October 2004
Volume 1, Number 1
Table of Contents
  Tenant-in-Common Investments: Another Way to Stave Off the Taxman
by Robert S. Arthur, Jr.

As the real estate market recovers from its recent slump, sellers of investment property are again being faced with an attractive problem: What do I do with my profit?

The alternative favored by the Internal Revenue Service has always been for the taxpayer to receive his profit and pay taxes at the long-term capital gain rate. While tax rates on long-term capital gains have been steadily reduced over the years (to a current federal tax rate of 15%), a number of investors who have no immediate need for the cash have sought to defer that gain through Section 1031 of the Internal Revenue Code. It allows an investor to effectuate a tax-free "exchange" of properties, which if undertaken within the requirements of the section and its regulations, will allow the taxpayer to defer any gain received on the sale of property far into the future.

The Rules
Over the years, the rules of Section 1031 have become more certain and understandable. Briefly, they are as follows:

1. Exchange Property. The old and new property must be either land, commercial, or rental property that is held for an investment purpose. For example, raw land can be traded for an office property or an apartment can be traded for an office building.

2. Proceeds. The taxpayer is not permitted to have any access to the money generated by the sold property. The proceeds of the sale of the old property must be held by a "qualified intermediary," also known as an exchange accommodator or facilitator, and used for the new acquisition.

3. Timing. First, from the time the sale of the old property is closed, the taxpayer has 45 days to identify up to three properties he wishes to purchase. Second, the identified property must be closed within 180 days of the closing date of the sold property.

4. Ownership. At the end of the trade transaction, the owner of the new property must be identical to the owner of the old property.

5. Reinvestment. To avoid a recognizable gain, the purchased property must be of equal or greater value and utilize all of the cash proceeds.

Please note that this is a simplified explanation of 1031 exchanges. Please consult with a real estate or tax attorney if you wish to undertake such an exchange.

The Problem
While using the exchange provisions of Section 1031 will avoid the immediate payment of taxes on any profit, the procedures required by the IRS create a number of business hurdles and problems for typical 1031 investors.

First, the timing requirements are stringent and unyielding. It is often very difficult to identify properties, negotiate purchase agreements, and undertake the necessary due diligence within the 45-day and 180-day time frames. If the seller of the trade property is aware of the buyer's conundrum, the seller's bargaining position is greatly reduced.

Second, many 1031 investors do not wish to remain actively involved in the management of real estate properties. Perhaps the investor has reached a point in his or her life when owning and managing a building make no sense due to travel desires, other business, or personal matters. The taxpayer might be looking for a more passive investment.

Third, the universe of properties available for the amount the taxpayer has to invest may be limited. The taxpayer may then be required to accept unattractive financial terms to acquire a suitable property.

Fourth, but not least, the taxpayer may be at a point in life when he or she would rather have a more liquid investment to satisfy a potential need for funds in the future.

The Solution
Over the last 5 to 10 years, a new real estate investment vehicle has been created to address the problems faced by 1031 investors. That vehicle is known as Tenant-In-Common (TIC) investments. Ownership of real property as tenants-in-common has been recognized for hundreds of years. For example, if three people have an equal ownership interest as tenants-in-common in real property, they each own an undivided one-third of the property and each can convey or encumber their undivided one-third interest in the same manner as they could if they owned the entirety of the property. More importantly, the IRS recognizes a TIC interest in investment property as a qualifying "trade property" for purposes of Section 1031 of the Code.

A number of real estate companies have been formed to offer TIC investments to trade investors. These companies vary greatly in size, product, minimum investment, and philosophy, but they are all designed to permit an investor to defer paying capital gains arising from the sale of appreciated investment real estate.

The properties selected by TIC companies are similar to those selected by syndicators of real estate partnerships, limited liability companies, or real estate investment trusts (REITs). They typically include seasoned, fully leased operating properties, such as apartment buildings and shopping centers. With these types of investments, an investor can share in current cash flow and participate in appreciation as leases are renewed and real estate prices appreciate. Most of these investment vehicles incorporate some debt in their investments to permit purchases of larger properties; however, it is rare for the debt to exceed 50% of the value of the property to ensure that cash flow will be present.

Investing in a TIC company is almost identical to investing in a public real estate limited partnership or LLC. An offering memorandum is prepared, projections are provided to the investor, disclosures are made, and the investor makes the decision whether or not to invest. Instead of executing a partnership or operating agreement in which the investor has no direct ownership of the property, the investor executes a Tenant-In-Common agreement, where the investor becomes the actual owner of an undivided interest in the property subject to the terms and conditions of the governing agreements prepared by the company. The ownership structure formulated by the TIC company is designed to shield each individual investor from any liability and provide the investor with a projected cash flow plus a share in profits when the asset is sold.

Most TIC investments estimate the length of time that the asset will be held for planning purposes of the investor. That period varies, but is often in the four- to eight-year range. Upon liquidation of the investment, the TIC investor can take her cash and pay the taxes, trade into a new property as a sole owner, or roll the investment into another TIC investment. Finally, some TIC agreements permit an investor to convey her investment to an insider or a third party under certain terms and conditions.

Many TIC companies specialize in certain geographic areas or types of properties. Therefore, if you are more comfortable in the multifamily market or believe that opportunities are greatest in a certain portion of the country, it is possible to locate a TIC company that fits that niche.

Conclusion
Although investing in a TIC company is not for everyone, it is important to know that a real estate vehicle exists that offers one more option for investors who wish to defer taxable gains. Each TIC investment is unique and will have a number of items for review, including fees paid to the TIC company, the amount of leverage, the type and location of the investment, and the estimated holding period. While each individual transaction must be reviewed on its own and compliance with Section 1031 of the Code is complicated, we believe that you should be aware of this potential vehicle for deferring gain on real estate transactions.

A partner in RJ&L's Denver office, Sam Arthur represents real estate lenders, developers, and owners in their business dealings. He advises both borrowers and lenders in financing transactions, including sale-leasebacks, synthetic leases, conduit loans, mezzanine financing, and nonrecourse/partial recourse financing. He is experienced in the formation of business entities necessary to successfully acquire and develop real property on the behalf of his clients. He also represents developers in accumulating properties for commercial and office development. Mr. Arthur is a 1979 graduate of the Georgetown University Law Center. He can be reached at 303-628-9561 or by e-mail at sarthur@rothgerber.com.

 

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