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Issue 130 Article 218
TIC's...Do They Bite?
Real Estate Considerations in Tax Deferred Transactions
Chris Burti, Vice President and Legal Counsel
Tenant In Common (TIC) properties are currently being touted as the be-all and end-all investment vehicle for replacement property in IRS Code Section 1031 tax deferred exchanges. Industry pundits are reporting a 300% increase in TIC property purchases annually. Enter “TIC” and “1031” into an Internet search engine and you will instantly turn up close to half of a million hits. What is it about this form of ownership that is generating all this excitement? Properly structured TIC investments provide significant benefits, including preserving the ability to acquire or dispose of these properties as part of a Section 1031 tax-deferred exchange when replacement property choices are limited or active property management is undesirable. They also present many practical and legal issues that a TIC investor must consider before becoming obligated to close a purchase transaction.
There are relatively few individuals, CPA's, attorneys, or financial advisors who are sufficiently well versed in converting a 1031 exchange relinquished property into a TIC to be able to counsel clients adequately in the risks and benefits. It can be a profitable opportunity or it may be a potential disaster. We will attempt to outline the fundamentals of a TIC, describe the IRS requirements for a ruling and discuss potential pitfalls in order to gain greater understanding of this increasingly important investment vehicle.
Ownership of an interest in a TIC property permits one to own an undivided fractional interest in a large, institutional-grade property in return for the investment of a relatively modest amount of money. It is preferable and typical for these properties to be professionally managed rather than investor operated. Instead of owning separate rental units and dealing with emergency repairs and late-night tenant phone calls, a TIC investor might simply own an interest in common with others in a larger income producing property whose maintenance and rent issues are handled by a professional property management company.
The TIC investor actually owns an interest in the underlying real property. This is in contrast with a partnership or LLC where the investor merely owns an interest in the business entity, which in turn owns the real estate. The relationship among TIC owners of a property is generally controlled by a tenancy-in-common agreement. The TIC agreement is analogous to a partnership agreement, but significantly different. If a TIC agreement is not carefully structured, the IRS may recharacterize it as creating a partnership for tax purposes. This would effectively destroy the ability of an investor to exchange the property on qualified basis under Section 1031. In making such a determination, the IRS will look at factors such as whether the TIC agreement permits majority voting among the owners to make major management decisions, which would point to characterization as a partnership. The IRS also considers whether profits are distributed among the TIC owners in proportion to their ownership interest in the property, which again points to partnership status. IRS Revenue Procedure 2002-22 is a guideline released by the IRS in 2002. The Revenue Procedure sets out a list of provisions for a TIC agreement that would avoid recharacterization as a partnership. It is extremely important to observe that while the Revenue Procedure does provide us with some guidance in structuring these transactions, they should not be considered as providing any kind of a safe harbor. We will discuss it in greater depth below, but it may be more helpful to first discuss the more general considerations of this form of ownership.
Those who benefit most from this type of an exchange may have the following in common.
1. They own investment property whose value has appreciated substantially.
2. They wish to reduce the burden of active property management.
3. They wish to defer capital gains tax if they sell.
4. They prefer income-producing investments.
5. And, lastly, they prefer the relative stability of real estate investments.
In a TIC, each investor owns property in common with all other investors. Often these investments are put together by sponsors that then market the investment to likely individuals or entities. The term ‘sponsor’ means any person or entity who divides a single interest in the Property into multiple co-ownership interests for the purpose of offering those interests for sale. The IRS rules demand unanimity among TIC owners for all major property decisions. In order to avoid the conflicts and delays caused by the unanimity requirement in the past, owners of a TIC would lease the entire property to the sponsor under a master lease. This placed the responsibility for most property management decisions on the sponsoring company, which might directly perform the property management responsibilities or outsource them. Under these arrangements, the sponsor/property manager made decisions, collected rents, deducted fees and passed the income along to the TIC. When the property was sold, the sponsor typically took a substantial share of the profits as an asset management fee.
IRS Revenue Procedure 2002-22 sets forth the considerations, the minimum information to be provided and the criteria that must be met before the IRS would agree to issuing a ruling on whether a specific project would be approved as replacement property for an exchange. The Procedure notes that the courts have characterized entities operating with the type of master leases and profit sharing arrangements described above as partnerships for federal tax purposes. That interpretation by the IRS has led TIC sponsors to change the way they do business to conform to the minimum requirements set out in the Revenue Procedure.
Some sponsors have established themselves as the property manager and the asset manager working directly for the TIC owners. As property manager, they will earn fees by performing day-to-day tasks such as maintenance and lease management. As asset manager, they will earn a percentage of increases in cash flow generated from property improvements that attract higher-profile tenants willing to pay higher rents.
There are also limitations on the number of investors that may participate in an individual TIC transaction. The number of co-owners is limited to 35 persons. For the purpose of the Revenue Procedure, a ‘person’ is defined as in Section 7701(a)(1), of the Code except that a husband and wife are treated as a single person and all persons who acquire interests from a co-owner by inheritance are treated as a single person. The Revenue Procedure does not address what happens if the number subsequently increases to more than 35 persons. The implication of the definition leads one to concern for potential disqualification if the number of owners should expand at a later date. However, subsection .06 requires that the investors have substantial freedom to dispose of their interest as a requirement for approval. Since this can easily lead to an increase in the number of owners, one would assume that the disqualification should be only prospective for new investors and not retroactive for existing ones.
The TIC may not file a partnership or corporate tax return, conduct business under a common name, or in any way hold itself out as a partnership or other form of business entity. The IRS will not issue a favorable ruling if the co-owners held interests in a partnership or corporation that owned the subject property immediately prior to forming the TIC. The Revenue Procedure has some very specific requirements dealing with the co-ownership agreement, voting, purchase options, restrictions on alienation, proportional sharing of profits, losses and distributions upon sale. The investors must share proportionately in any indebtedness secured by a blanket lien. The owners’ business activities must be limited to those customarily performed in respect to the maintenance and repair of rental real estate. The co-owners may enter into management or brokerage agreements, which must be renewable at least annually. All leasing arrangements must be bona fide leases for federal tax purposes. Rents must reflect the fair market value and the amount of the rent must not depend on the income or profits derived by any person from the leased property other than a fixed percentage of receipts.
TIC’s also provide an opportunity for an investor to engage in non-traditional investment strategies involving real estate without assuming the risk of having the investment considered inventory. An investor might exchange a multi-unit apartment building for a TIC interest with a business plan calling for a sale after five years. In turn, the investor can roll that investment into another as the property matures. Often an investor would rather be in a five-year business plan than a 30-year business plan. If they exchange appreciating property every five years or so and re-leverage each time, the returns will be much greater than if one property was held for 30 years.
It is helpful to know where the pitfalls are in order to avoid making the major mistakes that others wished they knew about before leaping into this new tax savings form of investment. We will address some of those pitfalls below.
Avoid dealing with an investment company that does not have the experience or expertise to put these transactions together competently. Look into their history of TIC offerings, and ask for referrals from satisfied clients. Ideally, this should be their only business or an independent division of a much larger organization. Be assured that all their properties are "A" grade commercial buildings and avoid organizations that deal in less desirable investments. Determine how they select their properties and what criteria they use to rank them. High quality investment properties are increasingly difficult to find and tend to sell quickly. Be cautious about private projects. Counsel caution in assembling a group of friends and acquaintances to put a project together unless someone in the group has extensive experience in commercial property investment and management as well as a savvy team of transaction advisors. Be certain that the project has applied for a ruling by the IRS if it has not already received one.
Choosing a competent Exchange Accommodator is critical. One that has not done their homework can be an invitation to disaster. The competent Qualified Intermediary will ensure that all the documents and money transfers meet all the IRS guidelines. They will set up your LLC and make certain that your transaction advisors have the latest relevant information necessary to successfully consummate the investment. You must avoid using a disqualified person as a QI. A family attorney, real estate broker, banker or CPA will likely not qualify. Everyone wishes to avoid the nightmare of a hefty bill for capital gains taxes and penalties, or the whole transaction falling through due to an incompetent or inexperienced Exchange Accommodator.
Avoid choosing a property management company based simply on the lowest bid instead of a successful track record. They are extremely crucial to the satisfactory performance of these investments. They will be depended upon to handle the day to day problems that arise, carry the proper insurance, pay the property taxes on time, and keep the property fully occupied and well maintained. Long term, triple net leases with annual income percentages set forth together with scheduled increases should be required. Some management companies are not willing or able to provide these. Review their track record with other properties, determine how long they've been in business and their creditworthiness. Determine if they have a history of foreclosures or make a practice of instituting special assessments. A good property management company is entitled make a decent profit, because their performance translates directly into investment stability and performance.
Make sure that competent counsel has carefully reviewed the TIC agreement and that the investor is provided an opinion of counsel that the investor is entitled to rely upon. TIC investors must realize that each owner in a TIC can force a sale of the property by filing a partition action. A partition action is essentially a proceeding in court requesting that the property should be either split into parts (which is not possible for most improved properties) or sold. Waiving the right to partition in the TIC agreement, however, may cause the IRS to treat the TIC as a partnership for tax purposes. In general, each co-owner must have the rights to transfer, partition, and encumber the co-owner’s undivided interest in the Property without the agreement or approval of any person. One permitted solution that most TIC agreements utilize is to give the other owners a right of first refusal to purchase the owners’ interest before they may file a partition action. This must be drafted carefully in order to be enforceable in the jurisdiction where the property is located. It must also be narrow enough to avoid characterization by the IRS as a waiver.
Another issue that should be controlled by the TIC agreement is the management of the property. Decisions to sell, borrow funds, lease or hire a property manager must be addressed. As noted above, the IRS has clearly signaled that it will treat majority voting on major decisions in a TIC agreement as a basis to recharacterize the TIC as a partnership. On the other hand, if unanimous approval for such decisions is required, one obstinate co-owner could block the other owners. Careful drafting of the TIC agreement can at least partially solve this problem by allowing TIC owners to purchase the interest of the single recalcitrant owner. Clearly, the investor should engage tax counsel to review the TIC agreement to see whether it will be treated as a partnership for tax purposes.
With any real property investment, tax issues are only one concern among many to consider. As with any investment, there are potential pitfalls. One risk is jumping in after the tax savings without carefully researching the suitability of the underlying property investment. Investors are often lured by the potential tax deferral and overlook examining whether the basic investment is sound. Even if the property is a sound investment, these are not liquid investments and may not be right for many investors. TIC’s are relatively illiquid because investors have to find a buyer for the interest, which can take time.
The investors must also obtain and examine all the information due-diligence requires in evaluating the property. Such materials would include property inspection reports, environmental reports, title reports, a property survey and a financial analysis of the prior operation of the property. Investors must also consider their ability to resell their interest in the TIC. It is not uncommon for an undivided interest in 10 percent of a property, if sold separately, to sell at a substantial discount to the pro rata value of the entire property. In addition the TIC agreement may contain first refusal rights in the other co-owners. These, in turn, can affect value.
Another problem faced by tenancy-in-common promoters is in the financing arena. Many lenders have rules that prevent them from making loans secured by properties that are co-owned by more than just a few individuals. Lenders are reluctant to make loans secured by property in the hands of numerous co-owners because in the event of a bankruptcy, foreclosure, or other legal proceedings involving the property, they will be forced to deal with all the co-owners individually and not collectively. Each owner is likely to have separate counsel with each having divergent interests and making disparate claims and demands. Often these may be in direct conflict with those made by the other co-owners.
One potential solution to this problem would be to have the property held by a Delaware statutory trust. In jurisdictions where the Delaware statutory trust is recognized, it would appear to provide a solution. Such a trust is considered to be the owner of the property for purposes of making a loan. In 2004 the IRS issued Revenue Ruling 2004-86. In this ruling the IRS held that because of the grantor trust rules of the Internal Revenue Code, the TIC co-owners who are the trust beneficiaries will be considered to be the owners of the property for Section 1031 purposes.
Revenue Ruling 2004-86 has several unfortunate restrictions that tend to make it impractical in many instances. The IRS limits the right of the trustee to acquire property, renegotiate the terms of its loans, refinance the debt, enter into or renegotiate leases, make certain cash investments, or make any modifications to the improvements on the property. If these rights exist, this structure may not be used in conjunction with a TIC involved exchange. With such severe restrictions, the most commonly recommended structure is a triple-net lease under which the trustee need not undertake any of the prohibited acts. A long-term lease will still present concerns because it may be necessary to renegotiate or refinance the property. To avoid these issues some newer business plans for TIC property management companies contemplate a sale after the fifth year. Some investors prefer longer-term investment strategies effectively ruling out this form of ownership. The tenancy-in-common industry is evolving at blinding speed. New ownership structures may eventually be developed that address lenders’ concerns with loans secured by properties owned by numerous unrelated individuals while still meeting the requirements of the IRS. The IRS ruling has insured that the Delaware statutory trust will have limited utilization in this area.
In recent years promoters have developed and marketed TIC investments, which are usually sold through real estate brokers. Depending on the structure, TIC interests might easily be deemed to be a security, like a stock or a bond, under federal and state securities laws. In such cases, the TIC interests must be registered under controlling securities laws unless an exemption from registration exists. These must be properly documented as a sale of a security, offered for sale and sold by licensed securities dealers.
One should expect to see major changes in the form of some type of IRS ruling or legislation from Congress designed to curb abuses resulting from the dramatic increase in the use of investments in TIC as tax deferral and investment device. TIC’s are often syndicated investment programs designed to attract investors into real estate projects. The success of the prototypical projects in this developing area has led to increasingly larger projects. It has also led to a profligeration of sponsors promoting these transactions without any certifying body or regulatory control.
Reported estimates from the TIC industry indicate that the amount of real estate purchased during 2005 approximated $16 billion. This is a huge increase of almost 300% from about $6 billion purchased in 2004. This rapid rate of increase is what concerns the IRS. At the industry estimate of $500,000 per investor, this is huge number of Section 1031 exchangers that are investing in TIC’s as replacement property. As noted above, the IRS released IRS Revenue Procedure 2002-22 in 2002. It was intended to set forth the minimum criteria that must be met before the IRS would agree to issuing a ruling on whether a specific project would be approved as qualified replacement property for an exchange. The real estate industry perceived the new revenue procedure as the IRS stamp of approval, triggering a TIC rush that has continued ever since. Yet, the simple fact is that very few of these projects have actually applied for approval or been approved by the IRS for qualified 1031 treatment as an interest in common.
This has the IRS concerned. They suspect that many of these transactions will not properly qualify as Section 1031 replacement property upon audit. The Securities and Exchange Commission is apparently also concerned it is suspected that as many as half of the projects that were sold last year were sold by people who were not authorized to sell securities. This is would be people such as real estate agents who believe that what they are selling is simply real estate and not a security. Real Estate Investment Trusts (REIT) are complaining that they are being outbid by the TIC promoters and therefore they can't buy enough properties. This leads to angry calls to members of Congress, which, in turn can be expected to lead to a push for change in this area as well.