What are 1031 TIC Exchanges? (Tenant in Common Property)
1031 TIC Exchanges are a form of real estate asset ownership in which two or more persons have an undivided, fractional interest in the asset, where ownership shares are not required to be equal, and where ownership interests can be inherited. Each co-owner receives an individual deed at closing for his or her undivided percentage interest in the entire property. In brief, a TIC owner has the same rights and benefits as a single owner of property.
Exchangers often have difficulty in locating and closing suitable replacement property within a 1031 exchange’s required 45-day identification period and the 180 day closing period. 1031 TIC exchanges can significantly reduce this difficulty.
What are 1031 TIC Exchanges? (Tenant in Common Property)
We focus in 1031 exchanges, which allow taxpayers to exchange real or personal property for new "like-kind" property, while deferring recognition of any capital gains or recapture of depreciation. We provide an array of services in effecting your 1031 transaction. The focus of our service, however, is on 1031 replacement property solutions known as tenants in common or TIC properties.
1031 TIC Exchanges are a form of real estate asset ownership in which two or more persons have an undivided, fractional interest in the asset, where ownership shares are not required to be equal, and where ownership interests can be inherited. Each co-owner receives an individual deed at closing for his or her undivided percentage interest in the entire property. In brief, a TIC owner has the same rights and benefits as a single owner of property.
Although the TIC ownership form has been used for many years, its popularity has increased due to a recent IRS ruling. Exchangers often have difficulty in locating and closing suitable replacement property within the 45 day identification period and the 180 day closing period. 1031 TIC exchanges can significantly reduce these risks.
The Mechanics of a 1031 Tenants in Common Exchange
Investors have long used 1031 exhanges 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: Brokers are securities licensed and can sell other products. Consider utilizing a 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?
1031 exchange have 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.
Who should consider Tenant-In-Common ownership?
Real estate investors who could potentially benefit from a TIC investment include investors who want to:
Sell their property and defer taxes through an IRC §1031 exchange.
Sell their property and avoid depreciation recapture.
Reduce the time, effort, and stress of locating quality replacement property.
Reduce the challenge of locating property on their own within 45 days.
Own institutional-grade commercial property.
Benefit from the knowledge and experience of commercial real estate experts.
Potentially increase depreciation deductions.
Eliminate day-to-day management responsibilities of owning real estate.
Diversify real estate holdings.
Potentially receive cash flow from real estate investments.
Receive estate tax planning benefits.
Have the ability to sell current property for fair market value without having to increase the asking price to include capital gain taxes that would have to be paid.
Potentially receive income from real estate on a tax-advantaged basis.
What are the advantages of Tenant-In-Common ownership?
TIC ownership might provide to investors the following advantages:
Provides a Viable Source of §1031 Replacement Property: Many real estate investors find it difficult to locate quality replacement property that meets their investment objectives and enables them to complete a §1031 exchange within the specified timeframes. TIC ownership creates an additional form of real estate inventory for §1031 replacement properties that investors may wish to consider.
Elimination of Management Responsibilities: Many real estate investors no longer desire the day-to-day burdens and responsibilities of being a landlord and do not want to be involved in active property management. Many TIC ownership programs have professional management which may have extensive experience in all phases of owning, managing and operating institutional grade commercial real estate.
Institutional-Grade Commercial Property: Provides investors the ability to acquire commercial or Class A properties, which in many cases are leased to national credit tenants. For many real estate investors who have "done it themselves," they have never had access to these types of commercial properties that have historically been accessible only by pension funds, insurance companies, and other large institutional investors, due to the overall value of the property.
Increase the Tax Efficiency of Real Estate: Real estate investors are able to defer capital gain and depreciation recapture taxes by performing a §1031 exchange and using TIC ownership as the replacement property.
Diversification: With potentially low minimum equity requirements, investors can diversify by purchasing a portfolio that consists of TIC ownership programs in different locations. This provides flexibility with a variety of property types, tenants, industries, etc.
Flexibility for §1031 Exchanges: TIC exchanges provide the flexibility to meet the equity reinvestment and debt requirement needed for full tax deferral and generally avoid taxable boot.
Flexible Investments: As little as $200,000 of equity can qualify for TIC ownership and an individual program could accept as much as $20 million from a single investor.
Potential Monthly Cash Flow: Many properties across the United States have appreciated in the last decade. In many areas, rental income has not kept pace with the appreciation.
Appreciation Potential: TIC investors are able to participate in the appreciation of an investment grade commercial property, if any.
Pre-Packaged Financing: Companies that structure TIC ownership programs generally acquire the property, arrange financing, perform due diligence and fully manage the property. Ordinarily the debt is non-recourse.
Back-up Property within the 45-Day Identification Period: Some investors performing an exchange have difficulty identifying and closing on replacement property within the 45-day identification period. A fractional interest in a TIC ownership property may help an investor meet their identification requirements before the identification period expires.
Stepped Up Basis at Death: TIC assets that are passed on to beneficiaries receive a full step up in basis when the original TIC owner passes away. This simply means that capital gain taxes will be forgiven after death. (Note: Consult with a tax or legal advisor regarding the tax laws that may be applicable.)
Due Diligence: The broker/dealer, sponsor and lender often perform their own due diligence. In addition, independent third party due diligence reports may also be available.
What are the limitations of Tenant-In-Common ownership?
TIC investors face the same basic risks that other real estate investors face such as market risk, economic risk, location risk, and legal risk, even though they only have an undivided fractional interest in the property. While TIC ownership can provide a real estate investor with numerous benefits, it is important to understand the limitations and risks of TIC ownership such as:
Lack of Liquidity: TIC investors must understand they are investing in real estate and a TIC transaction should be viewed as a long-term commitment. A TIC investor does not have a large group of ready and willing buyers for their respective fractional TIC ownership interest if they decide to sell their TIC interest before the TIC property is ultimately sold. Currently there is no secondary market for TIC ownership interests. Some TIC sponsors may help a TIC investor sell their interest to other TIC investors or to an outside investor.
Exit Strategy: There is generally no defined exit strategy for TIC programs other than the ultimate sale of the TIC property. Most TIC sponsors believe that they will hold a property for 4 to 10 or more years before selling the property. Additionally, an exchange in the future may be difficult because the TIC ownership percentage may be highly leveraged.
Lack of Experience: Few real estate investors understand TIC ownership. The majority of accountants, attorneys and real estate professionals do not fully grasp all the issues involved with TIC ownership. Many real estate investors do not have much experience in commercial real estate and may not be fully aware of the risks involved with commercial property ownership.
Rate of Return: There is no guarantee that a TIC will provide a higher rate of return than other real estate investments. There is no guarantee of consistent cash flow (or distributions) during the term of ownership. In fact, there is no guarantee that the TIC will make any money at all and investors may lose principal invested.
Co-Owners: Every TIC investor is locked into a long-term business relationship with many co-investors who have not known each other previously. Co-investors will have to agree, in most cases unanimously, to all major decisions affecting the TIC property.
Capital Call: TIC ownership is actual real estate ownership. If there is major work that needs to be done on the TIC property, or if a major tenant moves out, there could be a capital call placed on all TIC investors that is not covered by the capital reserve maintained for the property. This means a TIC investor could be required to put more money into the TIC property. Many TIC programs have an amount set aside in their operating budget to cover what the sponsor views as anticipated future costs.
Short-Term Debt Structure: To take advantage of low short-term interest rates, some sponsors are securing short-term financing, such as five-year loans. If the TIC property has not sold within the 5 year time period, the property will have to be refinanced and the rate on the loan may be adjusted to higher current market rates. Many investors believe that interest rates will be higher in the future. Higher future interest rates may force the investor to accept a lower overall rate of return.
Costs and Fees: Often there are many costs and fees involved in the sale of TIC ownership programs which may outweigh the benefits of tax deferral. There are costs and fees earned by the Registered Representative and others involved in the acquisition, syndication, packaging, distribution and sale processes. Other costs include property management and liquidation or disposition fees and financing or rate buy-down fees.
Estate Taxes: While it is true that a TIC investor may receive a "step up in basis" when they pass away, it is also true the value of the TIC interest will be included in the estate of the decedents if not properly planned.
Leverage: The higher returns achieved with leverage must be weighed against increased risk if the overall market or a specific property depreciates in value.
Recourse: TIC investors may assume liabilities that extend beyond their TIC investment. These can be triggered by bankruptcy, attempted termination of management, fraud or misrepresentation or a filing action for partition.
A 1031 tax deferred property exchange is an exchange in which capital gains tax and depreciation recapture tax are deferred. This referral is available to property owners who sell their property held for business or investment purposes and reinvest the net proceeds in other like-kind real estate. Property owners must meet the requirements of Internal Revenue Code (IRC) 1031. The purpose of the 1031 exchange is to allow sellers of investment property to buy replacement property of like-kind within a specific time period.
This is necessarily a summary. Each prospective purchaser should seek the advice of their own independent tax advisor as to Section 1031 and other tax issues.
Step 1
Find an experienced Qualified lntermediary (QI) to assist you with the exchange as early in the sale process as possible.
Local assistance for your real estate agent, CPA and attorney .
Safety of your funds while being held by the QI You should require a QI to provide insurance bond coverage.
Step 2
Instruct your real estate agent to include an "Exchange Cooperation Clause'' as an addendum to the purchase and sale agreement on the relinquished property. Sample language might look like: "Buyer hereby acknowledges that it is the intent of the Seller to effect an IRC f 1031 tax deferred exchange which will not delay the closing or cause additional expense to the Buyer The Seller :: rights under this agreement may be assigned to , a Qualified Intermediary for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and Qualified Intermediary in a manner necessary to complete the exchange."
Step 3
Contact your QI as soon as possible after escrow is opened or after entering into the purchase and sale agreement and advise them of your desire to do an exchange well in advance of the closing date. The QI will draft the appropriate Exchange Agreement, Assignments and Exchange Closing Instructions so they can be executed prior to closing on the property being sold.
Step 4
Identify a replacement property. Sellers have a maximum of 180 calendar days from the closing of the initial sale to complete the exchange. Within the first 45 days of this period a seller must designate candidate properties and properly identify them to the IRS. The funds in a trust account can be used as earnest money for designated property once all IRS requirements for a 1031 transaction are met.
What are the specific rules for identifying replacement property?
There are two rules for identifying the replacement property and one exception to the rules:
The Three Property Rule
This is the rule used most often in property exchanges. The exchanger is allowed to identify as many as three properties for potential exchange. There is no limit on the fair market value of these properties, under this rule. The exchanger does not have to actually acquire all the identified properties. This allows the identification of back-up properties in the event there is a problem acquiring one or more of the (up to) three identified properties. In any event the fair market value of the replacement property(s) must be at least equal to the actual sales price of the relinquished property(s) or there may be taxes due on part of the sale proceeds.
The 200% Rule
If more than three properties are to be identified, then the 200% of fair market value rule is used. There is no limit to the number of replacement properties that can be identified, but their combined fair market value cannot exceed 200% of the fair market value of the relinquished property(s) inclusive of both debt and equity.
Example
If the fair market value of the relinquished properties is $300,000, the exchanger can identify as many potential replacement properties as he or she wishes, as long as the total fair market value of the properties does not exceed $600,000 (200%) of the relinquished properties' fair market value.
The 95% Exception
If the exchanger identified more than three properties and the fair market value of the identified properties exceeds 200% of the sale price of the relinquished property, the identification may still qualify under the 95% rule. The exchanger must actually acquire identified properties whose value is at least 95% of the total fair market value of the identified properties.
Example
If the exchanger identifies 20 properties, each with a fair market value of $50,000, and is relinquishing a property that sold for $300,000, neither the 200% rule nor the three-property rule applies. As long as the exchanger buys at least 95% of the identified properties in terms of fair market value, the 95% rule applies. In this case, the exchanger would need to buy 19 of the 20 properties.
*Note: Failing to satisfy the identification rules may invalidate the entire exchange and could result in tax being due on the entire amount of gain from the sale of the relinquished property.
