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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2005

Tenancy-in-common: A matter of convenience vs. control

Tenancy-in-common (TIC) real-estate ownership is a structure in which two or more people have undivided fractional interests in an asset and ownership shares are not required to be equal. This method of ownership is fast becoming a popular choice among real-estate investors seeking replacement property under the Internal Revenue Code (IRC) Section 1031 tax-deferred exchange.

As 1031 investors are aware, the code’s harsh time restriction is a big hurdle facing a successful exchange. Investors, however, now have a better opportunity to pick and choose from the numerous 1031-TIC syndications available. TIC ownership also allows investors to diversify their 1031 exchanges into multiple properties and to have ownership stakes in larger, institutional-quality properties.

How does TIC work?

Under a TIC, also known as co-ownership of real estate or fractional ownership, investors receive an individual deed for their undivided percentage interest in the entire property. Each investor is considered a direct owner of the real estate. Through TIC ownership, the average person is able to enjoy the convenience of owning an institutional-type property with a minimum investment. The TIC program is a “coupon-clipper” or “mailbox-management” investment.

These programs, however, come with a definite lack of control. While the nature of the TIC ownership structure allows for significant control of the property, as compared to general and limited partnerships, the opportunities often are packaged with management and debt-financing in place. A TIC investment offers the passive investor superior efficiencies in identification, financing and closing of investment-type properties. A professional asset- and property-management company (the “lessee”) typically handles the day-to-day management and ultimate disposition of the real estate.

TIC history

Residential-real-estate owners have used TIC ownership for more than 25 years. Deferred exchanges came to the real-estate community in 1979 with the U.S. Court of Appeals decision in the Starker case (602 Fed.2d 1341). Today, Section 1031 is one of the only tax-planning provisions left for developers and property owners to defer their capital-gains taxes to the future.

The 1979 decision allowed for tax deferrals on rental, commercial, investment or business real-estate property exchanged only for acquisition of future like-kind property. After five years of uninterrupted exchanges, Congress stepped in again. By enacting Section 1031(a)(3), Congress limited the time frame available for exchanges; qualifying replacement property must be designated within 45 days after the sale of the old property, and exchanges must be completed within six months. Then, with the Tax Reform Act of 1986, Congress eliminated all capital-gains deductions and also increased the capital-gains taxes for corporations.

In 2001, only $32 million was invested in TIC transactions. In March 2002, the Internal Revenue Service issued new guidelines (IRS Revenue Procedure 2002-22) governing the structure of TIC-property investments. By 2003, investment amounts reached approximately $1 billion, with $3.7 billion invested by the end of 2004.

Structure

The most-overwhelming issue facing the real-estate industry has been whether a TIC deal can be sold as a security. Today, most TIC investments are structured as securities under the Securities Act of 1933, which requires that investors receive a private placement memorandum, created out of significant due diligence from the real-estate company, lender and securities industry. The guidelines allow for a maximum of 35 TIC owners in any one commercial property. The minimum purchase requirements are as low as $100,000, whereas the typical entrance into institutional-type properties begins at around $1 million.

The blending of a 1031 exchange and a TIC structure requires the interaction of three different entities:

  1. TIC brokers find the eligible properties. Typically, they work with numerous TIC sponsors to help the investor evaluate options and decide the right property and investment strategy.
  2. TIC sponsors are entities formed specifically to organize and facilitate TIC real-estate acquisitions. In many cases, the sponsor has a vested interest in the property itself. The sponsor is responsible for arranging the sen- ior debt portion (60 percent to 75 percent) and finding sufficient TIC investors to complete the acquisition.
  3. A qualified intermediary (QI) is the professional provider of the mandatory mechanics of an exchange. The QI is a person or entity who can legally hold funds to facilitate a 1031 exchange. To be qualified, the QI must not be a relative or agent of the exchanging party. The QI, also known as an accommodator or exchange facilitator, performs several important functions in the 1031 exchange process. These functions include creating the exchange of properties, holding the exchange proceeds and preparing the legal documents.

This portion of the deal is where timing becomes relevant. A broker looking for qualified properties usually has only 60 to 90 days to close the debt financing. An investor looking to place a 1031 exchange has 45 days to identify and 180 days to close without penalty. Needless to say, these two independent periods are rarely in sync. Hiring a qualified and experienced TIC sponsor to coordinate all facets of the transaction is critical to success.

Today, some TIC sponsors are preparing to make their biggest impression yet by forming private real-estate- investment trusts (REIT). This move to private REIT status is evolutionary. TIC sponsors are finding that a private REIT is faster and cheaper to register than a public one, given the red tape and expenses.

Some observers say the move is good for the industry. First, the private REIT structure gives investors a more-personal and active relationship with REIT managers. In addition, private REITs tend to concentrate on a particular type of real estate and a specific region, which means they can draw investors who share the same focus.

Return on investment

Initially, each TIC investor receives monthly or quarterly checks. The initial cash flow ranges from 5 percent to 8 percent of the initial invested equity or cash. Through tax advantages, tax shelters and property appreciation, a passive investor can recognize a greater return on investment (ROI) without the risk.

First, the deferral of capital gains and depreciation recapture (25 percent tax rate) into and out of the investment preserves significant wealth in the estate. Second, because the investor is taking the property with existing nonrecourse debt-financing (often a 60-percent to 75-percent loan-to-value ratio), the investor receives the TIC property on a stepped-up basis. This allows for additional depreciation pass-through and interest deductions that can shelter more than 50 percent to 60 percent of the cash-flow rental income from federal and state income tax. Third, after accounting for the additional return from appreciation of the TIC property, the after-tax ROI on an annualized basis can be even greater.

Overall, annual returns are projected in the low- to mid-teens, including cash flow, appreciation and principal reduction on the nonrecourse financing. For investors planning to take their real-estate investments to the grave, there is good news for their heirs. They get the property on a stepped-up basis, so the deferred tax liability is wiped out. One of the more-attractive benefits to TIC ownership is the reliable income and growth potential this type of property produces based on its tenants’ sophistication and strength.

The co-tenants must retain unanimous voting rights to approve a sale, lease, blanket mortgage and management contract. For decisions requiring a unanimous vote, a positive vote by 75 percent of the TIC owners  usually is sufficient to initiate the impasse-resolution procedure. This procedure allows TIC owners with 75 percent or more ownership of the property to offer to buy out the dissenting owners’ control. The dissenting TIC owners can accept the offer, buy out the 75-percent TIC owners at the same price per percentage ownership or change their votes.

Further, a TIC interest can be purchased, sold, gifted, bequeathed by will or inherited. It is also subject to property taxes, gift taxes and estate and inheritance taxes in the same manner as a sole-ownership property.

TIC investing and your clients

When discussing TIC investing with your clients, have them consider the following. Do they think of themselves as “coupon-clippers”? Do they like the ease and convenience of a monthly check delivered right to their mailboxes? On the flip side, are they control freaks? Do they need to be in charge? Do they enjoy the stress and headaches that come with managing their properties and tenants on a day-to-day basis?

If they enjoy control and stress, perhaps the convenience of a TIC investment is not right for them. However, if your clients relate to ease and convenience, this may be the type of investment they’re looking for.


 


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