San Francisco Apartment Association

the tic corner

TICs and 1031s–Part One

by D. Andrew Sirkin

Editor’s Note: This “TIC Corner” is the first part of a two-part article on TICs and 1031 exchanges. The second part will appear in the January 2008 issue.

Regular readers of this column know that over the course of its three-year run I have never mentioned 1031 tax-deferred exchanges. Yet if you type “TIC” or “tenancy in common” into any internet search engine, the vast majority of the millions of results 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 TICs
Much confusion stems from the tendency in both the “1031 TIC” and “subdivision-analogue TIC” worlds to load up the acronym “TIC” with more meaning than it actually contains. In fact, saying that an arrangement is a tenancy in common only reveals three things: (i) some asset is owned, (ii) there is 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. Calling something a “TIC” 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 term “fractional ownership” to describe both tax-driven and nontax-driven co-ownership arrangements, including ones which would have been called “timeshares” a few years back. The term “fractional 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 TICs with assigned usage rights, there are: (i) “subdivision-analogue TICs” that assign particular houses, apartments, rooms, offices, stores or storage spaces to each owner; (ii) “timeshares” (now commonly referred to as “fractionals”) that 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 owners is purely an investor. Within the world of TICs 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 1031s
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 an oversimplification of a complex set of rules, in general one can defer all gains taxes 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”: 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 be 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 provides 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 harbor,” 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 harbor” 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 the 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 TIC 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 must 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 no one who is not on title (such as the sponsor) may share in these amounts; and
  • the sponsor, broker or syndicator may be paid reasonable compensation based 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 the 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, upon receiving notice of a pending action, each co-owner is given a specific period of time within which to object; 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 affects 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 and pitfalls of 1031 tax-deferred TIC investments.

The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or SF Apartment Magazine. The information contained in this article is general in nature. Consult the advice of an attorney for any specific problem. More detailed information on this topic is available online at www.andysirkin.com. D. Andrew Sirkin’s law practice is devoted exclusively to tenancy-in-common, equity sharing, investment partnerships and other co-ownership matters. Copyright © 2007 by SF Apartment Magazine. All rights reserved.