Fractional ownership, also known asinterval ownership, is becoming anincreasingly popular form of propertyownership in resort areas across thecountry where the cost of property continues to rise.

Fractional ownership is an arrangementin which multiple individuals or entities hold shared legal title to a singleparcel of real estate or a condominiumunit. Each owner owns a fraction of thetotal ownership. This arrangementallows those who might not otherwisebe able to afford the resort lifestyle to do so by sharing the expense of ownership with others.

How does a fractional interest work?

Fractional ownership interests are similar to tenancies in common in thatthe owners receive a deed for a specificundivided interest in the property. Somestates, like Hawaii, allow only a limitednumber of fractional owners. Specifically,Hawaii restricts the number of fractionalowners for a single property to six (seeHawaii Revised Statute 514A).

Each owner is entitled to exclusive useof the property for only a designatedperiod of time proportional to theirownership interest. For example, if

Exchanging Fractional Ownership Interests Under Section 1031

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there are six owners, each one is entitledto 1/6 of the total number of days in theyear or 60 days a year. The fractionalowner receives a deed reflecting theirfraction of the total ownership. Thedeveloper provides a FractionalDeclaration or “Plan” which is a writtendocument outlining the rules governinguse and operation of the property bythe fractional owners.

Fractional owners pay a proportionateshare of all expenses according to theirownership. If an owner has a 1/6 shareof the property, that owner typicallypays 1/6 of the taxes, insurance, repairsand remodeling. Fractional owners alsoshare in the management of the property.Many developers will provide financingto purchasers of fractional interests, butthere are also conventional lenders whoare now providing loans on fractionalownership interests.

Can these fractional ownership interestsqualify as like-kind property in a realestate exchange? The answer is yes.

Unlike other forms of interval owner-ship, such as leasehold timeshares, thefractional owner holds direct legal titleto the property, reflected by a deed,subject to restrictions on use and possession corresponding to their fractionalized ownership interest.

As long as the primary purpose of thefractional ownership is for investmentpurposes rather than for personal use

and enjoyment, the investment shouldqualify for tax deferral under Section1031. There are two authorities thatsupport this proposition:

(1) A 1981 PLR allowed 1031 treatmentof a vacation home where the taxpayerintended to acquire property for personalenjoyment and as an investment. The IRS held that minor personal useshould not render property ineligiblefor Section 1031 if the relinquished andreplacement property are essentiallyinvestment property.

(2) The Treasury Regulations definequalified property as follows:Unproductive real estate held by oneother than a dealer for future use orfuture realization of the increment invalue is “held for investment” and notprimarily for sale.

Early investment in fractionalized ownership developments means thatinvestors will ultimately reap the bene-fit of rapid appreciation. Investors canmaximize that benefit by considering atax deferred exchange into other invest-ment real property rather than simplyselling their property and paying capitalgains tax. This gives an investor theability to leverage appreciation dollarsthat would otherwise be spent on taxes.

All investors should consult with theirtax advisor when considering use offractional ownership interests as part ofa Section 1031 tax deferred exchange.