Similar to a Delaware Statutory Trust (DST), a Tenancy in Common (TIC) 1031 exchange enables investors to jointly acquire high-value properties, opening up investment opportunities that may not be feasible for individual investors. By allowing investors to pool resources, this investment vehicle affords participation in a larger, potentially more lucrative, property market.
In the following guide, we’ll explore the intricacies of the TIC 1031 exchange, the rules governing these exchanges, and how they differ from a Delaware Statutory Trust (DST) 1031 exchange, giving you the knowledge you need to determine which structure may be appropriate for your investment objectives.
Tenants in Common Ownership Structure
In commercial real estate, Tenancy in Common (TIC) is a specific ownership structure that allows multiple parties to hold an undivided fractional interest in a property. Each owner, or tenant, owns a stake in the entire property, regardless of the size of their individual ownership fraction. For example, one investor may own 75% of the property while the other owns 25%. However, each investor has the same rights and privileges related to the property as a whole.
Fractional ownership creates flexibility by allowing investors to purchase partial ownership in high-value properties. This opens doors to investing in larger, higher-quality real estate holdings while giving investors the freedom to choose an investment amount that is in alignment with their financial capabilities, goals, and risk tolerance.
A Tenancy in Common agreement is created by a legal document that outlines each tenant's rights, responsibilities, and the proportion of property costs and profits they will bear. The agreement can be created at any time, allowing owners to further split their interests if additional investors wish to buy into the arrangement.
What is a Tenancy in Common 1031 Exchange?
A TIC 1031 exchange involves a group of 2 to 35 investors who pool their resources to acquire a single property through a 1031 exchange. The ownership fractions are not required to be equal, allowing each investor to purchase a percentage of the property based on their desired investment amount.
Each investor receives fractional ownership of the entire property and a share of the property's net income, tax benefits, and appreciation in its value, proportional to their stake in the property. In addition, each owner receives their own title insurance and property deed that is tied to their percentage of interest in the property, ensuring that they hold the same rights and privileges as they would if they were a single owner.
Each tenant can independently sell or borrow against their portion of the property ownership, and when a tenant passes away, their fraction is passed on to their heir. These features distinguish TICs from some other co-ownership structures and provide individual investors with an additional layer of autonomy.
Important Rules Governing TIC 1031 Structure
Internal Revenue Service (IRS) Revenue Procedure 2002-22 outlines specific criteria that must be met for a Tenants in Common (TIC) arrangement to qualify for a 1031 exchange. While this revenue procedure does not provide absolute assurance of a successful 1031 exchange, meeting these conditions can significantly increase the likelihood of IRS approval. The 15 required conditions are as follows:
- Number of Co-Owners: The number of co-owners in any TIC 1031 exchange may not exceed 35.
- Ownership as Tenants in Common: Each co-owner must hold title to the property as a Tenants in Common, either directly or through a disregarded entity e.g., single person LLC.
- No Business Entity Treatment: The co-ownership may not act in a way that indicates it is a business entity, such as conducting business under a common name or filing a corporate or partnership tax return .
- Co-Ownership Agreement: Co-owners may enter into a limited co-ownership agreement, provided the agreement does not establish a business entity.
- Voting: The co-owners must individually retain the right to vote on hiring any manager, selling the property, or creating or modifying a blanket lien. Sales, leases, or re-leases of all or a portion of the property must be unanimously approved by all the co-owners.
- Restrictions on Alienation: Each owner must have the right to transfer, partition, or place a lien on their share of the property without the consent or approval of any other party.
- Leasing Agreements: All leasing agreements must be deemed bona fide leases under federal tax rules and rents paid by leases must be based on the property’s fair market value.
- Sharing Proceeds and Liabilities Upon Sale of Property: Upon the sale of the property, debts secured by a blanket lien must first be satisfied, then any remaining sales proceeds must be proportionately distributed to the co-owners based on their ownership percentage.
- Proportional Sharing of Profits and Losses: Each co-owner must share in all costs associated with the property and all revenues generated by the property in proportion to their percentage of undivided ownership interest.
- Proportional Sharing of Debt: If the property is encumbered by debt or a blanket lien, all property owners must share in the debt in proportion to their percentage of undivided ownership interest.
- Loan Agreements: If a debt encumbers the property or debt is incurred to acquire an undivided interest in the property, the lender must not be related to the sponsor, manager, any co-owners, or any lessee of the property.
- Purchase Options: Co-owners may issue an option to purchase their undivided interest, as long as it is based on the property’s fair market value at the time the option is exercised.
- No Business Activities: The co-owners' activities must be limited to “customary activities,” such as those normally performed in connection with the maintenance and repair of rental real estate.
- Brokerage and Management Agreements: The co-owners may enter into brokerage or management agreements as long as they are renewable no less than annually and the agent is not a lessee.
- Sponsor Payments: Both the amount paid to a sponsor to purchase a co-ownership interest and the sponsor’s fees for services must be based on the interest’s fair market value.
Potential Benefits TIC 1031 Exchange
A TIC 1031 Exchange can offer several benefits that may be attractive to property investors. Following are a few of the reasons investors may consider this arrangement.
The ability to defer capital gains taxes is one of the primary benefits of a 1031 exchange, including those executed with a Tenants in Common agreement. As long as the proceeds from the sale of a commercial property are reinvested in a like-kind replacement property and the requirements of a 1031 exchange are met, no capital gains taxes are due at the time of the sale. This allows the full amount of the sale proceeds to be invested into the new property.
While the 1031 exchange process itself offers the chance to switch from one property type to another, a TIC 1031 exchange takes it a step further. By participating in a TIC, investors can acquire a fractional ownership in a diverse mix of properties, allowing them to spread risk across various real estate sectors and geographical locations, providing diversification and potentially leading to a more balanced investment portfolio.
Lower Minimum Investment Threshold
TIC 1031 exchanges allow investors to pool their resources, making it possible to participate in the acquisition of larger properties that may otherwise be out of reach. Lower investment thresholds can create attractive opportunities for those wishing to enter the institutional-grade property market without over-allocating their investment portfolio.
Access to Institutional Grade Properties
Large-scale, high-quality commercial properties such as apartments, office buildings, and shopping centers often come with a high price tag that can exclude individual investors. By combining resources through a TIC structure, investors have a greater potential to access these markets.
TIC 1031 Exchange Drawbacks to Consider
As with any investment strategy, it's crucial to understand the potential challenges a TIC 1031 exchange may present. The following are several considerations to be aware of when considering this investment structure.
Unanimous Voting Requirement
TIC arrangements typically require unanimous voting for major decisions, such as selling the property or entering into a new lease. This requirement can create potential delays and conflicts. If a unanimous agreement cannot be reached, investors may experience financial and liability issues.
Active Role in Property Management
Investors in a TIC 1031 exchange often play an active role in property management, including making key decisions such as hiring or terminating a property manager. For investors who prefer a more passive investment approach, this active involvement could be seen as a disadvantage.
Individual Qualification for Loans
In a TIC 1031 exchange, each investor typically must individually qualify for any loans associated with the property. This could potentially limit participation for investors who may not meet the lending criteria on their own.
Formation and Maintenance of an LLC
A TIC 1031 exchange typically requires members to form and maintain a limited liability company (LLC) for the purpose of holding the property. This creates additional complexity, administrative responsibilities, and costs that generally do not apply to direct property ownership.
Using a DST to Overcome TIC Exchange Limitations
At one time, a TIC 1031 exchange created unique opportunities for investors who wanted to purchase fractional shares of large, institutional-quality commercial properties and receive the tax benefits of a 1031 exchange. However, in August 2004, Revenue Ruling 2004-86 allowed investors to use fractional ownership in a Delaware Statutory Trust to serve as a replacement property in a 1031 exchange.
The structure of DSTs creates several potential benefits for investors and can help limit some of the drawbacks associated with a TIC 1031 exchange. The following features have made DSTs a popular option among investors engaging in 1031 exchanges.
Larger Number of Investors are Allowed Resulting in Lower Minimum Investments
The number of investors in a TIC 1031 exchange is capped at 35, which may constrain the size and quality of properties accessible for investment. In contrast, a DST is allowed to have to up to 2,000 investors. This results in lower investment minimums – typically $50,000 versus $250,000 or more for a TIC investment.
The requirement to form and maintain a single-member Limited Liability Company (LLC) adds complexity and expense to a TIC arrangement. However, DST investors receive beneficial interest in the property, effectively bypassing the need for an LLC. This structure is simpler and typically less expensive to set up and maintain, making a DST a more cost-effective choice for some investors.
No Voting Requirements
Any single investor in a TIC can potentially block a sale or leasing activity since unanimous approval is needed. Investors in a DST do not have the ability to block sale or leasing activities since these decisions are delegated to DST sponsor/trustee.
Since a TIC involves shared ownership, each investor's liability is proportional to their stake in the property. This can expose investors to potential risks.
A DST is a separate legal entity that assumes responsibility for all debts and obligations related to the property. This limits investors’ personal liability related to the property ownership.
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