Section 1031 Tax-Deferred Exchanges
Using Tenancy-in-Common Interests as
Larry Maples, Charles W. Caldwell, and Bob G. Wood, Jr.
2007 - Tight deadlines limit a property owner’s ability
to use an IRC section 1031 exchange to defer taxes on gains.
Once the property is sold and the proceeds transferred to
a qualified intermediary, the seller has 45 days to identify
replacement property, and 180 days to acquire it. The vagaries
of the market mean many taxpayers are unable to close on replacement
property within this timeframe; the result is that the IRC
section 1031 deferral is lost. Taxpayers
running up against these deadlines can gain some flexibility
by using tenancy-in-common interests (TIC) as replacement
are typically marketed as vehicles that provide the rewards
of real estate investment without the burdens of day-to-day
property management. By purchasing TICs, private investors
can invest in conservative, institutional-quality real estate
chosen by investment property professionals. The TIC market
has grown significantly over the past five years, from nine
sponsors in 2001 to 59 sponsors at the end of 2004 (Keat
Foong, “TICs Take Off,” Multi-Housing News,
April 2005). Property acquisition volume via TICs has grown
from $167 million in 2001 to more than $4 billion in 2005.
allow individual investors to join together to purchase
a property larger than any one of the individuals could
buy on his own. Each TIC investor owns a fractional interest
in the TIC property and is entitled to cash flow and tax
benefits from the property in proportion to the individual’s
investment. The fractional interests need not be equal in
amount, and they may be acquired and held for different
periods of time.
TIC investor might own and actively manage appreciated investment
property and want to convert it into an income-producing
investment and take a more passive management role. Because
the current property has appreciated, the owner will probably
seek a section 1031 “like-kind” exchange to
avoid the tax consequences of a sale. A properly structured
TIC property can meet the needs of these investors. IRS
Revenue Procedure 2002-22 helped clarify the conditions
that a TIC must satisfy for its multiple owners to have
an interest in real property rather than be considered a
partnership. TICs that meet the conditions of Revenue Procedure
2002-22 have been treated as real estate interests rather
than partnerships for tax law purposes. This is an important
feature, because partnerships cannot receive the favorable
tax treatment of section 1031 exchanges; although their
underlying asset may be real estate, the interest itself
is considered a form of intangible realty.
to a TIC Transaction
types of parties are involved in a TIC transaction: a sponsor,
a broker/dealer, and the TIC investors. TIC ownership interests
are typically sold as securities by broker/dealers, subject
to securities laws requiring that the broker/dealer perform
due diligence on the sponsor and the individual offering.
Although some sponsors acquire property outright and then
market it through broker/dealers to TIC investors, most
sponsors contract to purchase property and then use the
TIC investor funds to close the transaction. The deal may
be all cash, or leveraged.
prepare a private placement memorandum. This document contains
full disclosure about the property being purchased, the
TIC sponsor, the risks associated with the investment, third-party
opinions, and other details that can help prospective TIC
investors make informed decisions.
TIC agreement between the investors and the sponsor describes
the relationship among all of the TIC investors and addresses
the role of the sponsor, who is responsible for managing
the TIC property. The agreement between the TIC investors
and the sponsor is either a master lease, where the sponsor
pays the TIC investors a fixed amount of rent and retains
any property rents in excess of the fixed amount, or a management
agreement, where the sponsor distributes 100% of the property’s
net operating income to the TIC investors after deducting
a management fee. TIC investors must vote unanimously on
major property decisions, capital improvements, leases,
rents, and property asset managers, among other issues.
transactions usually close much faster than customary real
estate transactions—sometimes within days of the offering.
To avoid delaying the transaction and risk missing an attractive
offering that provides section 1031 exchange tax advantages,
potential investors should be preapproved by the broker/dealer
as an “accredited” investor—that is, meeting
certain minimum financial criteria. Because TIC transactions
receive favorable section 1031 exchange tax treatment, and
the timeframe for section 1031 tax advantages is limited,
sponsors and broker/dealers may have the upper hand if TIC
investors are under pressure to complete an exchange. These
conditions can lead to price escalations that reduce the
TIC investment returns.
the offering is oversubscribed or undersubscribed, the investor
may be unable to complete the section 1031 exchange. To
avoid these problems, it is wise for prospective TIC investors
to seek out several TIC alternatives with their brokers.
Because the TIC market is expanding rapidly, proper planning
should allow prospective TIC investors to complete section
of TIC Interests
TICs are intended to be long-term holdings, typically five
years or longer, at which time the sponsor sells the TIC
property and distributes the sale proceeds to the TIC investors.
TIC investors should always enter into a TIC transaction
with the intent of holding the interest for the period specified
by the sponsor in its private placement memorandum. Investors
wishing to liquidate before the sponsor’s sale date
may sell, but an established secondary market for the resale
of TIC interests does not currently exist. The most viable
option may be to resell the interest to other TIC investors
in the same property or to the sponsor.
or Real Estate
TIC ownership interests are usually sold as securities,
they are an investment in real estate. Some sponsors argue
that TICs are not securities, and sell them through real
estate agents. TICs sold as securities appear to have less
risk because of the due diligence required in the offering
of registered securities. The additional fees required for
the securities registration process, however, can increase
the cost of the investment and reduce the return for TIC
investors. SEC Regulation D requires that securities be
sold only through a licensed broker/dealer to accredited
question of whether a particular ownership arrangement creates
a partnership is an ongoing debate in tax law. In the last
few years, this question has received renewed attention
due to the growth of a new industry that specializes in
providing convenient forms of replacement property for taxpayers
trying to complete section 1031 exchanges. Whether a TIC
interest would be treated as an interest in real estate
or a partnership became a hot issue because a partnership
interest is not considered replacement property under IRC
body of case law provides examples of certain co-ownership
arrangements that were found to be partnerships for tax
purposes. In Bergford [94-1 USTC 5004 (CA-9,1993)],
for example, the court pointed out that limitations on an
investor’s ability to sell, lease, or encumber her
interest, combined with the manager’s participation
in profits or losses, made the arrangement look like a partnership.
Such decisions caused concern that a TIC interest could
be classified as an interest in a partnership and thus lose
the tax benefits of a section 1031 exchange.
reviewing the issue for some time, the IRS published Revenue
Procedure 2002-22, which provides guidelines for submitting
a ruling request. As a practical matter, the specific documentation
required to request a ruling limits the ability of a promoter
to obtain a ruling prior to marketing the TIC interests
for a specific property. Even though a ruling request for
a specific transaction may not be practical, many tax professionals
are becoming comfortable with issuing favorable opinions
on arrangements that satisfy the conditions of Revenue Procedure
2002-22. In other words, many believe that these guidelines
have become a safe harbor, and that obtaining a ruling is
not necessary if the conditions are met. As a result, the
TIC industry has undergone enormous growth.
most important elements of the conditions in Revenue Procedure
2002-22 are as follows:
to the property must be either direct or through an entity
not recognized under local law (i.e., a disregarded entity).
As a practical matter, the co-owners would be reluctant
to be subject to the legal risks of death or bankruptcy
of another owner. Thus, the use of a single-owner LLC—a
disregarded entity—is a common way to meet this condition
as well as the needs of the co-owners.
requirement is that the owners of the real property may
not hold themselves out as a joint venture or partnership.
This would include filing a tax return for the partnership
or conducting business under a common name. This requirement
includes the potentially troubling statement that the IRS
will not issue a ruling under this revenue procedure if
the property was owned by a separate entity immediately
prior to the formation of the TIC. [This requirement appears
to be inconsistent with the Bolker (85-1 USTC 9400,
CA-9, 1985) and Mason (55 CCH TCM 1134) decisions,
which held that the transfer of property immediately following
a distribution from a corporation or a partnership, respectively,
was a transfer by the shareholder or partner, not the entity.]
sale, lease, or re-lease of a portion or all of the property;
any negotiation or renegotiation of debt secured by a blanket
lien; as well as the hiring of any manager, or the negotiation
of any management contract, requires unanimous approval.
All other actions can be approved by co-owners holding more
than 50% of the undivided interests in the property. A power
of attorney can be granted to a property manager or other
person to execute specific documents with respect to an
approved action, but a global power of attorney is forbidden.
these voting requirements may seem restrictive to some,
the IRS has approved an “implied consent” provision
whereby each co-owner is given a specific period of time
within which to object upon receiving notice of a pending
action. An action is deemed approved if no co-owner objects.
The widely used triple net lease (in which the lessee pays
rent to the lessor, as well as all taxes, insurance, and
maintenance expenses that arise from the use of the property)
removes the need for co-owners to approve leases for the
property because the original lease agreement between the
co-owners and the master lessee is the only lease that needs
approval. The master lessee’s subleases to the actual
tenants are not subject to the co-owners’ approval.
co-owner generally must have the right to transfer, partition,
or encumber the co-owner’s interest without agreement
or approval. Revenue Procedure 2002-22, however, allows
co-owners to place certain restrictions on these actions
if they are required by a lender and if the restrictions
are consistent with customary commercial lending practices.
In addition, the agreement may give co-owners, sponsors,
or lessees the right to make an offer to any co-owner before
the co-owner transfers an interest in the property.
Procedure 2002-22 requires that any debts secured by a blanket
lien must be satisfied when the property is sold, and the
remaining proceeds must be distributed to the co-owners.
The reason is that the retention of profit or debt by one
of the co-owners would indicate a partnership because profits
and liabilities would be shared non–pro rata. This
provision is designed to ensure that there is no arrangement
between co-owners that would have a perpetual existence.
owner must share in all revenues and expenses in proportion
to the owner’s undivided interest in the property.
If one owner or the sponsor manager advances funds to cover
another owner’s shortfall, a 31-day limit is placed
on the advance, and the advance must be recourse to the
co-owner receiving the advance. This is a troubling requirement,
because complying with it could be a violation of the loan
agreement. Most lenders require that a single-member LLC
holding the owner’s interest be bankruptcy-remote,
which protects the asset from the creditors of the originator.
So, requiring individual owners to contribute cash to the
LLC to cover operating deficits would convert nonrecourse
liabilities into recourse liabilities, violating most loan
can grant a call option provided that the exercise price
reflects the fair market value at the time of exercise.
Revenue Procedure 2002-22, however, prohibits a co-owner
from acquiring a put option for persons involved in the
transaction. This may make a TIC an unattractive entity
for parking exchange proceeds until other replacement property
can be identified.
offerings are limited to 35 accredited investors. An accredited
investor is defined as having either a $1 million net worth
or an income of $200,000 for each of the past two years.
The average TIC investment is $500,000 to $700,000, and
the minimum is rarely below $150,000.
the IRS may consider a TIC to be real estate and not a security,
such interests are very likely to be considered securities
by the SEC. In fact, 90% of TIC sponsors offer these investments
as securities, and therefore require private placement memoranda.
The remaining offerings are sold by sponsors who view them
as real estate and offer them through real estate brokers.
There is always a risk that the SEC could impose penalties
on real estate brokers who participate in the sale of an
investors may be able to combine capital appreciation with
a steady cash flow partially sheltered by depreciation deductions.
Annual cash flow is commonly in the 6% to 8% range, with
a third to half of that sheltered by depreciation. Typically,
the property would be sold after several years with a total
annualized return in the 11% to 15% range. The investor
would then need to find other property to keep deferring
TIC investors may need to adjust their conceptions of value.
Their previously owned condominiums, rental properties,
and other real estate investments had value in their own
right, separate from the rental stream. Income-producing
institutional-grade real estate is valued based on capitalization
rates and future projected cash flows. The price paid may
substantially exceed the replacement cost of the real estate.
If rising interest rates pull capitalization rates up before
property income increases, the value of the investment could
financial health of a tenant can affect the value of projected
lease payments. Rent escalators may be another factor. Or,
a single tenant versus multiple tenants may add risk to
an investment, especially if an investor cannot afford to
diversify by holding several TICs.
following are the potential problems with a TIC investment:
Few TIC arrangements have guaranteed exit strategies,
because Revenue Procedure 2002-22 has a restriction against
put options, and promoters usually do not guarantee the
TIC value. As a result, TICs may not be well suited for
investors looking for a place to park exchange proceeds
until more-desirable investment property can be acquired;
there is no established secondary market for TIC interests.
TICs are more expensive than traditional acquisitions
of real estate. The additional expense of a TIC may amount
to 6% to 7% of a transaction. Depending upon how the transaction
is structured, the master lessee can make a significant
profit from the spread between the rent paid to the co-owners
and the rent received from the tenants.
A TIC may be oversubscribed, resulting in the elimination
of some investors. Undersubscription can also be a problem,
unless the sponsor uses its own funds to close the transaction.
Removing this risk comes at a cost to investors.
A TIC is real property, so the burdens of real property
ownership apply. For example, if a major tenant vacates
or if environmental problems surface, investors could
be subject to liability in excess of the original investment.
Furthermore, investors should exercise greater caution
as interest rates rise. Sponsors may become more desperate
to put deals together that generate fees but do not make
sense for investors.
Maples, DBA, CPA, is the Alumni Professor of Accounting;
Charles W. Caldwell, DBA, is a professor
of accounting; and Bob G. Wood, Jr., PhD,
a professor of finance, all at Tennessee Technological University,