Because of the tax deferral benefits that sellers of real estate may realize under IRC Section 1031, many of our clients are currently taking advantage of “tax deferred” exchanges. Although this communication is not to be deemed to be tax advice to you, we, along with our clients’ certified public accountants, have been involved in documenting numerous transactions effecting Section 1031 exchanges, including instances where:
(i) a group of individuals/entities were interested in “pooling” their 1031 exchange proceeds and purchasing property; and
(ii) one selling entity formed several new purchasing entities to invest the sales proceeds in a number of subsequent properties (each having its own financing with different lenders).
These more complicated transactions are made possible by the use of a Tenants in Common (“TIC”) structure which allows for multiple individuals or entities to invest in new properties by direct or indirect ownership of the real property
In effecting these transactions, however, the TIC form of ownership must conform to certain requirements imposed by the Internal Revenue Service. These requirements can be found set forth in detail in the IRS’s Revenue Procedure 2002-22. Therefore, in contemplating this type of transaction with multiple owners, please keep in mind the following requisites:
1. Separate Ownership. Each cotenant must hold title to the property as tenants in common under local law, and not one entity (such as a partnership or limited liability company).
2. Number of Cotenants. The number of cotenants is limited to 35 persons.
3. Non-entity Status. The TIC group must not file a partnership or other entity tax return, conduct business under a common name, refer to the cotenants as partners or members of an entity, or otherwise hold itself out as a partnership or other form of entity.
4. TIC Agreement. The cotenants may enter into a limited TIC agreement which must run with the land. Such an agreement may provide that a cotenant must offer its interest for sale to the other cotenants at fair-market value (determined as of the time the partition right is exercised) before exercising any right to partition. Certain actions on behalf of the TIC group may require the vote of cotenants holding more than 50 percent of the undivided interests in the property.
5. Voting. All cotenants 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 cotenants. 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.
6. Restrictions on Conveyance. Each cotenant must have the unrestricted right to transfer, partition, and encumber their own undivided interest in the property without the agreement or approval of any person. However, 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. In addition, the tenants in common may include a provision for the right of first offer or refusal as set forth in the Revenue Ruling.
7. Sharing Proceeds and Liabilities. 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 cotenants.
8. 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. Other cotenants may loan funds to the property to meet certain expenses under certain limited conditions
9. Proportionate Sharing of Debt. The cotenants must share in any debt secured by the property by a blanket lien in proportion to their undivided interests.
10. Options. The IRS does allow a cotenant to issue an option to purchase its undivided interest, 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. However, a cotenant may not acquire an option to “put” his/her undivided interest, to another cotenant.
11. Business Activities. The TIC’s activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property The applicable Revenue Ruling is usually referred to as what constitutes such activities. regulations.
12. Management and Brokerage Fees. Cotenants may enter into management or brokerage agreements with an agent, which must be renewed on an annual basis. The management/brokerage agent may be the a cotenant or related party, but cannot be a tenant of the TIC. The management agreement terms are somewhat restricted by the Revenue Ruling, and negotiating such agreement should take into account these restrictions. Unlike many other agreements, the determination of any fees paid by the TIC to the manager may not depend, in whole or in part, on the income or profits derived by any person from the property, and must be consistent with “fair market” rates.
13. Leases. All tenant leases must be bona fide leases for federal tax purposes. Rents must be for fair-market value and may not depend on the income or profits derived by any person from the property leased (other than a typical percentage rent clause).
14. Related Loans. The lender holding the mortgage on the Property may not be a person related to any cotenants.
15. Payments to Sponsor. If there is a “sponsor” of the TIC, the amount of any payment to a sponsor for the acquisition of the cotenant’s interest or for related services must be for fair market value, and cannot be calculated on the income or profits received by such cotenant.
As mentioned above, however, there are times when there is a seller who desires an exchange but wishes to invest in multiple properties (each with a different lender) and, in addition, may wish to bring in new investors. To avoid having many tenants in common involved in the financing process and documentation, as well as to maintain the privacy of investors, this type of seller may not wish to use the TIC structure. In these instances, we have structured transactions where a 1031 seller formed one or more new “disregarded” special purpose entities to take title to the replacement property or properties, which new entity or entities were 100% owned by the 1031 seller. Simultaneously, the selling entity amended its partnership or other ownership agreement to add the additional partners/owners to the existing selling entity, each group of investors being a special class of partner with economic rights and benefits limited to the one property in which they were investing. This type of structure provides certain benefits:
(i) it allows for one seller to form new entities to purchase multiple properties;
(ii) although these new entities are “disregarded” for tax and 1031 purposes, they are new, independent single purpose, single asset entities for lending purposes, thereby avoiding having all cotenants join in the loan documentation and allowing for different lenders to make loans on the different properties;
(iii) it allows bringing in new investors for different properties;
(iv) it avoids the TIC restrictions set forth above; and
(iv) it maintains the privacy of the individual investors since they will not appear on any TIC Agreement that may be of record.
As you can see from the foregoing, a TIC Agreement is a very simple and useful tool in effecting tax deferred exchanges with multiple parties, each of whom may desire to effect his or her own exchange. They must, however, satisfy various requirements to qualify for Section 1031 exchange purposes. Therefore, these documents should be carefully drafted and reviewed by appropriate legal and tax consultants. Sometimes, however, these tax restrictions may give investors some pause before entering into such an arrangement, even given the potential deferral of taxes. In such event, it may be appropriate to discuss a possible alternative structure as described above that may better suit the investors’ needs. In any case, with the proper structuring and consultation with a tax advisor, the TIC or alternative structures allow real estate investors a very convenient and effective vehicle for taking advantage of deferring capital gains for the sale of real property.