S.E.C. Real Estate Observer

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In the last issue, we related a recent phone inquiry that went something like this: “My client has just told me that I should stop looking for a $2,000,000 replacement property for him because his CPA is now recommending that he purchase a tenant-in-common interest in an offering for a large apartment complex. The CPA says that it is a way for my client to eliminate management responsibilities and it’s an easy solution to the timing problem of finding the replacement property. If he does not exchange, he will report about $500,000 in gain. I’m close to finding an acceptable property and we still have 35 days remaining in the identification period. Is a tenant-in-common project right for him, and if not, what do I tell him to convince him that he should continue to look for his replacement property?”

WHAT DOES THE BROKER TELL HIS CLIENT?

The following is a summary of responses to that question.

I would be concerned about the risk of disqualification as an exchange. Proceed with caution. A partnership interest is never eligible for favorable tax treatment under IRS Code Section 1031. In fact, partnership interests are specifically excluded from such treatment. The simple definition of a partnership is “two or more persons or entities in a common enterprise for profit.” This broad definition of partnership could arguably be applied to most co-ownerships of income producing real property. In the past, the IRS has generally ignored the exchange of real property held as TIC. In the past, there were not a sufficient number of significant cases to make it a major issue, so if the State did not treat TIC as a partnership, then the IRS ignored the issue.

However, in the recent past, there have been a number of large firms who have organized and promoted high-value properties to be held as TIC. These offerings of fractional interests were directed at owners who had sold their investment property and who were looking for replacement property. Some of the TIC syndication properties were acquired with a great number of individual owners. Apparently, the IRS has viewed this increased activity as an abuse of the IRS’s past reluctance to attack TIC as a partnership interest that would be ineligible for 1031 tax treatment.

The evidence of closer scrutiny by the IRS is the issuance of Revenue Procedure #2002-22. While this procedure does not set out standards for a safe investment in a TIC, it gives us an insight to their thinking about TIC syndications. The conditions set out in RP #2002-22 are those factors that the IRS has identified as being the standards that must be in compliance before the IRS will even consider issuing a Letter Ruling that the TIC entity will qualify for a 1031 exchange. I emphasize, these are conditions for requesting a Letter Ruling and not guidelines to be followed as law.
However, those forming TIC syndications seem to be relying on Revenue Procedure #2002-22 as being a safe harbor for forming these forms of ownership.

Many experts anticipate that in the near future, the IRS will come out with specific regulations that will define partnerships for income tax purposes. We are all waiting for that shoe to drop. What status does the TIC investor have if the IRS decides that these arrangements are really partnerships?
There are considerably higher costs associated with syndication of replacement property for Tenant-in Common (TIC) ownership. Nobody works for free, so the cost of forming the TIC syndication, marketing costs of ownership interests, commissions paid to brokers for acquiring investment funds (1031 investors), legal fees, accounting fees, and other costs are naturally passed on to the investor. These costs are not present in a classic exchange. Therefore, the investor pays, perhaps dearly, for the privilege of being a TIC investor.
There is the possibility of an inflated price on the property when sold to TIC investors. The sponsor could increase the value of the asset from the time the sponsor acquires control of the property to the time it is sold to TIC investors as fractional interests. The question arises, are the TIC investors paying more than the property is worth?

Important to me, but maybe not to everyone, is the loss of personal control of my investment. There is inherent potential conflict of interest between TIC owners and the manager of the syndication. It appears to me that there is no financial incentive for sponsor-manager to ever sell the real property! An economic incentive to the sponsor-manager in TIC syndication such as profit sharing, or a fee based on value increase, is not permitted under IRS Revenue Procedure #2002-22. The sponsor is permitted to collect annual fees on income, but is not permitted to share in the appreciation of the property, so why would he want sell? Selling the property would eliminate his annual fees!
A serious concern is the lack of liquidity of the fractional interest. After purchasing his interest, there is not likely to be a buyer for the investor’s ownership interest. Furthermore, my understanding is that the TIC entity will require (per IRS Revenue Procedure #2002-22) 100% approval of all TIC owners to authorize the sale of the property. That is often hard to accomplish when there are only two people. I can only imagine the difficulty getting a large number of unrelated persons to agree on the sale of the property.

We invite readers to add to these arguments, or to submit opposing views. Let us hear from you.