TICs AND 1031s—PART I

Regular readers of this column know that over the course of its three-year run I have never mentioned 1031 tax-deferred exchanges. Yet type “TIC”, “tenancy in common”, or "tenants in common" into any internet search engine and the vast majority of the millions of results one finds offer information relating to 1031 exchanges. This fact, coupled with an increasing volume of calls and emails relating to TICs and tax-deferred exchanges, or expressing confusion between issues relating to “1031 TICs” and the “subdivision-analogue TIC” arrangements generally discussed in this column, have inspired me to address the topic. Since the topic is large and somewhat complex, this will be the first of two consecutive TIC Corner articles addressing the issue.

The World of TIC’s

Much confusion stems from the tendency in both the “1031 TIC” and “subdivision-analogue TIC” worlds to load up the acronym “TIC”, or the full phrases “tenancy in common” and "tenants in common" with more meaning than it actually contains. In fact, saying that an arrangement is a tenants in common only reveals three things: (i) some asset will be owned, (ii) there will be more than one owner, and (iii) when an owner dies, his/her interest passes to his/her heirs rather than to the other co-owners. But saying something is a tenancy in common tells you nothing about what is owned, the owners’ purposes (tax or otherwise), or how the co-owned property will be used.

Further confusion is created by the increasing use of the terms “fractional ownership” and "shared ownership" to describe both tax-driven and non-tax-driven co-ownership arrangements, including ones which would have been called “timeshares” a few years back. The terms “fractional ownership” and "shared ownership" provides even less information about a co-ownership arrangement than “TIC” in that it reveals only that there is more than one owner.

To sort out the confusion, create categories and subcategories for different types of TIC arrangements. Start by distinguishing between TICs that assign the co-owners usage rights to the co-owned property, and TICs that do not. Within the world of tenancies in common with assigned usage rights, there are: (i) “subdivision-analogue TICs” which assign particular houses, apartments, rooms, offices, stores, or storage spaces to each owner; (ii) “timeshares” (now commonly referred to as “fractionals”) which assign particular usage times or intervals to each owner; and (iii) “equity shares” where one or more owner gets usage rights, and one or more other owner is purely an investor. Within the world of tenants in common arrangements without assigned usage rights, there are: (i) those that come together informally among groups of family members and friends, sometimes through inheritance, and hold property for investment purposes, and (ii) those that are organized by syndicators or sponsors to be essentially passive investments and repositories for the proceeds of 1031 tax-deferred exchanges.

The World of 1031’s

The phrase “1031 tax-deferred exchange” refers to Section 1031 of the Internal Revenue Code, which allows owners of investment real estate to defer some or all of their capital gains tax by reinvesting their resale proceeds. While this is somewhat of an over-simplification of a complex set of rules, in general one can defer all gains if the cost of the new property is greater than the sale price of the old one, and all cash from the sale is invested in the purchase. Not fully satisfying either or both of these conditions results in “boot”, meaning that some but not all of the tax otherwise due remains owed. The replacement property must be identified within 45 days and acquired within 180 days, although a “reverse exchange” (meaning buying before selling) is also possible. Within certain limits, multiple replacement properties may be identified, and it is permissible to close fewer than all properties identified.

Perhaps most important for our purposes, the replacement property must be of “like kind”, which has been interpreted to mean that one cannot exchange (i) from a personal residence into investment property or from investment property into a residence, (ii) from real estate located within the U.S. to real estate located abroad, (iii) from ownership of an entity which owns real estate (such as an LLC or a general or limited partnership) into another such entity, or (iv) from ownership of an entity which owns real estate into direct ownership of real estate (such as a TIC) or vice versa. Not surprisingly, many people try to circumvent the latter two requirements by dissolving entities just before sale and/or forming entities just after purchase, but this strategy remains extremely risky.

For a long time, the similarity between a partnership interest in a real estate-owning general partnership, which would not considered real property for 1031-exchange purposes, and a fractional interest in real estate, which would be considered real property for 1031-exchange purposes, created uncertainty and risk for both 1031 investors and 1031 investment sponsors. Then, in 2002, the IRS issued Revenue Procedure 2002-22 which describes circumstances under which a TIC interest in investment real estate will qualify as 1031-exchange replacement property. Although Rev. Proc. 2002-22 provide general guidelines rather than definitive regulations, and potential investors and sponsors are instructed to submit details of a specific transaction to obtain a definitive ruling as to 1031 qualification, most practitioners now feel 2002-22 creates a “safe harbour”, meaning that arrangements that adhere strictly to its requirements are considered to have a low risk of disqualification from 1031 tax-deferred treatment. The belief that a “safe harbour” now exists for TIC-based 1031 tax-deferred exchanges has created a huge and rapidly growing industry of brokers, syndicators and sponsors, and offerings of these investment opportunities are now abundant. Nevertheless, many, if not most, of these 1031 TIC offerings deviate from at least some of these requirements of Rev. Proc. 2002-22, because the requirements conflict with many of the basic notions of passive or sponsored investments.

The Requirements of Rev. Proc. 2002-22

The following is a list of the most important requirements for a tenancy in common arrangement to qualify as 1031-exchange replacement property:

• There must be 35 or fewer co-owners
• Unanimous co-owner approval is required for sale, refinancing, leasing, and management hiring; majority co-owner approval is required for other group actions
• Although co-owners may hire a manager (who may be the sponsor) to operate the property, the manager can be compensated only based on the gross rental income, not based on profits or investor return, and the owners retain final decision-making authority
• Each co-owner must retain the right to borrow against or transfer his/her share, or to partition the property (meaning force sale with proceeds allocated pro rata)
• Co-Owners must share pro rata (by titled ownership percentage) all income, expenses, debt service, profits and cash distributions, and a no one who is not on title (such as the sponsor) may share in these amounts
• The sponsor, broker, or syndicator may be paid reasonable compensation beased on the fair market value of the property, but may not be paid based on profits or investor return

  Many of these requirements conflict with the traditional goals and practices of investment syndicators and sponsors, as well as the desires of most passive real estate investors. For example, most sponsors would prefer to retain final authority over the management and disposition of the investment, and most passive investors would prefer not to be involved in day-to-day operation. Neither of these goals can be achieved while strictly adhering to the framework of 2002-22. Similarly, most sponsors would prefer to be compensated based on profits or investor return, and most investors would prefer the incentives created by such an arrangement. But such structures are also prohibited by the IRS guidelines.

  Fortunately, some relief from the rigidity of Rev. Proc. 2002-22 can be found in the more esoteric details of the guidelines. For instance, 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, and an action may be deemed approved if no co-owner objects. In addition, the TIC documentation may impose rights of first refusal as prerequisites to a forced sale of the property. Perhaps most significantly, variations in the general guidelines are permitted when required by a lender if the lender requirement is consistent with customary commercial lending practices. This last provision has been used by sponsors to justify significant deviations from many of the most problematic conditions of 2002-22, such as the ability of co-owners to encumber fractional interests.

  In the next installment of this article, I’ll discuss whether 1031 TICs are securities, and how the answer affect sponsors and investors. I’ll also compare the ownership liabilities of TICs with investments through entities such as LLCs and limited partnerships, and suggest the use of single-member LLCs to provide additional asset protection. Finally, I’ll address the benefits of 1031 tax-deferred TIC investments, such as diversification, spreading risks among a group, increasing stability with larger assets, and diminishing stress and workload, and the pitfalls, such as higher costs, oversubscription, loss of control, and lack of liquidity.

  TICs AND 1031s--PART 2

  
  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.