IRC Section 1031 Tax-Deferred Exchanges
Using Tenancy-in-Common Interests as Replacement Property

By Larry Maples, Charles W. Caldwell, and Bob G. Wood, Jr.

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JANUARY 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 property.

TICs 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.

TIC Basics

TICs 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.

A typical 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.

Parties to a TIC Transaction

Three 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.

Sponsors 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.

The 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.

Timing

TIC 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.

If 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 1031 exchanges.

Resale of TIC Interests

Most 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.

Securities or Real Estate

Although 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 investors.

Tax Hurdles

The 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 section 1031(a)(2)(D).

A considerable 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.

After 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.

The most important elements of the conditions in Revenue Procedure 2002-22 are as follows:

Title 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.

Another 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.]

Any 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.

Although 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.

Each 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.

Revenue 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.

Each 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 covenants.

A co-owner 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.

Investment Considerations

TIC 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.

Although 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 unregistered security.

TIC 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 the gain.

Potential 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 decline.

The 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.

The Downside

The 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.

Larry 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, Cookeville, Tenn.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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