Current challenges when highly appreciated California commercial real estate is owned by two or more people

The ownership of real property in California by more than one person can be one of the most complex situations that investors can get involved with.  Nearly ten years ago, I prepared a special report that described various approaches for co-owners to employ to reduce the risks of holding title to commercial real estate.  That guide discussed several options available to landowners for mitigating liability in this situation, including the use of corporations, limited partnerships, and limited liability companies to hold legal title.

Since then, little has changed in the law.  What has changed significantly over this period, however, is how much California real estate has appreciated in value, especially here in Silicon Valley.  By way of example, the median price of a single family home in Santa Clara County ten years ago was $582,500; today, it is $1,280,000, an increase of 120% !  Given this substantial level of capital appreciation, it’s no wonder that one of the biggest concerns for owners of Silicon Valley commercial real estate these days is avoiding or deferring income tax on capital gains.

For this reason, there has been a significant increase over the last several years in the use of Section 1031 tax-deferred exchanges.  The popularity of this option, however, has revealed a downside in the use of entities for risk avoidance:  Where property is owned by two or more people, holding title in a corporation, partnership or limited liability company prevents each owner from acquiring his or her own separate replacement property in an exchange in the event that they are not in complete agreement on where to reinvest their sale proceeds.  This is because Section 1031 tax-deferred treatment is allowed only for the taxpayer holding title to real property held for investment (the entity), and is not allowed for interests in the entity held by the beneficial owners.

As a result, several strategies have been developed for those situations where legal title to real estate is held by an entity in order to allow the beneficial owners to avoid the restrictions of Section 1031 tax deferral on their replacement property options.  Some of these methods require the beneficial owners to take title to the property in their own names for a period of time sufficient to satisfy the “held for investment” requirements of Section 1031.  While these techniques preserve the tax-deferred exchange benefits for those who employ them, and while there are methods available to limit liability for property owners besides the use of entities, these investors must be careful not to ignore the peculiarities of the California law of co-ownership.

In the absence of an agreement among the co-owners of real property, the rights of those co-owners are defined by California law governing the ownership of undivided interests in real property.  Those rights may differ substantially from the intentions of those investors who take title for tax deferral purposes.  For example, state law provides that each co-owner has an absolute right to occupy and possess the property for his or her own purposes and may not exclude any other co-owner from the property.  In addition, each co-owner has the right to file a lawsuit for partition of the property against the other co-owners, thus forcing a sale or buyout of the property.  Each co-owner also has the absolute right to sell or borrow against his or her own interest in the property, as well as to lease his or her own interest, regardless of the wishes of the other co-owners.  It is thus clear that California law is not particularly compatible with the orderly management and control of commercial real estate.

As such, in the event that co-owners of highly-appreciated California commercial property must resort to holding title to the property in order to take advantage of a Section 1031 tax-deferred exchange, it is imperative that those co-owners enter into a tenancy-in-common agreement to override the provisions of California law that are inconsistent with their understandings about the property.  These agreements are commonly used in connection with residential real property and may also be used for commercial property.  These agreements are established to provide for the specific rights and responsibilities of each co-owner regarding a variety of matters, including the management of the property, the sharing of maintenance and capital expenditures, dispute resolution, and the orderly sale or encumbrance of the property or a specific owner’s interest (for example, buy-sell rights).

In the case of investors who take title to California commercial real estate to preserve tax deferral under Section 1031, the formulation of a tenancy in common agreement must be carefully thought out.  On the one hand, the agreement should ensure that the rights and responsibilities of the parties under the agreement comport as closely as possible to the rights and responsibilities that existed under the entity.  On the other hand, care must be taken not to structure the agreement in such a way that the parties’ interests are less like tenancies in common and more like interests in the entities that they just exited, in order not to jeopardize their ability to defer tax under Section 1031.  These considerations are just one more example of the complexities that can arise when using this tax deferral strategy, and the planning that must be carried out in order to take advantage of Section 1031 tax deferral.