Tenancy-in-Common for a 1031 Exchange

Why TIC matters for 1031 exchanges

Partnerships and LLCs face a structural problem with 1031 exchanges: only the entity itself can exchange — individual partners or members cannot. With a tenancy-in-common (TIC) arrangement, each co-owner holds an undivided fractional interest in the property. Because each interest is held directly rather than through an entity, each co-owner can conduct their own 1031 exchange independently.

A co-owner may sell their TIC interest and do a 1031 into their own replacement property, while another co-owner takes cash (triggering gain). This flexibility makes TIC a common structure for investors who want to align on a property but retain individual exit options.

IRS requirements under Rev. Proc. 2002-22

The IRS issued Rev. Proc. 2002-22 to provide a safe harbor for TIC arrangements in 1031 exchanges. Key requirements: no more than 35 co-owners; decisions about the property require unanimous or at least supermajority approval; co-owners cannot share profits in a manner that looks like a partnership; and the arrangement cannot issue interests that are treated as equity securities.

If a TIC arrangement looks like a de-facto partnership — with a managing co-owner making most decisions, shared profits proportional to labor, or centralized control — the IRS may reclassify it, eliminating each owner's ability to do individual exchanges.

The drop-and-swap technique

When partners in an LLC want to exit a property via 1031 exchange, a common strategy is to first convert the LLC to a TIC structure by distributing undivided interests to the individual members (the \"drop\"), then have each member do their own exchange (the \"swap\"). The IRS scrutinizes this, particularly if the drop and swap happen close together — courts and rulings have found that a holding period of at least one to two years between the drop and the swap strengthens the argument that the TIC interests were held for investment.

The fifteen conditions of Rev. Proc. 2002-22, summarized

Rev. Proc. 2002-22 is not a statute; it is the IRS's list of conditions under which it will consider issuing a private letter ruling that an undivided fractional interest is a direct interest in real estate rather than an interest in a business entity. An arrangement that falls outside the safe harbor is not automatically a partnership, but staying inside it removes doubt. The most important of its roughly fifteen conditions: no more than 35 co-owners (a married couple counts as one, and heirs of a co-owner count as one); the co-ownership may not file a partnership return, conduct business under a common name, or hold itself out as a partnership; unanimous approval is required to hire a manager, sell, lease, or materially refinance the property; each co-owner may transfer, partition, or encumber their own interest without the others' consent (subject to commercially reasonable lender restrictions); revenues, costs, and debt must be shared in proportion to ownership; and any management agreement must be renewable no less often than annually with fees at market rates, not tied to income like a partnership distribution.

Because these conditions are demanding, many sponsors do not actually obtain a ruling; they structure to the spirit of the revenue procedure and rely on an opinion of counsel. The practical takeaway for an individual investor is to make sure the paperwork looks like co-ownership of real estate, not membership in a venture.

TIC as replacement property, and how DSTs compare

TIC interests are used in two directions. You can relinquish a TIC interest (the co-owner scenario above), and you can acquire a TIC interest as replacement property — buying a fractional share of a larger institutional asset you could not afford alone. This syndicated-TIC market lets a smaller investor complete an exchange into professionally managed real estate. The friction is financing and governance: a lender must underwrite a deal with multiple co-borrowers, and the unanimous-consent conditions can make day-to-day decisions cumbersome.

For passive replacement, many investors now prefer the Delaware Statutory Trust (DST). Under Rev. Rul. 2004-86, a beneficial interest in a properly structured DST is treated as a direct interest in real property that qualifies for 1031 exchange. A DST sidesteps the 35-owner cap and the unanimous-consent problem (the trustee, not the investors, makes decisions), which is why DSTs dominate the passive-replacement market. The trade-off is control: DST investors are truly passive and cannot direct operations, refinance, or force a sale, and the trust operates under 'seven deadly sins' restrictions that limit its flexibility. TIC gives control and complexity; DST gives simplicity and passivity.

A worked example: three co-owners, three exits

Three siblings inherited an apartment building and hold it as tenants in common, one-third each. They decide to sell for $3,000,000. Sibling A wants to defer tax and rolls her $1,000,000 share into a DST via a 1031 exchange. Sibling B also defers, exchanging his $1,000,000 share into a small retail building he will manage himself. Sibling C wants cash for a home purchase and simply takes her $1,000,000, recognizing her share of the capital gain and depreciation recapture. Because each holds a direct undivided interest rather than a partnership interest, each exit is analyzed on its own — A and B defer, C pays. Had the property been held inside an LLC, only the LLC could have exchanged, forcing all three into the same decision or into a risky last-minute drop-and-swap.

Financing and practical pitfalls

TIC financing is the recurring headache. Lenders typically want a single loan secured by the whole property, with every co-owner signing and often each severally liable, which can entangle owners' credit in ways they did not anticipate. Rev. Proc. 2002-22 also requires that any loan be non-recourse to the co-owners' other assets in certain respects and that debt be shared proportionately, so sloppy loan structuring can itself break the safe harbor. Other common pitfalls: letting one co-owner act as a de-facto general partner (which risks partnership reclassification); sharing profits based on effort rather than ownership percentage; operating under a common business name; and doing a drop-and-swap so quickly that the IRS argues the TIC interest was never held for investment. Get the structure, the loan, and the timing reviewed by a 1031-experienced advisor before closing — a reclassification after the fact can retroactively blow up every co-owner's exchange.

Swap-and-drop: the mirror-image timing question

The drop-and-swap converts an entity to TIC before the exchange; the swap-and-drop reverses the order — the partnership completes the 1031 into replacement property, then later distributes TIC interests to the partners who want out. Both raise the same core issue: Section 1031 requires that the relinquished and replacement properties be held for productive use in a trade or business or for investment. A distribution too close to the exchange lets the IRS argue the property (or the entity interest) was held for immediate distribution rather than investment, disqualifying the deferral. There is no statutory holding period, but the longer the interval and the clearer the investment intent, the safer the position. Many advisors favor straddling two tax years and holding for a year or more. Neither technique is a bright-line safe harbor, so both should be run past experienced counsel.

What happens to basis and depreciation after a TIC exchange

A 1031 exchange is a deferral, not a step-up, so your basis and depreciation history follow you into the TIC interest. The replacement TIC interest takes a carryover (substituted) basis: generally your old adjusted basis, increased by any additional cash invested and decreased by any boot received. Deferred gain and deferred depreciation recapture ride along and come due when you eventually sell the TIC interest without another exchange. For depreciation going forward, the carried-over basis continues on its existing schedule, while any additional 'excess' basis you added (from paying up for a larger interest) is depreciated as newly placed-in-service property. Because a TIC interest can itself be relinquished in a future 1031, investors can chain exchanges — TIC into DST into another asset — deferring indefinitely until a step-up in basis at death wipes the slate clean for heirs.

Frequently asked questions

Sources

• IRS — Like-Kind Exchanges (Real Estate Tax Tips)
• IRS — About Form 8824

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.

Related

• 1031 Exchange Calculator
• The Drop-and-Swap 1031 Exchange for Partnerships
• 1031 Exchange Rules and Deadlines