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The Mechanics of a 1031 Tenants in Common Exchange
Investors have long used 1031 exchanges to defer taxes, while swapping old properties for newer properties. The reasons for swapping real estate vary greatly. In today's market, finding real estate values can be a challenge and individual investors have been somewhat limited to residential properties and small commercial structures.
An IRS ruling in 2002 greatly expanded the pool of available properties, particularly for individual investors. The ruling pertains to joint tenant in common (TIC) legal structures or co-owned real estate (CORE), which quite simply, allows individuals to own a fractional interest in a property, such as an office building, apartment complex or shopping center. While tenant in common investment ownership has been around for quite some time, the 2002 ruling allowed investors to feel confident that the IRS was on board with the tenant in common structure for 1031 TIC exchanges, igniting a cottage industry.
The ruling, coupled with an increased interest in 1031 TIC properties, has led to a rapid growth in tenants in common and CORE investments. A 1031 TIC structure will allow investors to pool their resources and purchase larger, higher valued and better positioned properties than they might otherwise have access. Typically these more prestigious properties can also open doors to high quality lessees, such as Fortune 500 companies and government entities, reducing owner tenant risk. Real estate firms (Sponsors) organize the properties with professional management, removing day-to-day owner concerns.
TIC 1031 tenant in common exchanges are typically handled through broker-dealers and are under the oversight of the Securities and Exchange Commission (SEC).
The typical TIC replacement property investor meets all or many of the following scenarios:
- wishes to greatly reduce their management responsibilities
- has left over funds (boot) from another direct 1031 investment
- does not want to pay capital gains or depreciation recapture taxes
- seeks Grade "A" properties with large, well financed tenants
- cannot find suitable direct property in the 45 day period
- desires to remain in the real estate market for income and potential of capital gains
- Desires a higher degree of diversification both in properties and regions.
The TIC replacement investments are not without pitfalls. There has been a plethora of sponsors that have popped up following the 2002 IRS ruling. A few things that you should consider before entering in to any 1031 TIC investment*:
- How long has the sponsor been in business?
- Does the sponsor have experience not only in structuring deals, but also successfully selling the properties for the TIC replacement property investors?
- Do investors have control to hire and fire managers?
- What is the exit strategy for the property?
- Does the sponsor have experience in executing their stated strategies?
- Does the TIC 1031 broker have experience in marketing TIC deals?
- What percentage of the broker's business is related to TIC replacement properties? (Remember: TIC brokers are securities licensed and can sell other products. You should strongly consider utilizing a TIC broker that makes TIC exchanges a core part of their business)
- How solid are the tenant leases?
- How solvent are the tenants?
- Is the property relatively new and is it located in an area that is doing well economically?
It would be an understatement to say that 1031 exchange has become a driving force in commercial real estate sales transactions. While TIC interests are not perfect fits for all investors, 1031 TIC exchanges can be a good match for investors that are looking for potentially steady cash flow and limited management hassles on their replacement properties.
*This list is by no means a complete list necessary to perform complete due diligence, but hopefully provides potential investors with some important points to consider.
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