direct proportion to their undivided interest in the property. For example, an investor who owns 10% of the property must receive 10% of the rental income and be responsible for 10% of the operating expenses.
• All co-owners must share in any debt secured by the property in proportion to their ownership interests.
• One co-owner cannot advance funds to another to cover expenses for a period exceeding 31 days.
• A co-owner cannot acquire an option to sell their interest to the sponsor or lessee at a fixed price.

Management and Operations

The final group of conditions governs the day-to-day management and operational decisions of the property.

• While co-owners can unanimously agree to hire a professional manager, any management agreement must be renewable annually.
• The manager’s compensation cannot be based on the property’s net income but must be based on a percentage of gross revenues or another fixed amount.
• Co-owners must retain approval rights over major decisions, such as the sale of the property, entering into or modifying leases, or taking on new debt. While a manager can be authorized to handle routine matters, they cannot independently make significant strategic decisions without the co-owners’ consent.
• Each co-owner must have the unrestricted right to transfer, partition, or encumber their own interest, subject only to standard restrictions required by a lender.

The Private Letter Ruling Process

Taxpayers who believe their TIC arrangement satisfies the 15 conditions can formally request a Private Letter Ruling (PLR) from the IRS. A PLR is a written determination issued to a taxpayer that interprets and applies tax laws to their specific set of facts. Obtaining a favorable PLR provides assurance that the IRS will treat the TIC interest as direct ownership in real property, making it eligible for a 1031 exchange.

The process begins with a submission package that must include a complete statement of all facts and true copies of all relevant documents. Key documents typically include the co-ownership agreement, any management or brokerage agreements, and the property’s sale and lease agreements. The submission must also contain a detailed analysis of how the arrangement satisfies each of the 15 conditions and be submitted with a user fee to the IRS National Office.

Tax Implications of Compliance

Complying with the conditions of Revenue Procedure 2002-22 offers tax certainty. The primary benefit is the validation of the investor’s 1031 exchange. By confirming that the TIC interest is not a partnership interest, the IRS approves the deferral of capital gains taxes that would otherwise be due upon the sale of the relinquished property. This allows the investor to reinvest the full proceeds from the sale into a new property, preserving capital.

This certainty protects the investor from future challenges during an audit. With a PLR in hand, the taxpayer has a binding determination from the IRS regarding their specific transaction, provided the facts presented in the ruling request were accurate and complete.