Tenant-in-Common Investments Grow in Popularity

By Robert F. Blackmore

Since March 2002, Section 1031 tax-deferred exchanges of real property for tenant-in-common (TIC) interests have become a booming business, with TIC exchanges growing from approximately $150 million dollars in 2001 to industry estimates of $12 billion dollars in 2005. This growth has been fueled by favorable tax treatments for TICs arising from Internal Revenue Service Revenue Procedure 2002-22, which addresses the conditions under which an investor can defer payment of taxes on the sale of rental real estate by exchanging the property for a TIC interest. The Revenue Procedure establishes the guidelines that distinguish TICs from partnership interests that do not qualify for Section 1031 exchanges. In short, TICs are undivided fractional interests in rental real estate that result in shared ownership with more than one owner or investor that qualifies for a Section 1031 exchange.

This favorable tax treatment has been the catalyst for a unique industry with phenomenal growth and exciting opportunities for exchangers, but it has also created an opportunity for real estate investors. There are a number of TIC advantages, characteristics, and issues that exchangers and investors should consider.

1. While Section 1031 rules have steadied and clarified over the years, identifying appropriate replacement properties has been problematic, and the timing requirements are stringent and unyielding. With the growth of the TIC industry, the risk of timely locating target exchange properties has lessened, and investors are better able to tailor their replacement property to their specific needs and tolerances. These opportunities have been proven in the commercial real estate marketplace but have also become increasingly apparent in the multifamily industry and other specialized real property markets.
2. Because fractional interests are available, exchangers can identify and consider multiple TIC properties and diversify their investments. As a result, the risk of missing critical deadlines has decreased substantially, and the deal risk of working with a seller versed in Section 1031 requirements and negotiation tactics is also greatly reduced.
3. It has been estimated that 40 percent of all 1031 exchanges involve capital amounts of $250,000 or less. By acquiring fractional interests, TICs allow exchangers or investors to purchase higher quality institutional property than they could otherwise obtain and to participate in markets to which they would not typically have access. Although investors may not be able to outbid investment capital sources such as REITs, pension funds, and large institutional investors, they will have access to higher quality properties at cap rates not available to individual investors, but they will also be owning the investment with other investors who are unknown to one another.
4. With TICs, it is not uncommon for an exchanger or investor to have a number of investments to choose from and to effect closing within days of identifying their preferred investment. TIC sponsors identify the property, negotiate the deal, engage in substantial due diligence in the selection and approval of their properties, obtain financing, and package the deal for the exchanger or investor.
5. The scope of TIC markets has broadened, with sponsors specializing in specific types of property, such as industrial or multifamily, and operating in different regions of the country. This marketplace allows for greater diversification of principal between deals, geographically, and in types of properties, while delivering predictable, regular cash flow. In addition, TIC sponsors package the deals to provide for the day-to-day management of the property.
6. The question of liquidity has been raised as a concern with TIC investments, but it has also been touted as an advantage. In practice, TIC agreements are generally structured to give the other investors in the TIC deal the first opportunity to buy an interest before it is offered to outsiders, and sponsors have been quick to assist investors who require liquidation. Due to the relative newness of the investment vehicle, however, the secondary markets are just now emerging, and TICs are generally considered illiquid, as is real estate generally.
7. As with all investments, exchangers and investors should consider suitability of the investment for their investment goals and financial status. Given the importance of the tax impacts for exchangers, the sponsors' legal opinion should be a "clean" legal opinion that the TIC "should" or "will" qualify for exchange under Section 1031, not a legal opinion that the investment is "more likely than not" to qualify.
8. TICs can be a useful tool to effect other goals. For example, the sale of family or closely held businesses is often coupled with the sale of real estate. Separating the business from the real estate and addressing the tax obligations on sale of the real estate can often be problematic. To comply with the buyer's timeline, one might consider effecting a Starker (delayed through an accommodation party) exchange and the greater certainty of effecting that exchange that comes with the availability of TICs.
9. Finally, Section 1031 exchanges of property are technical and require strict compliance with Section 1031 requirements. TIC deals also require compliance with the conditions of Rev. Proc. 2002-22. While these combined provisions create an extremely powerful investment opportunity, they also require careful evaluation and assistance by professionals experienced in the techniques and their requirements.

TIC investments can be business as usual, provided one is experienced in real estate and desires to invest in the type of investment that is in accord with the expertise of the TIC sponsor. In the final analysis, the TIC is a new structure for syndicating real estate that is designed to comply with the 1031 exchange rules. TICs provide ordinary investors, as well as 1031 exchangers, with tremendous advantages and opportunities for pooling resources, minimizing tax risk, diversifying portfolios, and increasing the quality of one's investments. Although relatively new and still evolving, TICs appear to be an excellent investment tool for exchangers and investors alike and a good tool for furthering business deals involving real estate.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

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