the TIC Corner

By D. Andrew Sirkin

Editor’s Note: This “TIC Corner” is the second part of a two-part article on TICs and 1031 exchanges. The first part appeared in the October 2007 issue of this magazine.

In my first article on 1031 tax-deferred exchanges, I attempted to sort out the confusion over different types of tenancy-in-common (TIC) ownership arrangements by distinguishing between TICs that assign the co-owners usage rights to the co-owned property (the subject of all but the most recent of my past columns), and TICs that do not. This article addresses the latter type of arrangement, focusing specifically on TICs that are organized by syndicators or sponsors to be essentially passive investments and repositories for the proceeds of 1031 tax-deferred exchanges. The first article also explained the general background and nature of 1031 exchanges, and the specific requirements described by the IRS in Rev. Proc. 2002-22 for a TIC to qualify as 1031-exchange replacement property.

Are TICs Securities?
Perhaps the most enduring and difficult question associated with sponsor-organized TICs is whether the interests are securities under federal and/or state law. This question is important because the offering of securities is highly regulated. The perceived need for this regulation stems from the assumption that the buyer of a security is being enticed to give control of her money to someone else, thus creating the potential for deceit and abuse. Securities regulations impose extensive documentation requirements on every securities offering. In some cases, an offering must also be registered and approved by governmental agencies. The parties selling or promoting the offering must meet special licensing requirements that are generally not satisfied by real-estate licenses. Compounding the complexity of all of these regulations is the fact that they vary from state to state, and a particular offering will have to satisfy the requirements of federal law and those of one or more states based upon the location of the property, the marketing and the investors.

No one has a definitive answer on whether and when a TIC offering is a security, in part because of the huge amount of statutory, judicial and administrative law bearing upon the general question of what is and is not a security. The leading case in this area, SEC v. W.J. Howey Co., created the well-known “economic realities” analysis under which an interest will be classified as a security only if three elements are concurrently present: an investment of money, a common enterprise, and an expectation of profits derived solely from the efforts of the promoter or a third party. The court emphasized that, “form was disregarded for substance and emphasis placed upon economic reality,” meaning that whether or not a security has been created is not going to be determined by whether ownership is deeded real property or shares in an entity such as a limited liability company (LLC) or limited partnership (LP). Subsequent court decisions modified the third prong of Howey from “solely” to “substantially,” leaving us with the rather vague notion that the term “security” includes any investment made with an expectation of profits derived mostly from the efforts of the promoter.

In practice, the vagueness of the legal definition of “security” means that each TIC offering must be analyzed separately as a potential security, and that there will almost always be room for disagreement. My view is that the vast majority of 1031 TIC offerings would be categorized as securities by most administrative and judicial bodies because they are promoted as passive investments. By this I mean that even though the IRS’s Rev. Proc. 2002-22 requirements for 1031 TICs theoretically create some degree of investor power and control, the scope of that power and control is only peripherally related to the planning and operation of the enterprise, and investors are encouraged to stay out of day-to-day operations. Put more simply, the promoter generally provides a business plan for the TIC project, the investors decide whether or not to invest, and then those who choose to participate simply sign the documents, provide the money and wait for the result. Regardless of what the paperwork says or does not say, it is difficult to argue that this arrangement is not exactly the type of thing securities laws were designed to regulate.

If, indeed, most 1031 TIC offerings are securities, the news is generally good for investors and bad for project sponsors. Securities buyers are entitled to receive much more background information and disclosure material than real-estate investors, and have substantially more powerful legal remedies against those who sell and operate the project. The only downsides for buyers are the potential that return will be eroded by higher formation and transaction costs, and the fact that some buyers might be prohibited from participating in some investments due to their inability to meet the net worth and investor sophistication requirements for certain types of securities offerings. Unfortunately, all of the buyer advantages and disadvantages translate into increased cost, risk and burden for project sponsors.

Owner Liability
As discussed in the first part of this series, tax-deferred exchanges are possible only when investment real estate is exchanged for other investment real estate. An exchange into entity ownership, such as an interest in a limited partnership, membership in a limited liability company or shares in a corporation, will not qualify for tax deferral. A significant disadvantage of direct real-estate ownership, as compared with ownership of an entity that owns real estate, is the loss of liability protection. This means that the investor could be held personally responsible for debt or loss resulting from environmental contamination, personal injury or any other property-related problem. And while liability insurance can protect against certain types of liability, some losses cannot be insured, and even insured losses can exceed policy limits.

One way 1031 TIC sponsors have attempted to create liability protection is by converting ownership from a tenancy-in-common to an entity after a waiting period of 6-to-24 months. But it is unclear whether such a conversion would withstand an IRS audit. No one knows how long of a waiting period is required between acquisition of the TIC share and conversion of TIC ownership to entity ownership. Perhaps more important, if an intention to convert has been present from the start, the original TIC structure may be disregarded as a sham. And beyond these tax questions, a converting TIC structure still exposes the investors to heightened liability risk during the period before the conversion occurs.

A better and increasingly popular liability protection strategy is to have each TIC investor take title to her TIC share as a single member limited liability company (SMLLC). When appropriate forms are filed, an SMLLC is treated as a “disregarded entity” for income tax purposes, meaning that owning in this manner is equivalent to direct ownership of the TIC interest but still provides the liability protection of entity ownership. Note that while any LLC can qualify as a “passthrough entity” for income tax purposes, “passthrough entity” characterization is different from “disregarded entity” characterization, and only the latter will satisfy 1031 exchange requirements. An LLC can be considered an SMLLC when it has only one member, or when its only members are a husband and wife who file their income taxes jointly.

Exchanging into a TIC Versus Buying Alone
Prior to the IRS’s Rev. Proc. 2002-22, most owners in tax-deferred exchanges bought one or more replacement properties by themselves or with friends or family members. A few short years later, an entire industry exists to place these same owners in prepackaged replacement investments. This major shift in 1031 exchange practice results from the significant advantages offered by these sponsored TIC arrangements: group purchase allows the exchanger to spread transaction and operating costs over multiple owners and larger properties, thus increasing efficiency; exchangers can afford to participate in the purchase of larger and often more stable properties because they do not need to finance the entire acquisition themselves; the lower cost of entry resulting from group buying power allows exchangers to spread their available funds among more transactions, lowering risk through diversification; and the burden of finding and operating the replacement property is shifted from the investor to sponsors and managers.

But the advantages of sponsored TIC arrangements need to be carefully weighed against the disadvantages: loss of control over operation and the resulting loss of liquidity; increased exposure to loss from deceit, theft and mismanagement; costs associated with compensation to sponsors and increased asset management needs; and the risk that over- or under-subscription will prevent the exchanger from participating. In considering the last of these disadvantages, remember that 1031 tax-deferred exchanges require that the replacement property be identified within 45 days, and acquired within 180 days. The failure to meet either of these deadlines will cause the exchange to fail, potentially resulting in significant tax liability.

 

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The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of 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 © 2008 by SF Apartment Magazine. All rights reserved.