Tenant In Common & 1031 Tax Deferred Exchanges
Helping investors understand TICs & 1031 Tax Deferred Exchanges
Savvy Way for Seniors to Manage Their Real Estate Equity
March 31st, 2007 by Troy
Few would deny that real estate is a solid investment. Nationally, there hasn’t been a decline in home values since the end of World War II, according to the National Association of Realtors® in a report the one-million-member trade organization released in March of last year. These widespread equity gains in residential real estate, as well as monies from other sources, have led many to invest beyond their primary residence and into income-producing properties such as rental housing, apartment buildings, or small office or retail centers. Over the years, many of these investment properties have built up substantial equity.
However, many seniors now find themselves in a quandary. They have become equity rich, but are cash poor - with increases in the value of their property far outpacing income growth. Plus, they have grown tired of the day-to-day property management headaches such as toilets, tenants and trash, and want to simplify their lifestyle and enjoy golf, grandkids and gardening.
Of course they could always sell the property and unleash that accumulated equity, but this can have disastrous tax consequences. Moreover, even if they decided to sell and take the tax hit, where do they re-invest? After all, the Dow Jones is still 1,000 points below its high water mark reached in January 2000, the NASDAQ is less than half of its March 2000 peak, money market funds are barely ahead of inflation, and saving accounts can’t keep pace with inflation.
Investment Practices That Date Back Generations, Even Centuries
For years, investors have been using an investment option that allows them to sell a property and defer all taxes on capital gains by using the profits to acquire another “like-kind” property. In use since the 1920s, a 1031 exchange, so named for its designation in the IRS tax code, allows you to sell your income-producing property and “exchange” it for another while deferring capital gains taxes. Of course there are rules by which investors need to abide. Among them: the exchanged property must be of the same or greater value; the seller has 45 days after closing escrow on the old property to identify a new property; the seller has 180 days from the sale of the old property to close escrow on the new property.
Meanwhile, another real estate investment opportunity, Tenant-In-Common (TIC) ownership, has been around for centuries, dating back to British Common Law. TIC ownership allows for multiple parties to own an investment property, with each fractional owner holding separate title to his portion of the property. Additionally, like any property held in sole ownership, fractional ownership in a TIC can be purchased, sold, gifted, bequeathed by will or inherited. Naturally, it is also subject to property taxes, gift tax, and estate and inheritance taxes in the same manner as a solely owned property.
TIC ownership has been gaining momentum over the last 10 years, due largely to the increasing costs of acquiring real estate. By combining their resources, multiple investors can think beyond what they could purchase on their own, including gaining access to institutional-grade properties, such as grocery and drug store anchored shopping centers, large office buildings, malls, and multifamily apartment communities.
With the increasing popularity of TIC ownership, in March 2002 the IRS issued Revenue Procedure 2002-22, which set forth formal guidelines regarding the structure of TIC investments, including the maximum number of co-owners allowed in a property (35).
Combining Opens Opportunities to Seniors and Baby Boomers
Many seniors and Baby Boomers are now finding that investing in a Tenant-In-Common property through a 1031 exchange is an attractive - and increasingly mainstream - investment. Now, instead of merely exchanging a “like-kind” property as part of a 1031 exchange, an investor can sell the property and pool his proceeds with other investors. This allows the investor to swap, for example, that sole ownership in a three-unit apartment building into a fractional ownership of a class-A office building in downtown Chicago, as well as an additional fractional ownership of a 220-unit, professionally managed apartment complex in the suburbs of Los Angeles. Or the investor could swap the proceeds from the sale of a strip retail center into a regional shopping center anchored by national tenants.
Aside from freeing the investor from the obligation of property management, the investor has “traded up” into institutional-grade properties that are professionally managed and have received professional scrutiny for their continued financial performance through a comprehensive due diligence process. Also, the investor can potentially reduce investment risk through geographic diversification and investing in a spectrum of property types. The TIC investors get the same oversight that’s provided for a large institutional investor, including monthly reports, while potentially increasing monthly cash flow.
Rapid Growth in 1031 as TIC Investment
Since the IRS provided guidelines for TIC investments, total equity invested in this sector has more than doubled every year, according to Barron’s magazine. It went from $350 million in 2002, to $750 million in 2003, and to $1.8 billion in 2004. The total is expected to reach $4.2 billion for 2005.
But beyond the numbers, there are other factors contributing to the accelerated momentum of such TIC investments for seniors:
Demographics
Today’s class of seniors is the best educated and wealthiest ever. Investment and saving have long been a part of their financial discipline. Now, they are increasingly focused on wealth preservation, which involves minimizing the amount of taxes owed. TICs can accomplish just that - allowing a taxpayer to enjoy cash flow, potentially increase equity, while continuing to defer taxes.
Meanwhile, there are 76 million Baby Boomers (those born between 1946 and 1964) who are just beginning to retire, or preparing to do so. Perhaps no other generation has been so enriched by real estate. Consequently, they tend to be comfortable - and eager - to reinvest their gains right back in.
Lifestyle
Being at the beck and call of your tenants to repair an overflowing toilet, or an electrical malfunction is never fun. For a senior, the physical demands of hands-on property management can become that much harder. For busy Boomers it’s hard to find the time. Investment-grade properties - office buildings, shopping malls, apartment complexes and industrial properties, valued anywhere from $10 million to $300-plus million - employ professional asset and property managers. They relieve investors of day-to-day maintenance and leasing headaches. That can mean more days of uninterrupted golf, travel, time with grandkids and other pursuits.
Diversification
For those worried about a local real estate “bubble,” TIC investments give investors the opportunity to diversify into different real estate asset classes, upgrade their investment, and get into different markets. For example, by pooling the equity earned on a three-unit apartment building into a self-storage complex in the suburbs, a class-A office building across the country, or a 220-unit high-rise condominium tower, the investor softens potential revenue fluctuation from vacancies. He is also less beholden to the performance of a particular local market or asset class.
Estate Planning
For estate planning purposes, a TIC structured investment in inherently like any other real estate investment. Upon passing, your surviving heirs inherit the investments. They can either sell the real estate, 1031 exchange their investment into something else, or can continue the TIC process. Like it did for you, this allows your heirs to enjoy tax-deferred capital gains, cash flow, and the ease of having professional property managers deal with leases, tenants and maintenance.
An Investment That’s Right for You?
The benefits of investing in a property through Tenant-In-Common ownership are many:
* Ability to keep real estate in your investment portfolio
* Opportunity to diversify property holdings geographically and across property types
* Mitigation of vacancy risk with larger properties that have more tenants
* Elimination of day-to-day property management headaches inherent in sole ownership properties
* Deferral of capital gains taxes when acquired using the proceeds from a 1031 exchange
Of course, investors must remember that, TIC investments have the same material risks of their previous (indeed of all) real estate investments, including potential for property value decrease, illiquidity, change of tax status, and the possible impact of fees/expenses which may outweigh a property’s tax benefits.
Lastly, it is also important that the TIC real estate investment offered to you is structured as a security. When structured as a security the bar is set much higher for due diligence, confirmation of investor suitability, broker/dealer record keeping, and licensing and training of registered representatives.
This is neither an offer to sell nor an offer to buy real estate or securities. There are material risks associated with the ownership of real estate. Securities offered through Sigma Financial Corporation, Member NASD/SIPC.
by Christian Mirner, Exec VP - Real Estate, 1031 Exchange Options
3 Mistakes To Absolutely Avoid In A 1031/TIC Exchange
January 11th, 2007 by Troy
Paula Straub, Financial Advisor And Mortgage Originator
We’ve all made bad decisions in the past. Don’t you just hate to hear “I told you so” from your friends and family? Or, maybe you catch yourself saying “If only I’d have…”?
Personally, I’m one of those people who prefers to learn from someone else’s mistakes. If you’re at all like me, and you have thought about doing a 1031 exchange into a tenant in common (TIC) property, take note. You can avoid making the 3 Major Mistakes that others wished they knew before leaping from the frying pan into the fire!
Before I let you in on the secrets, let me briefly explain what a 1031 exchange into a tenant in common property is. It’s a fairly well-kept secret in and of itself.
A 1031 exchange is when an investment property owner sells his current property and exchanges it for a “like-kind” property of equal or greater value. By doing so, he defers the payment of capital gains tax and the consequences of recaptured depreciation.
By exchanging into a tenant in common property, or a TIC, he becomes a part owner of a large commercial property managed by professionals, who in turn pay him a monthly income. It comes with fewer strings than private annuity trusts, charitable remainder trusts, or an exchange into another property that still needs your attention and often drains your wallet. I find that very few individuals, CPA’s, attorneys, or even financial advisors are sufficiently well versed in the 1031 exchange into a tenant in common property. It can be a terrific deal!
Those who benefit most from this type of an exchange usually have several things in common. 1.They own investment property that has appreciated significantly in value. 2.They are tired of all the hassles of property management. 3.They don’t want to pay huge amounts of capital gains tax if they sell. 4.They would like to have a significant increase in monthly passive income. 5.And, lastly, they still enjoy the relative stability of owning real estate.
Know of anyone who fits this description? If so, read on.
There are 3 Major Mistakes that can turn your investment into a nightmare. So, avoid these at all costs when contemplating this type of exchange.
Mistake #1: Dealing with an investment company that does not have their act together. If they seem like they don’t know what they are doing, run! Look into their history of TIC offerings, and ask for referrals from satisfied clients. Ideally, this should be their only business. Are all their properties “A” grade commercial buildings, or are they somewhat less desirable? Ask how they find the properties and what criteria they use to select them. Quality properties are hard to find and sell out quickly. In real estate, the quality properties will remain more desirable, even when the mediocre properties start to lag. Ask yourself if you would like to have your office in that building, or go to see your doctor there, or if you’d shop in that strip mall.
Note: Also be cautious going the private route and getting into Limited Partnerships when only one or two major players make all the decisions. And, unless you have extensive experience in commercial property, don’t get together a bunch of your friends and choose this property on your own.
Mistake #2: Choosing an Accommodator that has not done many, many of these transactions. This Qualified Intermediary makes sure all the documents and money transfers meet all the IRS guidelines. They will set up your LLC. You must use an Accomodator that you don’t already have a relationship with. Your family attorney or estate planning attorney may not qualify. The last thing you want is the IRS sending you a hefty bill for taxes or penalties, or the whole transaction falling through due to an incompetent or inexperienced Accommodator!
Mistake #3: Skimping on the property management company. They are extremely crucial to the performance of your investment. You will be depending on them to handle the day to day problems that arise, carry the proper insurance, pay the property taxes on time, and keep your building fully occupied and in tip top shape. This company should offer you a long term triple net lease that has your annual income percentages spelled out, along with scheduled increases. There aren’t many out there willing or able to do this. Ask for an accounting of their track record with other properties, how long they’ve been in business and for a list of any judgments brought against them. See if they’ve ever requested special assessments, or had any foreclosures. A good management company is worth its weight in gold. You want them to make a tidy profit, because their performance is directly related to your investment stability.
Well, there you have it. Don’t be “Penny wise and Pound Foolish”. This is one time that hiring the best will definitely bring you the most favorable results. It should truly be a win-win situation for everyone involved.
By avoiding the 3 Major Mistakes for a 1031 exchange into a tenant in common property, you will be the one saying “I told you so” as you collect your monthly check and watch your investment grow!
TIC investment expands into secondary market
December 26th, 2006 by Troy
Real Estate Weekly, Jan 12, 2005 by Jeffrey R. Dunne
Known in the industry as “tenancy-in-common” investment structures, “TICs” are currently finding more and more appeal among the investment community.
This method of investing is part of a growing trend among real estate investors who seek to shield themselves from ordinary capital gains by buying partial ownership interests in a property.
Although joint ventures and partnerships are similar in investment purpose, TIC investments are unique and different because of their added tax benefits.
TICs have recently become popular because of an Internal Revenue Service tax ruling two years ago. Derived from the concept surrounding the popular 1031 tax exchange, this ruling allowed investors to reinvest capital in fractional ownership to avoid capital gains taxes.
In the case of 1031 exchanges, real estate sellers can reinvest the earnings from a property sale into real estate of equal or greater value to avoid immediately paying taxes.
The TIC structure, however, has broader appeal since it attracts investors, which are not required to exchange a property for the purchase of a similar property.
In the face of low interest rates and a precarious stock market, those looking for higher returns are looking to invest in real estate and finding TICs an easy way to enter into the market. This convenient approach to investing prompted the emergence of REIT investment and has become an impetus for TIC growth.
Here is how a TIC works in practice: A pool of investors acquires an asset; then, both the property’s debt and equity is split equally based on ownership shares.
Generally, these types of deals gamer annual returns of approximately 10%.
Advantages to the TIC approach, in addition to those tax-related, include diminished concern with the day-to-day operation of the building and a lower risk threshold due to the percentage ownership in the property. However, this partial ownership also leads to less control over the fate of the property, including decisions on leasing and management changes and the eventual sale of the asset because the decision requires full agreement among investors before taking action.
In many arrangements, such decisions can be made by a managing partner, thereby eliminating possibly contentious situations.
TICs are expected to continue to grow in popularity among the investment community, largely as an option for private investors.
Although not yet a fully matured investment market, the TIC structure, in particular, has a broad appeal for 1031 investors looking to defer income tax and enjoy substantial cash flow.
COPYRIGHT 2005 Hagedorn Publication
COPYRIGHT 2005 Gale Group
15 Guidelines for Tenant-In-Common Properties and Sponsors
December 21st, 2006 by Troy
By Alexandra Aiken, JD
Proper structuring is a critical step in tenancy-in-common transactions. Pursuant to Revenue Procedure 2002-22, the Internal Revenue Service will consider issuing a private-letter ruling to an interested party if the following 15 conditions are met and/or are present in a proposed TIC transaction.
TIC Ownership. Each of the co-owners must hold title to the property, either directly or through a disregarded entity, as tenants in common under local law. The title to the property as a whole may not be held by a single entity recognized under local law.
Number of Co-Owners. The number of co-owners or investors is limited to no more than 35 persons. For this purpose, a person is defined by Internal Revenue Code 7701(a)(1); however, husbands and wives and all persons who acquire interests from co-owners by inheritance are treated as single persons.
No Treatment of Co-Ownership as an Entity. The co-ownership may not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying any or all of the co-owners as partners, shareholders, or members of a business entity, or otherwise hold itself out as a partnership or other form of business entity. The individual co-owners similarly may not hold themselves out as partners, shareholders, or members of a business entity.
Co-Ownership Agreement. The co-owners may enter into a limited co-ownership agreement that runs with the land. Such an agreement may provide that a co-owner must offer its interest for sale to the other co-owners, the sponsor, or the lessee at fair-market value (determined as of the time the partition right is exercised) before exercising any right to partition. (See Section 6.06 of Rev. Proc. 2002-22 for conditions relating to restrictions on alienation.) Certain actions on behalf of the co-ownership may require the vote of co-owners holding more than 50 percent of the undivided interests in the property. (See section 6.05 of Rev. Proc. 2002-22 for conditions relating to voting.)
Voting Conditions. Co-owners must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any leases of a portion or all of the property, or the creation or modification of a blanket lien. Any sale, lease, or release of a portion or all of the property, any negotiation or renegotiation of indebtedness secured by a blanket lien, the hiring of any manager, or the negotiation of any management contract (or any extension or renewal of such contract) must be unanimously approved by the co-owners. For all other actions, the co-owners may agree to be bound by the vote of those holding more than 50 percent of the undivided interests in the property. A co-owner who has consented to an action in conformance with Rev. Proc. 2002-22 Section 6.05 may provide the manager or other person with a power of attorney to execute a specific document with respect to that action, but may not provide the manager or other person with an unlimited power of attorney.
Restrictions on Alienation. Each co-owner must have the right to transfer, partition, and encumber their own undivided interest in the property without the agreement or approval of any person. Restrictions on the right to transfer, partition, or encumber interests in the property that are required by a lender and that are consistent with customary commercial lending practices are not prohibited. (See Rev. Proc. 2002-22 Section 6.14 for restrictions on who may be a lender.) Moreover, the co-owners, the sponsor, or the lessee may demand the right of first offer (the first opportunity to offer to purchase the co-ownership interest) before any co-owner may exercise their right to transfer their interest in the property. In addition, a co-owner may agree to offer the co-ownership interest for sale to the other co-owners, the sponsor, or the lessee at fair-market value (determined as of the time the partition right is exercised) before exercising any right to partition.
Sharing Proceeds and Liabilities Upon Sale of Property. If the property is sold, any debt secured by a blanket lien must be satisfied and the remaining sales proceeds must be distributed to the co-owners.
Proportionate Sharing of Profits and Losses. Each co-owner must share in all revenues generated by the property and all costs associated with the property in proportion with their undivided interest in the property. The other co-owners, sponsor, or manager of the property may advance funds to a co-owner to meet expenses associated with the co-ownership interest unless the advance is recourse to the co-owner (and, where the co-owner is a disregarded entity, the underlying member of the co-owned interest) and is for a period not to exceed 31 days.
Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by the property by a blanket lien in proportion to their undivided interests.
Options. A co-owner may issue an option to purchase its undivided interest, referred to as a call option, provided that the exercise price for the call option reflects the fair-market value of the property determined at the time the option is exercised. For this purpose, the fair-market value of an undivided interest in the property is equal to the co-owner’s percentage interest in the property multiplied by the fair-market value of the property as a whole. A co-owner may not acquire an option to sell an undivided interest, referred to as a put option, to the sponsor, the lessee, another co-owner, the lender, or any person related to any of the parties.
No Business Activities. Co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property according to IRS Rev. Ruling 75-374, 1975-2 C.B. 261. Activities will be treated as customary for this purpose if they do not prevent an amount received by an organization described in 511(a)(2) from qualifying as rent under 512(b)(3)(A) and associated regulations. In determining what constitutes the activities of the co-owners, all activities of the co-owners, their agents, and any persons related to the co-owners with respect to the property will be taken into account, regardless of the capacity in which the activities were actually performed. For example, if the sponsor or a lessee is a co-owner, then all of the activities of the sponsor or lessee (or any person related to the sponsor or lessee) with respect to the property will be taken into account in determining whether the co-owners’ activities are customary activities. However, activities of a co-owner or a related person with respect to the property (other than in the co-owner’s capacity as a co-owner) will not be taken into account if the co-owner owns an undivided interest in the property for less than six months.
Management and Brokerage Agreements. Co-owners may enter into management or brokerage agreements with an agent, which must be renewable at least once a year. The agent may be the sponsor or a co-owner (or any person related to the sponsor or a co-owner), but may not be a lessee. The management agreement may authorize the manager to maintain a common bank account for the collection and deposit of rents, and to offset expenses associated with the property and revenues before disbursing each co-owner’s share of net revenues. The manager must disburse to the co-owners their shares of net revenues within three months of the date of receipt of those revenues irrespective of circumstances. Further, the management agreement also may authorize the manager to prepare statements for the co-owners showing their shares of revenue and costs from the property, and to obtain or modify insurance on the property and to negotiate modifications of the terms of any lease or any indebtedness encumbering the property (subject to the approval of the co-owners). (See Rev. Proc. 2002-22 Section 6.05 for conditions relating to the approval of lease and debt modifications.) The determination of any fees paid by the co-ownership to the manager may not depend, in whole or in part, on the income or profits derived by any person from the property, and may not exceed the fair-market value of the manager’s services. Any fee paid by the co-ownership to a broker must be comparable to fees paid by unrelated parties to a broker for similar services.
Leasing Agreements. All leasing arrangements must be bona fide leases for federal tax purposes. Rents paid by a lessee must reflect the fair-market value for the use of the property and may not depend, in whole or in part, on the income or profits derived by any person from the property leased (other than an amount based on a fixed percentage or percentages of receipts or sales). (See Rev. Proc. 2002-22 Section 856(d)(2)(A) and the regulations therein.) This means that the amount of rent paid by a lessee may not be based on a percentage of net income from the property, cash flow, increases in equity, or similar arrangements.
Loan Agreements. The lender may not be a person related to any co-owner, the sponsor, the manager, or any lessee of the property for any debt that encumbers the property or any debt incurred to acquire an undivided interest in the property.
Payments to Sponsor. Except as otherwise provided, the amount of any payment to a sponsor for the acquisition of the co-ownership interest (and the amount of any fees paid to a sponsor for services) must reflect the fair-market value of the acquired co-ownership interest (or the services rendered) and may not depend, in whole or in part, on the income or profits derived by any person from the property.
Net Lease, Net Net Lease, and Triple Net NNN Lease
December 12th, 2006 by Troy
What is the difference between a net lease, a net net lease and a triple net nnn lease?
Double net NN means that the tenant pays for everything except structural repair.
Triple net NNN means that the tenant is responsible for generally everything including structural repair, BUT every lease is different, it is best to actually see copy of any lease very early in any negotiation process. Many triple net leases hold the landlord still responsible for roof repairs. It is ALWAYS a matter of negotiation between the parties.
In residential leasing you deal with people, but in commercial you deal more with contracts and corporations.
In addition to NN and the NNN leases, there is such thing as a Bond Type Lease which basically means that the tenant will pay on the lease no matter what even if the building burns down or other disaster happens.
The advantage of a bond type lease is that the landlord can take that Bond Type Lease and actually securitize it and get money for it, provided of course that the tenant is of investment quality.
Always get complete financials on the tenant or you are wasting your time and be sure it’s not some shell company that is a subsidiary of some large company that sounds good, remember, the lease is only as good as the company behind it.
Section 1031 Exchanges and Tenancy in Common Interests
December 5th, 2006 by Troy
Christine Tour-Sarkissian
I. Introduction
A popular way of acquiring real estate today is through use of Tenancies in Common (TICs). TICs allow small investors to exchange their smaller properties for a fractional interest in a much larger property. The issuance by the Internal Revenue Service (IRS) in March 2002 of Rev Proc 2002–22, 2002–1 Cum Bull 733, clarifying the steps that investors in a TIC should take in order to make their investment eligible for tax deferral under the Internal Revenue Code (26 USC §1031) when participating in like-kind exchanges, adds to the appeal of these arrangements and has created a huge growth in the TIC market.
II. Background
Real estate investors who have held properties for a long time generally have low taxable bases and have exhausted their ability to further depreciate them. They seek to (a) realize the value of their assets without incurring significant taxable gains and (b) reinvest their equity in new property with higher returns, more depreciation, and greater appreciation potential.
In the past, such investors would avail themselves of tax deferral under §1031 by simply locating, and then exchanging into, suitable replacement properties. However, prices in many areas of the country are so high that investors are unable to find appropriate replacements. It is often hard, for example, to find a triple-net-leased property occupied by a creditworthy tenant for less than $5 million. Thus, many investors are forced to exchange for more expensive property, causing significant negative cash flow. Exchanging for a TIC can avoid that problem and also enable investors to find the necessary replacement within the narrow time period allowed by §1031.
To respond to varying investor needs, “sponsors” have devised a variety of TIC arrangements for investors to acquire. Some sponsors will purchase a large piece of property, directly or through a controlled entity, under a long term triple-net lease with a high-credit, stable tenant (e.g., Walgreen’s or Home Depot), arrange appropriate financing, divide title into tenancy in common interests (TIC units), and offer these units to exchangers and other investors. See Wamstad, Feature A Boost From the IRS: On Tax-Deferred Exchanges and Tenancy-In-Common, 13 Bus Law Today 41 (Mar./Apr.
2004). An exchanger can then acquire as many units as it needs to avoid having a taxable gain from the disposition of its former property.
Other sponsors purchase property with an existing loan already in place to be assumed by the investors, or enter into a contract of purchase and assign that contract right to the investors, who then simultaneously close on the property. The sponsors may also master lease the property from the TIC or manage it for the investors. See Borden & Wyatt, Syndicated Tenancy-in-Common Arrangements:
How Tax-Motivated Real Estate Transactions Raise Serious Nontax Issues, 18 Prob & Prop 18 (2004). In sum, there is a huge variety of prepackaged TIC interests that include different kinds of property and different kinds of financing arrangements. Investors may choose based on the kind of property offered to them, the rate of return, and the financing arrangements that they prefer.
A. The Legal Nature of a TIC Interest
To create a TIC that qualifies under §1031, it is necessary to satisfy the tenancy in common laws of the state. A tenancy in common is not an independent entity like a partnership, a corporation, or an LLC. No formal writing is necessary for its creation, nor is any filing required. A TIC is a way of holding title whereby each participant individually owns a physically undivided interest in an entire parcel of the property. CC §686; Wilson v S.L. Rey, Inc. (1993) 17 CA4th 234, 242, 21 CR2d 552.
Each cotenant in common is entitled to:
• Share with the other tenants the possession of the whole;
• Receive a prorata share of rents or profits from the property;
• Transfer or lease the interest; and
• Demand a partition of the property.
There is no rent liability from one cotenant to another for possession. Tom v City & County of San Francisco (2004) 120 CA4th 674, 16 CR3d 13. Typically, each cotenant’s share is expressed in the instrument of conveyance as a percentage interest in the whole; otherwise, all cotenants are presumed to have equal interests.
B. TIC Arrangements
A TIC property may involve a triple-net lease with a single tenant and no management by the owners. It may also involve multiple tenants subject to a master lease, with the sponsor as master lessee or manager, having in turn subleased the property to the actual tenants. This removes the investors from management functions. Alternatively, a separate entity may be a manager, but not a sponsor. See Stein, Tax-Free Exchanges and Fractional Interests: TICs, Tax, Go!, 45 Orange County Law 18 (Aug. 2003).
After the sponsor (often a large real estate investment company) has acquired the property and has a TIC agreement or agreements ready, it will require each of its potential investors to form singlemember LLCs that will execute the tenancy in common agreement. The reasons for single-member LLCs are:
• Lenders prefer borrowing from entities that are legally separate and more remote from the risk of bankruptcy; and
• If the LLC files bankruptcy, its nature as a single-asset entity will facilitate an early dismissal or relief from the automatic stay, and it is not likely to have major creditors besides the lender.
Sponsors who choose to participate in TICs may do so at different stages of the project, e.g., offering, organizational, operating, liquidation. Some TIC agreements give the sponsor discretion to remain or become a tenant in common with the investors, and thus participate in the profits from operations or the profits from the resale of a TIC interest. Other agreements also require that the sponsor be used as broker on any later sale of an interest. Others provide for the sponsor, or an affiliated entity, to, e.g., manage the property, collect the rents, pay the mortgage, deal with tenant defaults, re-lease the property when tenants leave. The sponsor may also have the power to finance or
refinance. All of these additional activities, of course, will generate additional fees to the sponsor. Cuff, Revenue Procedure 2002–22 and Section 1031 Exchanges Involving Tenancies In Common, Creative Tax Planning for Real Estate Transactions (ALI-ABA Course of Study, Sept. 26–28, 2002); Cuff, Section 1031 Exchanges Involving Tenancies-In-Common, Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances (PLI Course Handbook June 2003).
III. Advantages and Disadvantages of TIC Arrangements
A. Advantages
1. Ease of identification
Too often, an investor waits until after closing the sale of its current property to identify a
replacement property and finds itself 44 days later scrambling for any property it can find. A TIC can eliminate this problem, since the sponsor does all the work, eliminating the need to spend that time within the 45-day identification period or the 180-day closing period. The sponsor’s website, which shows all properties currently available and their projected returns, allows an investor to perfectly match up a replacement with the cash received from the earlier disposition. The exchanger/investor can then make its selection based on the characteristics of the property—e.g., its size and nature, the amount required to invest, and the projected returns.
2. Due Diligence by Sponsor
Large projects will involve the evaluation of complex leases and the generation of income
projections and loan documents. Sponsors also have to prequalify or accredit investors by doing necessary credit checks to ensure that potential investors satisfy minimum net worth requirements. When sponsors are experienced real estate dealers who have already analyzed the project and prepackaged it, it is easy for investors to purchase units within their §1031 deadlines. Sponsors will predraft the necessary documents (purchase agreement, escrow instructions, tenancy in common agreement, property and asset management agreement, assignment and assumption agreement, tax opinion letter, and private placement memorandum containing information regarding the due diligence
of the sponsor and all disclosures related to the property), thereby relieving each investor from additional hassles and costs. The USA Patriot Act (Pub L 107–56, 115 Stat 272) has further increased the sponsors’ burden by adding new due diligence requirements on lenders; now, loan agreements contain language that each TIC member, any guarantor, or any affiliate of either shall not become a person restricted from doing business under the regulations of the Office of Foreign Asset Control (OFAC) of the Department of the Treasury. Some lenders also require ongoing covenants and indemnities relating to OFAC to ensure ongoing compliance. In anticipation of these lenders’ requirements and policies, sponsors are taking additional steps to screen their prospective investors more carefully and accredit them ahead of time.
3. No Management Responsibilities
The property and the assets (e.g., leases, bank accounts) are professionally managed by the sponsor itself or by a management company arranged by the sponsor. This feature is one of the main advantages of TICs because investors often do not want to have property management duties or headaches; they like the passive nature of these TIC investments and the fact that they will be professionally managed. See Aiken, Evaluating Co-Ownership of Real Estate (CORE) or Tenant in Common (TIC) Interests in Real Estate (Exeter 1031 Exchange Services) (available at http://www.exeterco.com/pdfs/Article_CORE_TIC.pdf). This may make it particularly attractive to older investors who prefer truly passive investments.
4. Diversification and Sizeable Returns on Investment
TICs allow investors to diversify their portfolios both geographically and through different kinds of properties, e.g., office buildings, medical buildings, energy replacement properties, retirement homes. Investors can acquire not only higher grade, institutional-type properties, but also those having a stable level of return over many years.
5. Easy Financing
The sponsor will often put the investor in touch with a lender or mortgage broker already familiar with the project, one who may have already committed to loan on the property—perhaps with preset rates, reserve requirements, nonrecourse carve-outs (see below), default provisions, and transfer requirements—thus avoiding delays and the need to shop and negotiate terms.
6. Nonrecourse Loans
Sponsors often arrange for nonrecourse financing to make these TICs even more attractive to exchangers/investors. This does not mean that lenders like them; that is why, even though the loans may be nonrecourse, lenders (1) include their customary carve-outs to protect themselves from the intentional misbehavior of a TIC co-owner and (2) may still require personal guaranties. See Swenson & Dickson, The Recent Trend Toward Financing Tenancies in Common Poses Substantial Challenges to Lenders, 28 Los Angeles Law 40 (Sept. 2005).
7. “Parking” Arrangements
An investor confronting the 45-day property identification deadline—who does not want to commit to a long term investment and desires no management duties and a return on its investment—may decide “to park” its exchange money in one of these TICs until an alternative investment materializes. This can only be done if the TIC is structured so that there is a fixed termination date or an exit strategy is in place.
B. Disadvantages
1. Fear of Recharacterization
Despite an investor’s best laid plans, a TIC arrangement may nevertheless be treated as a
partnership by the IRS. For a historical analysis, see Levine, Exchanging Real Estate (Professional Publications & Education, Inc., Denver, 2005). See also Levine, Real Estate Transactions, Tax Planning, chap 29 (Thomson-West, St. Paul, 2005).
Exchanges of interests in partnerships and other business entities are not eligible for §1031 treatment (see McKee, Neslon, & Whitmire, Federal Taxation of Partnerships and Partners ¶3.03[5] (“Partnerships Distinguished from Co-Ownership of Property”) (3d ed 1997)); therefore, an investor needing to complete a §1031 transaction must be sure that its acquired TIC interest will be treated as an interest in real property and not as an interest in the entity that owns it. Rev Rul 75–374, 1975–2 Cum Bull 261. The Revenue Ruling further provides that the mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a partnership; however, tenants in
common may become partners if they actively carry on a trade, business, financial operation, or venture and divide the profits thereof. Commissioner v Tower (1946) 327 US 280, 90 L Ed 670, 66 S Ct 532; Allen, Section 1031: When Exchanges and Partnerships Collide (PLI Course Handbook June 2006).
Customary services performed by co-owners or their managers do not automatically lead to a TIC being recharacterized as a partnership; however, “additional services” could have that effect. Cuff, Section 1031 Exchanges Involving Tenancies-In-Common, Tax Planning For Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 2004 at 867 (PLI Course Handbook June 2004). The line between the two is very fine; therefore, careful structuring and drafting of the TIC documents becomes absolutely crucial.
Revenue Procedure 2002–22 has clarified some of these concerns, but it is neither a law nor even an IRS ruling. It is merely an invitation to taxpayers to request an IRS ruling on the taxability of a transaction or event, with the suggestion that if it satisfies the criteria outlined in the procedure, then the actual ruling may be favorable. Rev Proc 2002–22, §3. It is not surprising that most TIC offering materials stress this risk.
2. Liquidity and the Difficulty of Finding an Exit Strategy
An undivided interest in real estate may be difficult to market. See Borden & Wyatt, Syndicated Tenancy-in-Common Arrangements: How Tax-Motivated Real Estate Transactions Raise Serious Nontax Issues, 18 Prob & Prop 18 (2004). In fact, some authors claim that the National Association of Securities Dealers (NASD) believes that TIC interests are illiquid, that there is no secondary market for them, and that a subsequent sale of one may only be possible at a significant discount. The only perceived benefit of the lack of liquidity, if there can be one, for the investor is that if the TIC is part of the decedent’s estate, the investment can be significantly discounted. This, in turn, will present some estate planning strategy advantages. Nevertheless, for most investors, the need for liquidity is crucial; it is for this reason that many TIC investors need the assurance that they have an exit plan. That is why most sponsors, such as RealtyNet Advisors (a brokerage specializing in TICs for exchange purposes), advertise using language such as: Liquidity.
RealtyNet maintains a secondary market for ownership interest in RealtyNet sponsored properties. On a best efforts basis, we can find a buyer to acquire your partial ownership interest. The longest it has taken us to find a buyer for an existing TIC client has been two months.
Adding to illiquidity concerns, lenders often require prepayment penalties or lock-in provisions specifically intended to prevent an early exit by the investor. TIC agreements invariably require the selling or trading co-owner to first offer the interest to other co-owners, the sponsor, or lessee at market value. Although this makes the marketability of TIC interests more cumbersome, it gives rise to a market for these TICs and simplifies the financing of these transfers.
3. Volatility and Risk Factors
TIC investments are often volatile and risky, since they depend on the expected stream of rental income from the underlying property. If there is only one tenant, rather than multiple tenants, the risk is increased, since everything depends on the financial health of that tenant. Other factors, such as fluctuations in interest rates and changes in market prices for similar properties, will affect the underlying value. In fact, many private placement memorandums specifically list all of the real estate, financing, and tax risks related to TICs.
4. Due Diligence Still Required
Despite the fact that TIC sponsors perform the due diligence, investors and their agents
nevertheless are generally advised to make their own investigation of the credibility and track record of the sponsor and its management company. TIC brokers are advised by the NASD and the California Department of Real Estate not to automatically rely on the sponsors, but to investigate to ensure that a sponsor’s offering document does not contain false or misleading information. The investigation should include:
• Background checks of the sponsor’s principals, their track record, their structure, and their compliance with Rev Proc 2002–22; and
• Review of the agreements and the fundamental bases for all projections.
Berkeley, Real Estate Interests In Securities: TICs/DSTs (ALI-ABA Course of Study, Mar. 16–18, 2006).
TIC projects are typically offered as Regulation D offerings, one of the exemptions to the Securities and Exchange Act of 1933, which requires that a private placement memorandum be generated covering all aspects of the sponsor, the property, and necessary disclosures. Investors, their brokers, and their lawyers should therefore be careful to review the documents to ensure that the particular investment is suitable to that particular exchanger/investor.
5. Forced Sale
In certain circumstances, a TIC can be forced to sell its underlying property, either by the
bankruptcy trustee under 11 USC §363(h) (in case one of the co-owners declares bankruptcy) or by the IRS under IRC §7403 (if the IRS holds a lien against a co-owner for unpaid taxes).
6. Bankruptcy
The filing of bankruptcy by any one co-owner may affect the other co-owners—and the project—if the trustee in bankruptcy seeks to reject and terminate any of the TIC agreements in order to manage the bankrupt estate. In addition, the bankruptcy of one co-owner may force the others to cover that share of expenses and stay them from seeking to recoup what they are paying, thus increasing the risk that the entire project may go bankrupt.
Lenders protect themselves against co-owner defaults by demanding bankruptcy-remote entities, such as single-member LLCs; but a bankruptcy filing by an investor’s LLC could make the bankruptcy trustee a new tenant in common subject to the rules of the TIC agreement. Thus, a lender may also require that its nominee sit on the board of each LLC and that all operating documents require unanimous consent for filing bankruptcy. See Krabacher, Tenancy-in-Common: Financing and Legal Issues, 33 Colo Law 89 (June 2004); see also Weissburg & Trott, Special Purpose Bankruptcy Remote Entities, 26 Los Angeles Law 12 (Jan. 2004) (available at http://www.lacba.org/Files/LAL/Vol26No10/1475.pdf). Investors may also have to supply lenders with personal guaranties and other assurances. There may be “lockbox” restrictions on cash transfers. (A lockbox arrangement requires all cash receipts to be deposited into a separate bank account, jointly controlled by the lender and the borrower, that allows the lender to closely monitor cash disbursements.) Krabacher, Tenancy-in-Common: Financing and Legal Issues, 33 Colo Law 89 (June 2004). See also Fletcher & Tarkenton, Protecting the Lender: Lockbox and Bankruptcy Remote Entities, 5th Annual Mortgage Financing Program, Real Property Probate and Trust Law Section
(ABA 1999); Senecker, How to Document Securitized Commercial Real Estate Mortgage Loans, 15 Prac Real Est Law 41 (May 1999).
In the near future, lenders may begin requiring investors to use Delaware Statutory Trusts (DSTs) instead of TICs because they give lenders even greater protection, since creditors of the beneficial owners of a DST cannot assert claims directly against the property held in the DST. A DST is a trust established to hold title to property in which a trustee acts as a fiduciary and beneficial interests in the trust are sold to investors. With careful structuring and drafting of the trust documents, beneficial interests in a DST have been determined to qualify for tax deferral under §1031. On July 20, 2004, the IRS clarified the use and tax consequences of DSTs in the context of §1031 exchanges by releasing Rev Rul 2004–86, 2004–2-Cum Bull 191. Many authors believe that the use of DSTs is superior to TICs since, among other things, the financing is easier and the 35-member limitation does not apply. There are, however, other limitations that may make their use more cumbersome. See Berkeley, Real Estate Interests in Securities: TICS/DSTS (ALI-ABA Course of Study, Mar. 16–18, 2006), and Lipton, The “State of the Art” in Like-Kind Exchanges, 19 Prac Real Est Law 31, 34 (May 2003); see also Pederson, The Rejuvenation of the Tenancy-in-Common Form for Like-Kind Exchanges and Its Impact on Lenders, 24 Ann Rev Banking & Fin L 467 (2005). Nevertheless, investors should consider DSTs because, like TICs, they are eligible for §1031 exchange benefits.
7. Fears of Foreclosure
If the gross cash flow is not sufficient to cover the TIC’s debts, all the TIC owners may have to respond to cash calls to avoid foreclosure, since financing is aggregate rather than individual. While lenders do sometimes make individual loans to individual TIC owners according to the amount of their investment, they generally make all co-owners jointly and severally liable for the entire loan, with a blanket lien on the entire property. Gordon, CMBS: Tenants-in-Common Becoming More Common, Commercial Securitization for Real Estate Lawyers; Real Estate Finance in The Capital Markets: Risks and Rewards 217, 220 (ALI-ABA Course of Study, Apr. 1–2, 2004).
8. Liability
There is no assurance that all of the tenants in common will perform their obligations under the TIC documents. A concern of every investor and the lender is that a creditor of one co-owner may reach or affect the interests of the other co-owners. A lien on one cotenant’s interest could adversely affect the marketability of the entire property. TIC investors expect the sponsor to do in-depth financial due diligence on the other investors before putting them into a common pool. Most TIC agreements include covenants of contribution, indemnities, representations, and warranties. In addition, while most property managers seek to maintain adequate liability insurance coverage, it may turn out to be insufficient or unavailable, making the other tenants in common personally liable for certain losses.
9. Death
The death of one co-owner will not affect the others, as would be the case for joint tenancy, but the heir may not be as creditworthy and may have different goals or investment needs than the remaining co-owners.
10. Divorce
In California, a spouse cannot shield the property from being included in the divorce, thereby exposing the property to judicial proceedings. Sponsors seek spousal consent from married investors in community property states, but these may not be effective.
11. Limited Number of Investors
TICs are often limited to 35 investors in order to meet the requirements of Rev Proc 2002–22. This may make it difficult to acquire expensive, high grade, or unique property that needs the funding base of a greater number of investors.
12. Fear of Partition
TIC co-owners must retain the right to partition the property in order to comply with the
requirements of Rev Proc 2002–22, since a fundamental principle of tenancy in common interests is the freedom to alienate one’s interest. However, partitioning property may lead to a forced sale. While the procedure permits lenders to place restrictions on co-owners’ right to partition that are consistent with “customary commercial lending practices,” lenders are very cautious in waiving the right to partition and employ numerous methods to avoid it, e.g., requiring that a co-owner offer the property
to the other co-owners before selling it to an outsider. See IRS Letter Ruling 200513010; see also Pederson, The Rejuvenation of the Tenancy-In-Common Form For Like-Kind Exchanges and Its Impact On Lenders, 24 Ann Rev Banking & Fin L 467 (2005).
13. Tenant Credit Risk
Only a limited number of high-credit tenants exist, and even they may present a credit risk. The failure of a major triple-net tenant, or of several smaller ones, can jeopardize the entire project. Since investors in TICs have no management duties to begin with, these risks are less controllable by them. They must rely on the sponsor and the lender to have enough motivation to monitor the property and its management properly.
14. No Fiduciary Duty?
It is not clear to what extent cotenants have any fiduciary duties to each other. One cotenant could take an action that is not in the best interest of the others, thereby exposing its cotenants to litigation. Sponsors and property managers, or their affiliates, claim that they have no fiduciary duties towards the cotenants; while this claim is dubious, it is nevertheless crucial for the investors in these TICs to investigate the sponsor and property manager of any project to ensure that they have good reputations, expertise, stability, and track records.
15. Securities or Real Estate?
Property that constitutes a “security” (as defined in §1031(a)(2)(C)) will not qualify for like-kind exchange protection. Many securities attorneys believe that TICs constitute “securities” under state and federal securities law. Even if a TIC is a security, it may still be real estate under state real estate law, and thus escape the §1031(a)(2)(C) exclusion. See Borden & Wyatt, Syndicated Tenancy-in-Common Arrangements: How Tax-Motivated Real Estate Transactions Raise Serious Nontax Issues, 18 Prob & Prop 18 (Sept./Oct. 2004).
The TIC industry has recognized that these arrangements generally fall within the scope of securities laws. Sponsors generally use a real estate broker in the syndication and also hire securities brokers to sell TIC interests. Investors need to understand the implications of TIC interests being viewed as securities, especially with regard to the limitations on their ability to later dispose of them. (Sponsors should also be mindful of rules against the sharing of commissions under real estate and securities laws.) Due to these concerns, TICs are sold with a formal offering memorandum, which includes formal budgets, tax opinions, indemnity agreements for payments made under recourse provisions of the mortgage loans, and other documents to create structures to cap liability. In March 2005, the NASD issued Notice to Members 05–18, in which it concluded that TICs generally constitute investment contracts and therefore are securities for purposes of the federal
securities laws and NASD rules.
In sum, for tax purposes, TICs are deemed to be real estate and thus eligible for treatment under IRC §1031 if executed and structured properly, as prescribed by Rev Proc 2002–22. However, for securities law purposes, TICs are considered securities, and therefore must comply with all federal securities laws. That is often why most sponsors advertise their product by claiming that they have obtained a legal opinion from a reputable law firm attesting to the fact that they have complied with the rules and Rev Proc 2002–22. Berkeley, Real Estate Interests in Securities: TICS/DSTS (ALI-ABA
Course of Study, Mar. 16–18, 2006). See Aiken, Evaluating Co-Ownership of Real Estate (CORE) or Tenant-in-Common (TIC) Interests in Real Estate (Exeter 1031 Exchange Services) (available at http://www.exeterco.com/pdfs/Article_CORE_TIC.pdf).
16. Bonds or Real Estate?
If an investment is characterized as a bond, §1031 is not available. A long term triple-net-leased property with a creditworthy lessee can look quite bondlike to an investor, especially when the tenant has an absolute obligation to pay rent, unrelieved by condemnation or destruction of the property, and bears all operating expenses, taxes, maintenance, and insurance—and the lessor merely collects rent checks. Sponsors may be tempted to enter into such arrangements in order to make their product more attractive to investors since the investors are relying on a secured flow of rental income. However, because of the threat that the IRS may say that this arrangement is no longer a typical
triple-net lease (lacking credit risk), but is truly bondlike, it is safer for most planners and tax advisors to stay away from such structures if they want to preserve their §1031 nonrecognition feature. Borden & Wyatt, Syndicated Tenancy-in-Common Arrangements:
How Tax-Motivated Real Estate Transactions Raise Serious Nontax Issues, 18 Prob & Prop 18 (2004).
17. Referral Fees to Real Estate Brokers
It is questionable whether a broker/sponsor can pay referral fees to third parties for any business they refer. If TICs are viewed as investment contracts under securities laws, such fees can be paid only to registered brokers dealers (NASD Rule 2420). This requirement disqualifies real estate brokers who are not also broker/dealers. Consequently, many brokers involved in the sale of TICs secure both a securities license as well as a real estate brokers’ license. Brokers who do not have a securities license
often view TIC interests as competition to their business and therefore are more hesitant to steer clients to such investments. Aiken, Evaluating Co-Ownership of Real Estate (CORE) or Tenant-in-Common (TIC) Interests in Real Estate (Exeter 1031 Exchange Services) (available at http://www.exeterco.com/pdfs/Article_CORE_TIC.pdf). Needless to say, in most deals that are clearly structured as a real estate transaction, this issue does not come up.
IV. Revenue Procedure 2002–22
A. Purpose
Revenue Procedure 2002–22 made tenancy in common ownership deals very attractive by allowing tenancy in common interests to be exchanged for other real estate. This opened up huge markets of exchange alternatives for individual investors.
At the heart of the procedure is the concern that the investor be truly an owner of real estate, rather than in a business venture or partnership. Section 3 (Scope) of Rev Proc 2002–22 provides:
This revenue procedure applies to co-ownership of rental real property (other than mineral interests) … in an arrangement classified under local law as a tenancy-in-common.
It is not clear what happens to community property, joint tenancy, and similar co-ownership arrangements. The procedure, by its terms, does not apply to property not held as a tenancy in common.
The procedure provides guidelines for requesting advance rulings. The guidelines are not
substantive rules. The procedure does not create a safe harbor, although most practitioners treat it as such and believe that the IRS will only issue a ruling when some of the conditions are not satisfied. Recently, however, sponsors have stopped requesting revenue rulings. Most sponsors are asking their attorneys, or attorneys associated with reputable firms, to issue tax opinion letters with many caveats instead. Most opinion writers take the position that, if all the conditions set forth in the procedure are met, their clients may go forward.
The procedure, however, has made lawyers, accountants, and taxpayers cautious when cotenancy arrangements violate one or more of the guidelines. Although TIC arrangements have not yet been tested in the courts, most authors believe that courts reviewing them will take a more liberal approach than the requirements set forth in the procedure. Today, sponsored TICs are being marketed either as having received favorable advance opinions from attorneys specializing in the area or as being “ruling eligible” under the revenue procedure; those that do not receive such opinions, or are not ruling eligible, may soon be at a competitive marketing disadvantage. See Tuchman, Swap Till You Drop—Structuring Co-Ownerships Under Code Section 1031 After Revenue Procedure 2002–22 (Mar. 25, 2002) (available online at http://www.lplegal.com/mjt_co_ownership).
B. Conditions
There are 15 conditions to receiving an advance ruling from the IRS under Rev Proc 2002–22:
1. Tenancy in Common Ownership. Co-owners must hold title to the property (either directly or through a disregarded entity) as a tenant in common under local law. Title to the property may not be held by an entity.
2. Limited Number of Owners. Owners must not exceed 35 persons. Husband and wife are treated as one person, as are persons acquiring an interest from a co-owner by inheritance.
3. No Treatment of Co-Ownership as an Entity. This condition addresses co-owners doing business under a common name. Thus, using a fictitious business name may violate this condition. The owners also should not identify themselves as “partners” or “members.” The IRS has reservations about any technique whereby co-owners who were in a partnership dissolve it and form a TIC in anticipation of a §1031 exchange. This liquidate-and-exchange device is quite popular, but it risks recharacterization as a sale by the partnership.
4. Co-Ownership Agreement. The parties may enter into a limited co-ownership agreement that runs with the land and binds subsequent purchasers. Most agreements require that a selling co-owner first offer the interest to the other co-owners or the sponsor at fair market value.
5. Voting. Certain actions require unanimous approval by the owners:
• Any sale, lease, or re-lease of any part or all of the property;
• Negotiation or renegotiation of any debt secured by a blanket lien;
• Hiring of any manager; and
• Negotiation of any management contract (or any extension or renewal).
This requirement is difficult to meet because it is often impossible to get all owners to vote unanimously. Devices used to finesse this requirement—e.g., master leases and profit sharing—can easily lead to recharacterization as a partnership and defeat the ability to exchange. Fickes, An Uncommon 1031 Deal, Nat’l Real Est Investor (Aug. 1, 2003) (available online at http://www.nreionline.com/finance/netlease/real_estate_uncommon_deal).
The guideline permits other cotenancy decisions to be made by a simple majority vote of the owners. See IRS Letter Ruling 200327003 and Allen, Section 1031: When Exchanges and Partnerships Collide (PLI Course Handbook June 2006).
6. Restrictions on Alienation. For reasons already stated, cotenants and lenders usually want to control the transfer of interests. This guideline requires that each co-owner must be able to transfer, partition, and encumber its interest without the approval of anyone else. Restrictions required by a lender consistent with customary commercial lending practices are not prohibited.
7. Split on Property Sale. If the property is sold, all debts secured by any blanket lien must be satisfied and the remaining sale proceeds must be distributed to the co-owners. This bars arrangements designed to survive the disposition of the property, as is often the case with partnerships. This requirement, however, has no basis in economic reality because it ties up the flexibility of the owners and the needs of lenders, and is not legally justified. See Weller, Selected Like-Kind Exchange Issues, Fifth Annual Real Estate Tax Forum (PLI Course Handbook Feb. 2003); see also Weller, Current Developments in Like Kind Exchange Transaction Planning, Creative Tax Planning for Real Estate Transactions (ALI-ABA Course Handbook Oct. 7–9, 2004).
8. Proportionate Sharing of Profits and Losses. Each co-owner must share in all revenues and costs associated with the property in proportion to its interest. Special allocations of profits or losses are usually indicative of a partnership arrangement. There may be some situations in which a nonprorata arrangement might make sense. A cotenant could be required to indemnify the other cotenants if the first cotenant damages the property, e.g., by discharging hazardous waste on the property. The ownership interest of a cotenant might be separately assessed for purposes of property in a state, such
as California, that limits property tax revaluations except in case of changes of ownership. This ruling guideline apparently prohibits such an indemnification or a requirement that a cotenant bear excess property taxes imposed as a result of a change of ownership.
9. Proportionate Sharing of Certain Debt. The co-owners must share in any debt secured by a blanket lien in proportion to their interests, and any blanket lien must be recorded. This prohibits many creative financing arrangements and TIC arrangements responsive to different debt/equity ratio needs of different co-owners.
10. Options. A co-owner may grant others—other co-owners, lessees, or third parties—an option to purchase a co-owner’s interest (call option), provided that the exercise price for the call option reflects the fair market value of the property as of the time the option is exercised. Therefore, an exercise price at a predetermined price may not meet the guideline. Absolutely prohibited by the revenue procedure are “put” options, in which a co-owner holds a right to sell the co-owner’s undivided interest to the sponsor, the lessee, another co-owner, or the lender, or any related person. The effect is to make such an interest unattractive to those who want only to extend their 180-day exchange period; therefore, such investors will be disinclined to acquire a TIC interest because it gives them no guaranteed exit strategy.
11. Customary Nonbusiness Activities. The co-owners’ activities must be limited to those
customarily performed in connection with the maintenance and repair of rental real property. See Rev Rul 75–374, 1975–2 Cum Bull 261. However, activities of a co-owner or a related person with respect to the property (other than in the co-owner’s capacity as a co-owner) will not be taken into account if the co-owner owns an undivided interest in the property for less than six months.
12. Management and Brokerage Agreements. To qualify under the guideline, the management or brokerage agreements cannot exceed one year.
The manager may be the sponsor of the cotenancy or a co-owner, but may not be a lessee. The management agreement may authorize the manager to perform certain simple tasks, such as:
• Maintaining a common bank account for the collection and deposit of rents and to offset expenses
associated with the property against any revenues before disbursing each co-owner’s share of net revenues;
• Preparing statements showing the co-owners’ shares of revenue and costs from the property;
• Obtaining or modifying insurance on the property; and
• Negotiating modifications of the terms of any lease or any indebtedness encumbering the property, subject to the approval of the co-owners.
The determination of any fees paid by the co-ownership to the manager must not depend in whole or in part on the income or profits derived from the property, since it may be indicative of a partnership between co-owners and manager and may not exceed the fair market value of the manager’s services. Any fee paid by the co-ownership to a broker must be comparable to fees paid by unrelated parties to brokers for similar services. See Cuff, Section 1031 Exchanges Involving Tenancies-In-Common, Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 2004 at 867 (PLI Course Handbook June 2004).
13. Leases. All leasing agreements must be bona fide leases for federal tax purposes. Rents must reflect the fair market value for the use of the property, which means that they must not depend on income or profits of the tenant unless based on a percentage of receipts or sales. See IRC §856(d)(2)(A). The co-owners should not share in the profits of the tenant.
14. Loan Agreements. The lender cannot be related to any co-owner, the sponsor, the manager, or any lessee. This absolute limitation on related party loans will force careful checking of the identity of co-owners and lessees.
15. Payments to Sponsor. Payment to the sponsor for (a) the acquisition of the co-ownership interest and (b) any other services must reflect the fair market value of the interest or the services, and may not depend on income or profits from the property. Thus, the sponsor is prohibited from sharing in the net profits derived from the property.
V. Conclusion
The proliferation of TICs in the marketplace presents new opportunities and challenges to lenders, sponsors, and investors.
The lenders’ challenge is to structure the financing so as to minimize their risks and at the same time allow borrowers to comply with the guidelines of Rev Proc 2002–22. Lenders must carefully analyze the credit risk posed by their borrowers and take a conservative approach toward qualifying the property and the borrower. Attorneys and tax advisors must analyze the bankruptcy, foreclosure, and priority issues their clients face in these types of arrangements and accompanying documents. The lender’s watch list in Swenson & Dickson, The Recent Trend Toward Financing Tenancies in Common Poses Substantial Challenges to Lenders, 28 Los Angeles Law 40 (Sept. 2005), is a good guideline for lenders.
Sponsors should take care in structuring their own involvement in these TICs. They should realize that the success of TICs is market driven. Sponsors should find ways to ensure that their investors’ fractional interests will remain marketable and valuable with readily available exit strategies. Finally, sponsors should be mindful of their disclosure duties since, despite their beliefs, fiduciary duties toward the investors may attach. Sponsors who want to remain competitive in this market will have to seek and receive advance rulings from the IRS and more reassuring tax opinions from reputable attorneys in the field. Investors should thoroughly investigate the sponsor, the property, and the asset manager of a particular TIC and study their track records. They should not rely solely on the information provided to them by the sponsors. Investors should analyze all risks associated with any given TIC and consult their tax advisors, estate planners, and accountants before entering into any TIC arrangement. While Rev Proc 2002–22 was enacted to address the need for clarity on these prepackaged TIC arrangements, it is believed that the guidelines are not limited to prepackaged TICs. Indeed, the procedure has greater impact in regular typical nonsyndicated, nonprepackaged TICs, since those are
more common.
Many practitioners may view Rev Proc 2002–22 as a major break with the IRS’s past position, since there are now guidelines to ensure that TIC arrangements will not be treated as interests in partnerships rather than interests in real estate. However, the guidelines spelled out in the procedure do not guarantee anyone involved that the IRS will provide an advance ruling, much less a favorable one. The procedure will undoubtedly have great significance in audits, but should not cause taxpayers to fully rely on them. For the time being, the guidelines set forth in Rev Proc 2002–22, in many respects, have become major hurdles for taxpayers to overcome. The IRS is still in a study stage, and
the fact that the procedure has gone far beyond the existing case law in this area will give no comfort to most lawyers and tax advisors. Thus, for the moment, all that can be done is to proceed with extreme caution.
Tenant-in-Common Investments
December 4th, 2006 by Troy
Tenant-in-Common Investments:
Another Way to Stave Off the Taxman
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.
Capital Gains Taxes: There’s more than one rate
November 28th, 2006 by Troy
I thought this was a good article about the way capital gains tax is determined. It’s very easy to follow for those who are new to capital gains tax calculations. - Troy
By Kay Bell • Bankrate.com
Money gurus are always preaching long-term investing. Not only will that give you a better shot at earning more, it’ll also get you a lower tax rate when you sell.
But exactly what rate you get depends on several things, including when you bought the asset, when you sold it, your overall income level and sometimes what tax-code changes are made in the meantime.
Currently, capital gains may be taxed at 5 percent, 15 percent, 25 percent or 28 percent or a combination of rates. These tax levels are known as long-term capital gains and apply to assets that you hold for at least 366 days (more than one year). The long-term capital gain tax is, generally, much lower than what you pay on your regular income.
In fact, it is a taxpayer’s income level that generally determines which capital gains rate is owed. If your profit pushes you into a higher bracket, you could possibly be taxed at a combination of rates.
And you could face yet another rate depending upon the type of property you sell.
May is a good month for lower rates
For many years, investors whose overall income put them in the top four income-tax brackets faced a long-term capital gains rate of 20 percent, while lower-income investors paid capital gains taxes of 10 percent.
Tax-law changes in May 2003, however, lowered the rates by 5 percent each. Most investors, which generally means folks in the higher income ranges, now find their capital gains taxed at 15 percent. Taxpayers in lower income brackets pay only 5 percent on most investment earnings.
These lower rates were scheduled to end on Dec. 31, 2008.
However, in May 2006, lawmakers agreed to extend this tax break for investors for another two years. Now capital gains and qualified dividends will continue to be taxed at 15 percent (or 5 percent for lower-income taxpayers) through 2010.
Remember, each of these is the long-term capital gains rate. In most cases, that means you have to hold an asset for more than a year before you sell it. If you cash it in sooner, you’ll be taxed at the short-term rate, which is the same as your ordinary income tax level, which could be as high as 35 percent.
While the 5 percent and 10 percent rates have received the most attention, at least on Capitol Hill, for the last few years, there are several other categories of capital gains taxes. Here’s a breakdown of all the tax levels.
5-percent rate
This capital gains rate applies to taxpayers in the 10-percent or 15-percent income tax brackets. They will pay a maximum 5-percent long-term gains rate on property held for more than a year.
Lower-income investors get an even better investment sale deal in 2008. That year, these filers will pay no tax on sales of long-term holdings.
The 5-percent rate still applies to a portion of your gains even if your asset sale pushes you into a higher bracket. For example, if, as a single filer, your taxable income was $25,000 but you netted another $7,000 from a long-term stock sale, some of that gain would still be taxed at the lower 5 percent capital gains rate even though technically you were bumped into the 25-percent tax bracket.
In this case, $29,700 (the 2005 income ceiling for the 15-percent bracket) minus your ordinary income of $25,000 gives you a $4,700 capital gains cushion at the 5-percent level. Only the remaining $2,300 of gain would be taxed at the 15-percent rate applicable to your new, higher tax bracket.
15-percent rate
This most widely paid capital gains tax rate applies to long-term investments by individuals in the 25-percent or higher tax brackets. When you hear “lower capital gains rate,” it generally means this level, because there are few investors with incomes low enough to qualify solely for the 5-percent rate.
25-percent rate
This rate applies to part of the gain from selling real estate that depreciated. Basically, this keeps you from getting a double tax break. The Internal Revenue Service first wants to recapture some of the tax breaks you’ve been getting via depreciation throughout the years. You’ll have to complete the work sheet in the instructions for Schedule D to figure your gain (and tax rate) for this asset, known as Section 1250 property. More details on this type of holding and its taxation are available in chapter three of IRS Publication 544, Sales and other Dispositions of Assets.
28-percent rate
Two categories of capital gains are subject to this rate: small business stock and collectibles.
If you realized a gain from qualified small business stock that you held more than five years, you generally can exclude one-half of your gain from income. The remainder is taxed at a 28-percent rate. If you’ve already hired a tax professional to help you sort out the 25-percent rate on depreciable property, she can help you figure this tax, too. Or you can get the specifics on gains on qualified small business stock in chapter 4 of IRS Publication 550, Investment Income and Expenses.
If your gains came from collectibles rather than a business sale, you’ll still pay the 28-percent rate. This includes proceeds from the sale of a work of art, antiques, gems, stamps, coins, precious metals and even pricey wine or brandy collections.
Five-year rates disappear … for now
The changes that dropped long-term rates also eliminated (for transactions after May 5, 2003) two capital-gains rates that previously had been in effect.
The 8-percent and 18-percent rates existed for investors who were committed for the longer haul. Both of these rates, the 8 percent one for taxpayers in the 10-percent and 15-percent income tax brackets, and the 18-percent rate for those in the top four brackets, were applied to assets held for at least five years. By dropping simple long-term (more than one year) rates even lower, the latest capital gains changes supersede the five-year rates.
However, depending on future tax legislation, the five-year rates (as well as the “old” 10-percent and 20-percent long-term categories) might return.
For now, the 5-percent and 15-percent rates are in effect through 2010. But they are still considered “temporary.”
In 2003, the capital gains tax cut was scheduled to expire at the end of 2008. The deadline was included to ensure that the tax cuts then didn’t produce too much red ink on the federal budget ledger sheet. However, such tax revenue losses weren’t as troublesome three years later when the majority of lawmakers voted to extend them through 2010.
So now, the prior tax law and its higher rates won’t return until Jan. 1, 2011. That is, of course, unless lawmakers make further changes before then.
In the face of such indefinite tax laws, what’s an investor to do? Since most people will pay less taxes on their long-term gains thanks to the 2003/2006 laws, financial experts say to take advantage of today’s lower rates when they fit into your portfolio plans.
But don’t forget about the Dec. 31, 2010, deadline. And definitely keep an eye on federal tax-law writers in the interim.
Freelance writer Kay Bell writes Bankrate’s tax stories from her home in Austin,
Texas, and blogs on tax topics at www.dontmesswithtaxes.typepad.com
– Updated: May 29, 2006
What is a tenancy in common (TIC)?
November 28th, 2006 by Troy
The acronym “TIC”, which stands for tenancy in common, along with the terms “cotenancy” and “fractional ownership”, refer to arrangements under which two or more people co-own a parcel of real estate without a “right of survivorship”. This type of co-ownership allows each co-owner to choose who will inherit his/her ownership interest upon death. By contrast, the type of co-ownership called “joint tenancy” requires that each co-owner’s interest pass to the other co-owners upon death.
The TIC has become a popular style of ownership in many different real estate contexts. For example, income property investors and real estate syndicators are increasingly using tenancy in common as a vehicle to facilitate income tax-deferred exchanges, a trend that has been propelled by recent IRS rulings recognizing certain tenancy in common structures as legitimate vehicles for these exchanges. At the same time, vacation home buyers and resort developers are increasingly using tenancy in common (often called “fractional ownership” in this application) to share ownership and usage of vacation properties so that owners need not buy more than they can use and afford, but still get legal title to real estate (unlike in a traditional “time share” arrangement).
This article will focus on a third common usage of tenancy in common which is the co-ownership of multi-unit property by co-owners who each wish to have exclusive usage rights to a particular area of the property. TIC owners own percentages in an undivided property rather than particular units or apartments, and their deeds show only their ownership percentages. The right of a particular TIC owner to use a particular dwelling comes from a written contract signed by all co-owners (often called a “Tenancy In Common Agreement”), not from a deed, map or other document recorded in county records. This type of tenancy in common co-ownership should not be confused with the legal subdivisions known as the “condominium” and the “stock cooperative”, as discussed below.
What is the difference between a tenancy in common and a condominium?
In a condominium, property has been legally divided into physical parts which can be separately owned. Each condo owner owns a particular area of the property which is delineated on a map recorded in the public records, and has a deed which identifies the area which is individually owned. By contrast, TIC owners own percentages in an undivided property rather than particular units or apartments, and their deeds show only their ownership percentages. The right of a particular TIC owner to use a particular dwelling comes from a written contract signed by all co-owners (often called a “Tenancy In Common Agreement”), not from a deed, map or other document recorded in county records. The difference between physical division of ownership in county records (as in a condominium) and an unrecorded contract allocating usage rights (as in a tenancy in common) is significant from both regulatory and practical standpoints, as discussed below.
What is the difference between a tenancy in common and a cooperative?
In a “stock cooperative” or “co-op”, a corporation or other legal entity owns the property, and the owners of that entity each hold shares of the entity along with usage rights to a particular apartment (often but not always expressed in a document called a “proprietary lease”). In most locations, a stock cooperative is legally recognized as a form of subdivision, and this recognition brings co-op ownership within the scope of most local subdivision restrictions and regulations. As a result, laws that restrict or prohibit the conversion of apartment buildings into legal subdivisions such as condominiums generally impose those same restrictions and prohibitions on the conversion of apartment buildings into stock cooperatives. In practice, this means that if you can convert to a co-op, you can also convert to a condo, and you would always choose the condo conversion over the co-op conversion because condos are easier to sell and finance. On the other hand, if it is burdensome or impossible to convert to a condo, the same difficulties will apply to a co-op conversion, but will not apply to TIC conversion. That is why people form tenancies in common rather than cooperatives.
Why have TICs become so popular?
As the price of real estate continues to rise, and communities adopt ever stricter growth and condominium conversion restrictions, more and more people are turning to tenancies in common and other non-traditional co-ownership structures as a way to maximize their buying and selling power. These arrangements lower prices and increase choice for buyers by allowing them to pool resources and buy more real estate than they otherwise could or would, while agreeing among themselves on an allocation of rights and responsibilities so each buyer does not end up with more than he/she needs. At the same time, tenancy in common arrangements increase sale prices and marketing options for sellers by allowing them to sell fractions of their property to buyers for prices that generally add up to more than what the seller would receive from a single buyer. The popularity of tenancies in common has been further enhanced by the recent introduction of “fractional loans” which allow co-owners to have individual mortgages, substantially decreasing the risk of co-ownership.
Why not form an LLC or limited partnership instead of a tenancy in common?
Limited liability companies (“LLCs”), limited partnerships, and corporations are entities that can provide a variety of management and liability protection advantages over direct fractional ownership arrangements such as tenancy in common. But for co-ownership groups who plan to occupy some or all of the co-owned property, the legal and tax disadvantages created by these entity structures generally outweigh the benefits. Specifically, under generally accepted interpretations of tax laws, owners of LLC memberships, limited partnership interests or corporate shares are not considered to own real estate (unless the entity qualifies as a stock cooperative), and therefore cannot claim the tax benefits of real estate owner-occupants such as the ability to deduct mortgage interest and property tax, and the ability to claim the $250,000/500,000 tax-free gain on resale. If the LLC, limited partnership or corporation can be deemed a stock cooperative, it is likely to encounter regulatory barriers as discussed above.
Can a tenancy in common owner sell his/her own interest?
Each cotenant can sell his/her tenancy in common interest at any time and, contrary to what many people unfamiliar with tenancies in common assume, TIC interests have been readily re-salable for at least the past 10 years. Sales of TIC interests involving group loans are typically subject to rights of first refusal and buyer approval to insure that the co-owners can vet prospective buyers and make sure they are qualified. Marketability is enhanced if, by resale time, the group has a track record of solving its problems and paying its bills, greatly decreasing the buyer’s risk.
What legal restrictions apply to TIC formation?
The legal restrictions applicable to tenancy in common formation and ownership vary from state to state. In California, appellate courts have recognized a distinction between recorded and unrecorded documents assigning usage rights, and this distinction means that local laws restricting or prohibiting the conversion of apartment buildings into legal subdivisions such as condominiums do not apply to the creation of a tenancy in common arrangement so long as no document deeding or otherwise assigning usage rights is recorded in public records. Consequently, tenancy in common formation does not require any filing or approval with local governmental agencies (such as counties, cities or towns).
On the other hand, tenancy in common formation in California does require the approval of the California Department of Real Estate (DRE) if the property to be co-owned and occupied by the group contains five or more residential units. The DRE approval process currently takes 6-9 months to complete, and results in the issuance by DRE of a “Public Report” (often called a “White Paper”). The Public Report contains extensive information and disclosures about the property and the tenancy in common group, and must be given to all prospective buyers. Resale of tenancy in common interests are generally allowed without a Public Report, but the rules defining what constitutes a true “resale” (as opposed to a sham designed to circumvent approval requirements) are strict.
Over the years, San Francisco lawmakers have tried on various occasions to restrict or discourage tenancy in common formations indirectly. In each instance, these measures have proven to be ineffective or been rejected by the courts. The most recent effort (in 2001) attempted to make tenancy in common ownership more risky by making exclusive occupancy agreements (even unwritten or implied ones!) illegal and unenforceable. The law was held a violation of the constitutional right of privacy by the California Court of Appeal in 2004. The Court specifically recognized that strict constitutional limitations apply to the ability of government to interfere with co-owners’ private internal arrangements relating to usage of their shared property, and stated that keeping owners and their apartment buildings in the rental housing business is not a sufficiently strong governmental interest to justify such an interference.
The upshot is that, under current California law, a TIC of the space-assignment type discussed in this article could be formed for any building (residential, commercial, or mixed use) in any location in the state. Neither the location of the building, nor its zoning, size, layout, age, unit mix or construction, matter from a regulatory standpoint.
What is included in a TIC agreement?
The following is a partial list of issues a tenancy in common agreement should cover:
• Division of the property into “individual” and “group” spheres with regard to usage rights and maintenance responsibilities;
• Description of the owners’ financial obligations including initial deposits, reserve accounts, mortgages (if shared), taxes, common area maintenance and other expenses;
• Formulas for determining each owners’ monthly payment in advance and periodically adjusting the amount;
• Management of the property including accounts receivable, accounts payable, regular reporting, maintenance and janitorial;
• Rules governing usage of the property by the owners (e.g. pets, noise, floor covering) and enforcement provisions;
• Meeting and decision making procedures;
• Provisions defining when a default has occurred and describing remedies;
• Policy in the event of death or bankruptcy;
• Sale of interests, group approval of prospective purchasers, and rights of first refusal; and
• Dispute resolution.
The goal in tenancy in common agreement preparation should not be “simplicity” or brevity. A short agreement is unlikely to directly address the real-life problem that will cause you to need the agreement. Consequently, using the short agreement to resolve a dispute will require interpretation and extrapolation, processes that make dispute resolution more difficult, time-consuming and costly. A tenancy in common agreement should be long enough to cover every issue imaginable, well organized (including an index or table of contents) so that a needed provision can be located quickly and easily, and written in language that is understandable yet sufficiently nuanced to avoid crating ambiguity or loopholes. In the unlikely event that you ever need to use your TIC agreement, you will want to be able to find a section that directly addresses your problem and clearly provides a solution.
A common mistake in creating a co-ownership agreement is postponing resolution of difficult issues (“we’ll just work that out later”) to avoid uncomfortable confrontations and preserve a transaction. The issues that seem most difficult to address are generally the most likely to lead to a dispute. Another common mistake is to assume everything will work out exactly as planned (particularly with regard to when people will occupy the property and whether and when they will sell). Housing plans are closely related to employment, health and domestic situations, and these regularly change in unforeseen ways. A good co-ownership structure is durable enough to adapt to dramatic changes in occupancy and ownership plans without being renegotiated, and certainly should never cause one owner to sell his/her home as a result of another owner’s life changes.
Even a well-prepared tenancy in common agreement should be used only in the event friendly relations among group members break down. While it is useful to have owners’ rights and duties well defined, relying on the agreement to dictate a response to actual events is unwise. Even the best agreement will rarely anticipate all circumstances, and applying a formulaic response that does not quite fit the situation may not reveal the best course of action. Such an approach encourages group members to adopt firm positions based on agreement interpretations, and an impasse may develop. A better strategy is to rely first on discussion. The goal should be to develop a consensus that all owners can accept even though some may believe that the agreement dictates a more personally advantageous decision. If a consensus cannot be reached, the TIC Agreement can provide a final resolution.
How are tenancy in common ownership percentages determined and what do they mean?
There is little consistency in how tenancy in common ownership percentages (as shown after each owner’s name shown on the recorded deed or deeds to the co-owned property) are determined. In some groups, each owner holds an equal share, while in others the shares are determined by the relative value or square footage of the assigned areas of the property. The ownership percentages are often used for the allocation of certain shared expenses, most frequently insurance and common area maintenance, but it is important to note that there is no legal requirement that any expense be allocated according to ownership percentage. As discussed below, TIC ownership percentages should never be the basis for allocation of property taxes.
Many people incorrectly assume that tenancy in common ownership percentages control owners’ resale prices, and/or division of proceeds if the entire property is resold or refinanced. In fact, a well-drafted co-ownership agreement never allows ownership percentage to control resale or refinance proceeds allocation because such an arrangement would be unfair to owners who make wise investments in improving their homes. An owner’s individual resale price should always be up to that individual owner and his/her buyer, and should never be determined or affected by his/her ownership percentage or by an appraisal of the entire property. In a resale or refinance of the entire property, proceeds allocation should be determined by an appraisal of the fair market value of each owner’s interest based on the qualities and amenities of the owner’s assigned areas.
How are tenancies in common financed?
Historically, most tenant in common groups shared one or more apartment building loan(s) which were secured by the entire property. Under this “group loan” arrangement, the tenancy in common Agreement would specify the percentage of each loan that was owed by each co-owner, each owner would contribute his/her share of each loan payment as part of his/her monthly “dues” to the group, and the group would make each payment to the lender. While group loans remain the norm for tenancy in common financing, several banks have recently introduced programs under which each co-owner has his/her own loan. Individual tenancy in common loans are secured only by one co-owner’s percentage share in the property, meaning that one co-owner’s mortgage default does not imperil the other co-owners. Yet another popular TIC financing option is individual mortgages carried by a seller or former owner, often in conjunction with an underlying loan that predates the tenancy in common formation.
With a tenancy in common group loan, how is each owner’s payment determined?
Each co-owner’s tenancy in common group loan payment is determined by the amount of the group loan he/she is responsible to repay. When the TIC is first formed, each owner’s down payment is subtracted from his/her purchase price to determine how much of the group loan that owner is responsible to repay. The difference between a co-owner’s purchase price and down payment, often called the co-owner’s loan amount or loan share, is divided into the total amount of the group loan to determine the co-owners loan percentage. The co-owner’s loan percentage determines how much of the monthly payment on the group loan that co-owner must pay.
For example, imagine that Jane and Bill are buying a two unit building together for $1,000,000. Jane, who will have the right to live in the better unit, is paying $600,000 for her share, and Bill is paying $400,000 for his share. The $600,000/400,000 split of the price is based upon the relative value of the two units in the building. Bill, who has more savings than Jane but a lower salary, is making a down payment of 25% of his price ($100,000). Jane, who has little savings but a good job, is making a down payment of 10% of her price ($60,000). The TIC group loan amount will be $840,000 which is the difference between the $1,000,000 purchase price and the total down payment of $160,000 ($100,000 from Bill and $60,000 from Jane). Bill’s loan amount is $300,000 (400,000-100,000), and his loan percentage is 35.71% (300,000/840,000). Jane’s loan amount is $540,000 (600,000-60,000) ), and her loan percentage is 64.29% (540,000/840,000). If the monthly payment on the TIC group loan is $4,200, Bill will pay $1,500 and Jane will pay $2,700.
Assuming each co-owner pays exactly his/her share of the monthly group loan payment each month, the loan percentages will not need to be adjusted. The gradual decrease of the amount owed over time (due to loan amortization) will not affect the loan percentages. The loan shares will require adjustment only if a co-owner decides to pay more than his/her regular monthly payment (perhaps to pay down his/her loan amount more quickly) or if the loan is refinanced. When loan percentages differ dramatically from ownership percentages, extra documentation should be used to provide additional security to the owner with substantially greater equity.
How can the risks of tenancy in common group loans be managed?
Obviously, a shared loan arrangement creates the risk that a co-owner who has paid his/her share could nevertheless face foreclosure because another co-owner failed to pay. Tenancy in common groups typically manage this risk by (i) undertaking a complete investigation into the background and qualification of potential co-owners before allowing them to join the group, (ii) requiring a similar evaluation each time a tenancy in common ownership interest is resold, (iii) making sure all payments on the shared loans are made form the group bank account (rather than directly from each owner to the lender), (iv) keeping reserve funds which can be used to make payments while a non-paying owner is sold out of the group, and (v) creating a powerful