Many investors hold real property through a limited liability company (LLC). An LLC offers valuable liability protection and management flexibility, but it can create a significant obstacle when the members eventually decide to sell the property and their tax objectives diverge—some members wishing to defer their gain through a like-kind exchange under Section 1031 of the Internal Revenue Code, and others preferring to cash out.

Because LLC, and not its individual members, own the real estate, and because interests in LLCs are taxed as partnership interests, the LLC does not qualify for Section 1031 treatment and the members cannot simply go their separate ways.

This article explains a two-step solution: 
•    First, transferring the property out of the LLC to the members as tenants in common so that each owner can independently pursue a Section 1031 exchange or a taxable sale; and
•    Second, replacing the LLC’s operating agreement with a Tenancy in Common Agreement to govern the property once it is held directly by the co-owners.

Understanding Tenancy in Common

A tenancy in common (TIC) is a form of concurrent ownership in which two or more people hold undivided interests in the same parcel of real property. Each co-owner—often called a “tenant in common”—has the right to use and possess the entire property, regardless of the size of their ownership share. Ownership percentages need not be equal; for example, one co-owner might hold a 60% interest while another holds 40%.

Importantly, a tenancy in common does not include a right of survivorship. When a tenant in common dies, his interest does not pass automatically to the surviving co-owners. Instead, it passes to the deceased owner’s heirs or beneficiaries under his will or estate plan. This distinguishes a tenancy in common from a joint tenancy, where the right of survivorship applies.

Why Section 1031 Does Not Work Inside an LLC

When real property is held in a multi-member LLC, the LLC is generally treated as a partnership for federal income tax purposes, and the entity itself—not its individual members—owns the real estate. Section 1031 permits an investor to defer capital gains tax when real property held for productive use in a trade or business or for investment is exchanged for like-kind replacement property. Critically, however, Section 1031 expressly does not apply to interests in a partnership.

This limitation has a direct consequence for LLC members. Because an individual member owns an interest in the LLC rather than a direct interest in the real estate, that member cannot exchange his or her membership interest and qualify for deferral. The LLC can complete an exchange at the entity level, but only if all members agree to reinvest the entire proceeds into replacement property.

That unanimity breaks down precisely when the members’ goals diverge—when some wish to defer their gain and others wish to sell and pay the tax. To give each owner independent control over his or her own tax outcome, the property must be taken out of the LLC before the sale.

The First Step: Transferring the Property to Yourselves as Tenants in Common

The most common solution is for the LLC to distribute the real property to its members as tenants in common before the sale, so that each member holds a direct, undivided fractional interest in the real estate itself. This transaction is often called a “drop and swap”—the property is “dropped” out of the LLC to the members, who then “swap” their individual interests.

Once each member owns a direct real property interest as a tenant in common, those who wish to defer gain can independently exchange their fractional interest into replacement property under Section 1031, while those who prefer to cash out can sell their interest and recognize their gain. In this way, converting to a tenancy in common allows members with different objectives to go their separate ways in a single transaction.

A Word on Timing: The drop-and-swap structure carries tax risk and demands careful planning. Section 1031 requires that both the relinquished and replacement property be held for productive use in a trade or business or for investment.

The Internal Revenue Service may scrutinize a conversion that occurs immediately before a sale, arguing that the members received the property with the intent to sell rather than to hold for investment, which can disqualify the exchange. For this reason, practitioners generally recommend that the distribution to tenants in common occur well in advance of the sale, and that the co-owners genuinely hold and treat the property as an investment during the interim.

The longer and more clearly the property is held as a tenancy in common before disposition, the stronger each member’s position that he or she holds a qualifying interest.

The Second Step: Replacing the Operating Agreement with a Tenancy in Common Agreement

Once the property has been distributed out of the LLC, the LLC’s operating agreement no longer governs it. The operating agreement is a contract about the entity and its membership interests; after the transfer, the members own the real estate directly, and there may be little left for the entity to administer.

Continuing to rely on the old operating agreement—or on no written agreement at all leaves the co-owners without a governing document suited to their new form of ownership and exposes them to the rigid default rules that state law imposes on tenants in common.

Replacing the operating agreement with a Tenancy in Common Agreement is therefore a critical second step. Beyond governing the day-to-day relationship, the new agreement must be drafted so that the arrangement is respected as a genuine co-ownership of real property rather than a continuation of the partnership. In Revenue Procedure 2002-22, the Internal Revenue Service set out conditions under which a fractional interest will be treated as an undivided co-ownership interest eligible for Section 1031 treatment rather than an interest in a business entity— addressing matters such as limiting the number of co-owners, requiring that title be held as tenants in common, prohibiting the co-owners from holding themselves out as a partnership, requiring specified approval for major decisions, and sharing revenues and expenses in proportion to ownership interests.

A Tenancy in Common Agreement that mirrors an operating agreement too closely—vesting centralized management authority or otherwise resembling a partnership—can jeopardize the very tax treatment the transfer was designed to preserve.

A well-drafted Tenancy in Common Agreement reconciles the practical need to manage the property with the legal requirement that the arrangement not resemble a partnership. It documents each owner’s fractional interest as of the distribution, establishes how the property will be operated during the holding period, and anticipates that some co-owners may exchange while others sell—addressing rights of first refusal, coordination of a joint sale, and the allocation of proceeds and closing costs.

9 Key Provisions Your Tenancy in Common Agreement Should Address

1.    Ownership Shares and Capital Contributions. The agreement documents each co-owner’s percentage interest in the property and their initial capital contribution. Clearly defining ownership shares at the outset—consistent with the interests received on the distribution from the LLC—prevents future disagreements about who owns what.

2.    Allocation of Expenses. Co-owners must share ongoing costs—mortgage payments, property taxes, insurance, utilities, maintenance, repairs, and capital improvements. The agreement specifies how these expenses are divided (often in proportion to ownership shares) and establishes a process for handling shortfalls if one owner fails to contribute.

3.    Use and Occupancy. The agreement sets out who may occupy the property, any use schedules (particularly important for vacation or shared-use properties), and whether the property may be rented to third parties. If rental income is generated, the agreement governs how it is divided among the owners.

4.    Management and Decision-Making. Not every decision about a property carries the same weight. A Tenancy in Common Agreement typically distinguishes between routine management decisions and major decisions (such as significant repairs, refinancing, or selling the property) and establishes voting thresholds. Because the arrangement must not resemble a partnership, major decisions are commonly reserved to the unanimous or specified approval of the co-owners rather than delegated to centralized management.

5.    Transfer Restrictions and Rights of First Refusal. One of the most important protections in the agreement is a restriction on a co-owner’s ability to sell, transfer, or encumber their interest to a third party without first offering it to the other owners. A right of first refusal gives the remaining owners the opportunity to purchase a departing owner’s share before it is offered to outsiders, and buy-sell or buyout provisions establish a mechanism and pricing methodology for these transactions.

6.    Partition Protection. Under most state laws, any co-owner can force a sale of the entire property through a partition action—a potentially disruptive and costly court proceeding. The agreement can waive or limit partition rights or establish an agreed process for handling a co-owner’s desire to exit, thereby preventing an unwanted forced sale of the property.

7.    Dispute Resolution. Mediation and arbitration clauses provide a structured, private alternative to litigation. These provisions can save co-owners significant time and expense and help preserve personal relationships.

8.    Death, Incapacity, and Default. Because a tenant in common’s interest passes through the owner’s estate, the agreement should coordinate with each owner’s estate plan to ensure a smooth transition. The agreement also addresses remedies if an owner becomes incapacitated or defaults on their financial obligations.

9.    Financing. The agreement addresses whether financing will be shared among all owners or obtained individually on a fractional basis and clarifies each owner’s liability exposure in connection with any loans secured by the property.

Why Planning Matters

For real property owners who hold title through an LLC, planning ahead is essential when the members’ investment horizons and tax goals begin to diverge.

Transferring the property to the members as tenants in common allows each owner to chart an independent course—whether deferring gain through a Section 1031 exchange or selling for cash—and replacing the operating agreement with a carefully drafted Tenancy in Common Agreement ensures that the co-ownership is properly governed and respected for tax purposes.

Taken together, these two steps protect each owner’s investment, preserve valuable tax flexibility, and provide a clear framework for managing the property and any future sale. Because the interplay of partnership tax rules, Section 1031, and state real property law is complex, owners should engage experienced tax and real estate counsel before undertaking either step.
If you have questions about your 1031 options, please connect with Tom directly at tek@gdblaw.com. 

Disclaimer: This article is provided for general informational and educational purposes only and does not constitute legal advice. Co-ownership arrangements involve complex legal and financial considerations that vary by jurisdiction. Co-owners should consult a qualified real estate attorney in their jurisdiction to prepare a Tenancy in Common Agreement suited to their specific circumstances.