TICs AND 1031s—PART 2

This TIC Corner is the second of two consecutive articles addressing 1031 tax-deferred exchanges. In the first, I attempted to sort out the confusion over different types of tenancy in common ownership arrangements by distinguishing between TICs that assign the co-owners usage rights to the co-owned property (the subject of all but the most recent of my past columns), and TICs that do not. This series addresses the latter type of arrangement, focusing specifically on tenants in common that are organized by syndicators or sponsors to be essentially passive investments and repositories for the proceeds of 1031 tax-deferred exchanges. The first article explained the general background and nature of 1031 exchanges, and the specific requirements described by the IRS in Rev. Proc. 2002-22 for a tenancy in common to qualify as 1031-exchange replacement property.

Are TICs Securities?

Perhaps the most enduring and difficult question associated with sponsor-organized TICs is whether the tenant in common interests are securities under federal and/or state law. This question is important because the offering of securities is highly regulated. The perceived need for this regulation stems from the assumption that the buyer of a security is being enticed to give control of her money to someone else, thus creating the potential for deceit and abuse. Securities regulations impose extensive documentation requirements on every securities offering. In some cases, an offering must also be registered and approved by governmental agencies. The parties selling or promoting the tenants in common offering must meet special licensing requirements which are generally not satisfied by real estate licenses. Compounding the complexity of all of these regulations is the fact that they vary from state to state, and a particular offering will have to satisfy the requirements of federal law and those of one or more states based upon the location of the property, the marketing, and the investors.

No one has a definitive answer on whether and when a tenancy in common offering is a security, in part because of the huge amount of statutory, judicial and administrative law bearing upon the general question of what is and is not a security. The leading case in this area, SEC v. W.J. Howey Co., 328 U.S. 293 (1946), created the well-known "economic realities" analysis under which an interest will be classified as a security only if three elements are concurrently present: (i) an investment of money; (ii) a common enterprise; and (iii) an expectation of profits derived solely from the efforts of the promoter or a third party. The Court emphasized that "form was disregarded for substance and emphasis placed upon economic reality", meaning that whether or not a security has been created is not going to be determined by whether ownership is deeded real property or shares in an entity such as a limited liability company (“LLC”) or limited partnership (“LP”). Subsequent court decisions modified the third prong of Howey from "solely" to "substantially", leaving us with the rather vague notion that the term “security” includes any investment made with an expectation of profits derived mostly from the efforts of the promoter.

In practice, the vagueness of the legal definition of “security” means that each tenants in common offering must be analyzed separately as a potential security, and that there will almost always be room for disagreement. My view is that the vast majority of 1031 TIC offerings would be categorized as securities by most administrative and judicial bodies because they are promoted as passive investments. By this I mean that even though the IRS’ Rev. Proc. 2002-22 requirements for 1031 tenancy in common theoretically create some degree of investor power and control, the scope of that power and control is only peripherally related to the planning and operation of the enterprise, and investors are encouraged to stay out of day-to-day operations. Put more simply, the promoter generally provides a business plan for the TIC project, the investors decide whether or not to invest, and then those that choose to participate simply sign the documents, provide the money, then wait for the result. Regardless of what the paperwork says or does not say, it is difficult to argue that this arrangement is not exactly the type of thing securities laws were designed to regulate.

Owner Liability

As discussed in the first part of this series, tax-deferred exchanges are possible only when investment real estate is exchanged for other investment real estate. An exchange into entity ownership, such as an interest in a limited partnership, membership in a limited liability company, or shares in a corporation, will not qualify for tax deferral. A significant disadvantage of direct real estate ownership, as compared with ownership of an entity that owns real estate, is the loss of liability protection. This means that the tenants in common investor could be held personally responsible for debt or loss resulting from environmental contamination, personal injury, or any other property-related problem. And while liability insurance can protect against certain types of liability, some losses cannot be insured, and even insured losses can exceed policy limits.

One way 1031 tenancy in common sponsors have attempted to create liability protection is by converting ownership from a tenancy in common to an entity after a waiting period of 6-24 months. But it is unclear whether such a conversion would withstand an IRS audit. No one knows how long a waiting period is required between acquisition of the tenancy in common share and conversion of TIC ownership to entity ownership. Perhaps more important, if an intention to convert has been present from the start, the original TIC structure may be disregarded as a sham. And beyond these tax questions, a converting TIC structure still exposes the investors to heightened liability risk during the period before the conversion occurs.

A better and increasingly popular liability protection strategy is to have each tenant in common take title to his/her TIC share as a single member limited liability company (“SMLLC”). When appropriate forms are filed, an SMLLC is treated as a “disregarded entity” for income tax purposes, meaning that owning in this manner is equivalent to direct ownership of the TIC interest but still provides the liability protection of entity ownership. Note that while any LLC can qualify as a “pass-through entity” for income tax purposes, “pass-through entity” characterization is different from “disregarded entity” characterization, and only the latter will satisfy 1031 exchange requirements. An LLC can be considered an SMLLC only when it has one member, or when its only members are a husband and wife who file their income taxes jointly.

Exchanging Into A TIC Versus Buying Alone

Prior to the IRS’ Rev. Proc. 2002-22, most owners in tax-deferred exchanges bought one or more replacement properties by themselves or with friends or family members. A few short years later, an entire industry exists to place these same owners in pre-packaged replacement investments. This major shift in 1031 exchange practice results from the significant advantages offered by these sponsored TIC arrangements: (i) group purchase allows the exchanger to spread transaction and operating costs over multiple owners and larger properties, thus increasing efficiency; (ii) exchangers can afford to participate in the purchase of larger and often more stable properties because they do not need to finance the entire acquisition themselves; (iii) the lower cost of entry resulting from group buying power allows exchangers to spread their available funds among more transactions, lowering risk through diversification; and (iv) the burden of finding and operating the replacement property is shifted from the investor to sponsors and managers.

But the advantages of sponsored tenants in common arrangements need to be carefully weighed against the disadvantages: (i) loss of control over operation and the resulting loss of liquidity; (ii) increased exposure to loss from deceit, theft and mismanagement; (iii) costs associated with compensation to sponsors and increased asset management needs; and (iv) the risk that over- or under-subscription will prevent the exchanger from participating. In considering the last of these disadvantages, remember that 1031 tax-deferred exchanges require that the replacement property be identified within 45 days, and acquired within 180 days. The failure to meet either of these deadlines will cause the exchange to fail, potentially resulting in significant tax liability.

About the Author

D. Andrew Sirkin is a recognized expert in fractional ownership and other co-ownership arrangements including shared vacation homes, TICs, equity sharing, co-housing, and legal subdivisions such as condominiums. His practice areas include transaction planning, offering materials, co-ownership agreements and CC&Rs, entity formations, regulatory approvals, fractional lending and mediation. From offices in San Francisco California, Evergreen Colorado, and Paris France, he has worked on projects all over the World, including most U.S. States, as well as Italy, France, Spain, Portugal, Ireland, Argentina, Nicaragua, Costa Rica, Panama, Dominican Republic, Nicaragua, Belize and Mexico. Since 1985, he has prepared fractional ownership documentation for over 6,000 clients. He is an accredited instructor with the California Department of Real Estate, and frequently conducts co-ownership workshops for attorneys, real estate agents, corporations, and prospective home buyers. Andy is the co-author of The Condominium Bluebook, published annually by Piedmont Press, and The Equity Sharing Manual, first published by John Wiley and Sons in November 1994 (order the book). He has written numerous articles on related topics, including "Fractional Ownership" and "Questions and Answers on Tenancy In Common", all of which are available at www.andysirkin.com. Mr. Sirkin can be contacted via email at DASirkin@earthlink.net. Mr. Sirkin can be reached by telephone at 415-738-8545.