The decline of the equities markets, favorable interest rates, and expanded use of tax-deferred like-kind exchanges have all led to a significant increase in real estate investment. In particular, the demand for passive secure investments to duplicate or replace those in the equities and fixed income markets has dramatically increased. New guidance for tenancy in common (“TIC”) programs has provided a growing distribution system for sellers of shopping center properties to a market comprised of investors involved in tax-deferred exchanges and others increasingly interested in an investment in commercial real estate, but on a passive level.

Internal Revenue Code §1031 is one of the kinder and more generous sections of the tax code. Whether an individual real estate investor, or a company faced with an opportunity to sell a facility it no longer needs, a real estate owner can achieve substantial tax-deferral savings by structuring a transaction as a §1031 like-kind exchange.

Owners who are selling a parcel of real estate and who intend to purchase other real property in the near future can defer all of the capital gains taxes on the sale of the old property. Tax savings for a corporate taxpayer are approximately 35 percent of the gain on the sale of investment or business-use real estate. Savings for an individual taxpayer typically range from 20 to 25 percent of the gain.

Section §1031 provides that no gain or loss will be recognized on the transfer of an investment or business-use asset, if that asset is exchanged for like-kind property that also will be held for investment or business-use.

Since no gain is recognized, it follows that all capital gains taxes will be deferred.

Satisfying the like-kind criteria is easy for real estate assets. All real estate in the United States is like-kind to all other domestic real estate, regardless of whether it is commercial, industrial, multifamily residential or unimproved. An apartment building, a quarry pit or a warehouse may all be swapped for a shopping center because they are all “like-kind.”

How does an investor turn the sale of an apartment building in Michigan and the purchase of a 4.8 percent tenant in common interest in a shopping center in Illinois into a like-kind exchange? Actually, it’s pretty easy. The tax laws do not require the swap to be simultaneous. In fact, most exchanges are non-simultaneous, for the simple reason that a purchaser of investment real estate is not likely to have acceptable property to exchange back. In a non-simultaneous exchange, the buyer’s purchase money is used to acquire replacement property from a third party seller. The tax laws give the real estate owner (“exchanger”) 180 days from the sale of the old property to acquire the new property. The exchanger is allowed to continue to search the market for acceptable replacement property during the first 45 days of this 180-day period. Additionally, the exchanger is even permitted to identify alternate replacement properties. Frequently, an exchanger works with a company offering commercial real estate with a tenancy in common investment method. These companies are called “sponsors.”

The §1031 investor has always desired a simple alternative to traditional replacement property options as a cure for the onerous 45-day identification deadline. Mature individual investors often prefer a more passive form of real estate investment than their previous holding. Now the “regular” investor is also seeking an alternative and diverse investment solution.

These circumstances have led to a tremendous increase in demand for tenancy in common ownership structures or “TIC” properties. These are typically commercial real estate assets that have been specifically structured for fractional ownership by multiple parties. The co-owners or tenants in common will have true fee ownership of the asset but will remain passive with respect to the day-to-day management of the facility. The burgeoning TIC industry has worked directly with the IRS and Department of Treasury to provide an approved means for the like-kind exchange investor to utilize this important new solution.

In March 2002, the IRS released Revenue Procedure 2002-22, which details 15 tenets of TIC ownership, covering issues such as number of co-owners and form of title-holding entities, ability to transfer and the requirement that all co-tenants share proportionately in the profits, losses and blanket debt. Importantly, the IRS now allows TIC owners to enter into management and brokerage agreements respecting the property. This guidance now provides investors and their advisors the basic map of what to look for in a TIC structure to ensure compliance with §1031 regulations.

Tax deferred exchanges under §1031 continue to grow in use and have recently been estimated between $200 and $400 billion in transactional volume on an annual basis. As these highly structured serial transactions increase, so too, grows the need for an inventory of ready replacement property. The TIC deals solve that problem by bringing institutional quality real estate to a level that makes it accessible to the individual investor. TIC ownership also provides the investor the ability to simply plug in his or her exchange proceeds and debt requirement without an exhaustive search for a specific property that matches his or her particular equity and debt needs.

Independent investors now have the ability to invest in asset classes, property values and credit tenant leases that were previously available to REITs, pension funds and large real estate organizations. These properties are available throughout the United States and are often professionally managed. TIC structures and the sponsors that create them also provide excellent exit strategies for REITs and other institutional owners. TIC sponsors can take these larger properties and sell them in undivided fractional pieces to individual investors at a slight premium. In some cases, the TIC sponsor will retain the REIT as manager of the property well beyond the initial transaction. This will provide both earnings per share (EPS) and funds from operations (FFO); both are critical components of REIT valuation.

The TIC industry has grown rapidly in an effort to serve an ever-increasing demand. An investor’s due diligence should include investigation of whether a particular sponsor and the program structure offered are reputable, reliable and likely to pass an IRS audit. Additional important factors to evaluate include management of the property (both property and asset management), experience, diversity and hidden fees. Some sponsors manage their own properties. Some only offer one asset class. Many have fees that are generated when the property is sold and which may not be disclosed up front.
Some sponsors have worked extensively with regulatory authorities to ensure total §1031 compliance; others have not. Legal opinions have now become the currency that sponsors offer their clients for comfort, but not all legal opinions are the same. Major law firms will offer opinions ranging from “Substantial Authority” (less than 50 percent likelihood of withstanding an audit); “More Likely Than Not” (51 percent in the taxpayer’s favor, 49 percent against); “Should” (51 percent to 80 percent favorable); to a “Will” opinion, which is the highest level of legal opinion at 80 to 95 percent certainty of acceptance by the IRS. The primary factor determining the level of opinion is the number of IRS tenets that the sponsor has complied with. While a number of sponsors are offering excellent real estate investments that do not comply with all 15 criteria issued in the revenue procedure, only full compliance (15 out of 15) will ensure tax deferral for the §1031 investor.

As with any new industry, there will be some shake out in the years to come. However, it certainly appears that the TIC structure is here to stay. The ability to invest on a passive basis in high quality commercial real estate with reliable income streams and maintain the tax benefits of ownership is an investment tool that no investor can afford to leave out of his toolbox. REITs gained in popularity in the 1980s when diversity of investment holdings became the mantra. However, neither REIT stock nor a limited partnership interest, along the bastion of passive real estate investment, will qualify for tax deferral under §1031. The only approved means for co-ownership of real estate in compliance with tax deferral regulations is tenancy in common.
The key to a smooth acquisition of a TIC interest in a like-kind exchange involves not only a quality TIC program and sponsor, but also the use of a reputable, institutional qualified intermediary. Tax laws prohibit the exchanger from holding or controlling the sale proceeds during the interim between sale and purchase. The sale proceeds are sent directly from the closing to the qualified intermediary, an independent third party who will hold these exchange funds in a restricted account and subsequently disburse directly to the seller of the replacement property.

Care should be taken when selecting a qualified intermediary. Many individuals, such as agents, related parties and the exchanger’s attorney, accountant and real estate broker, are disqualified from acting in this capacity. Moreover, an institutional qualified intermediary can protect this very time-sensitive transaction from problems arising from the bankruptcy, death, disability or other ill-timed legal difficulty to which individuals are prone.

Even with an institutional qualified intermediary, financial strength and stability should be considered. The exchanger should be comfortable that the money will still be there when it is time for the purchase of replacement property, regardless of what other difficulties the qualified intermediary may have. The qualified intermediary should also provide form documents for the various steps required to complete the exchange, and a knowledgeable, professional staff to assist them and their tax advisors through the morass of fine print contained in the Internal Revenue Code and the Treasury regulations governing §1031. A first rate qualified intermediary should also understand and accommodate the “fire drills” inherent in this type of transactional business. It should be able to liquidate funds and disburse on short notice.

Section §1031 like-kind exchanges are one of the last legal tax loopholes available to both businesses and individuals. The tax rules provide a framework that painlessly allows an investor to sell actively managed real estate to one buyer, purchase an undivided tenant in common interest in professionally managed replacement real estate from a different seller and defer all of the capital gains taxes on the sale. Substantial tax savings can be achieved with a little help from a professional qualified intermediary and a reputable TIC program sponsor, working in conjunction with the real estate investor’s attorney and accountant. Shopping center owners, working with TIC sponsors, have a new opportunity to provide an inventory of much needed diverse, secure and passive real estate investments to §1031 and non-tax driven investors alike.

Suzanne Goldstein Baker is vice president of Investment Property Exchange Services, Inc., an institutional qualified intermediary. Rob Hannah is CEO of Tax Strategies Group, LLC, a TIC sponsor. Both are based in Chicago.


©2003 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.