Tenants in Common Ownership
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I seem to have been directly in the path of “TIC” real estate offerings all year long. Even though TIC interests in real estate have been around for years, interest has increased dramatically since 2002, when the IRS provided guidance. A revenue procedure that indicated that a taxpayer can use a TIC investment, if properly structured, as either relinquished property or replacement property in a qualifying tax-free exchange.
The real estate industry has perceived the new revenue procedure as the IRS’s “stamp of approval,” and a “TIC rush” in real estate TIC investments has been on ever since. I have been in a quandary over this new product with warning comments coming from very qualified real estate brokers, and positive comments from equally qualified brokers about the huge advantage for the investor of owning, for a modest amount of money, a fractional interest in a large institutional-grade investment property.
Hopefully this information will bring those who read it, to a level of understanding of what a TIC is in the world of commercial real estate.
First of all I have been amazed to be told that what is going on now with TIC ownership and the IRS is simply a “revenue procedure” and the IRS has actually NOT RULED on the TIC investment, the jury is still out on that ruling.
There is a real requirement for anyone interested in a TIC investment to engage tax counsel to review a TIC agreement to see if it will be treated as a partnership for tax purposes, and therefore not qualifying for a tax-free exchange.
As with any real estate investment, the investor must obtain and examine due-diligence information about the property. Information would include property inspection reports, environmental reports, property survey and financial analysis of the prior operation of the property.
The investor must also consider the ability to resell their interest in the TIC. A significant consideration should be the management of the property. Decisions to sell, borrow funds, lease, or hire a property manager are controlled by the TIC agreement and unanimous approval for these decisions is required. One negative vote could block the will of the other owners.
Finally one should make sure that drafting the TIC agreement into a carefully structured agreement is of the utmost concern as the IRS can re-characterize it as creating a “partnership” for tax purposes and the result is that the ability to exchange on a tax-free basis into or out of a TIC is destroyed.
The IRS has provided definitive guidance to taxpayers in structuring sound transactions. The distinctions between a TIC interest in real estate and a partnership are not clear.
The danger, of course, is that an exchange involving a TIC interest that was treated as a partnership by the IRS would be a taxable sale.
Rev. Proc. 2002-22 provides IRS guidance for safely structuring a TIC interest so that it will not be deemed a partnership, and a taxable sale.
To obtain a favorable ruling each of the Revenue Procedure’s 15 requirements must be met. The 15 requirements are:
1. TIC Ownership- Each co-owner must hold title to the property as a tenant in common under local law.
2. Number of Co-Owners – The number of co-owners cannot exceed 35 persons.
3. No Treatment of Co-Ownership as an Entity. The owners must not act like an entity. They cannot file a partnership or corporate tax return, conduct business under a common name or refer to themselves as partners, shareholders, or members of an entity.
4. Co-Ownership Agreement – The Revenue Procedure specifically allows co-ownership agreements.
5. Voting – TIC Agreement may include voting provisions. Co-Owners holding no more than 50% of the undivided interest in the property must approve any specific action and that voting must be unanimous approval.
6. Restrictions on Alienation – There can be no restrictions on the right to transfer, partition, or encumber a co-owner’s interest in the property. Certain restrictions are allowed such as restrictions on alienation contained in loan documents that are commercial and customary. The sponsor or the master lessee may have a right to make the first offer to buy the co-owners interest but the more common right of first refusal is not specifically allowed.
7. Sharing Proceeds and Liabilities Upon Sale – If the property is sold, any debt secured by a blanket lien must first be satisfied before distributing the remaining proceeds to the co-owners.
8. Proportionate Sharing of Profits and Losses – Each of the co-owners must share all profits and losses in proportion to their undivided interests in the property.
9. Proportionate Sharing of Debt – Co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.
10. Options – The Revenue Procedure allows call options to be issued by co-owners.
11. No Business Activity – The co-owners activities “must be limited to those customarily performed in connection with the maintenance and repair of rental real property.
12. Management and Brokerage Agreements – Co-owners may not enter into management or brokerage agreements unless they are “renewable” annually.
13. Leasing Agreements – All leases must be bona fide leases for federal tax purposes.
14. Loan Agreements – No co-owner, sponsor, manager, or lessee may make a loan to acquire a TIC interest in the property.
15. Payment to Sponsor – Any payment to a sponsor must reflect the fair market value of the services provided and may not be based on income or profit from the property.
The most significant problems in a TIC interest will be the requirement for unanimous consent to sell, finance, or enter into a management contract with respect to the property.
Most transactions will probably be structured under a long-term Master Lease to avoid the requirement for unanimous consent for leasing or entering into a management contract.
The Revenue Procedure will become the standard for structure in the TIC common transactions. A sponsor of TIC transactions will likely structure all of their transactions so that its requirements are met, and the investor/taxpayer can be assured that their tax-free exchange transaction will be fully tax-free.
Understanding the TIC offering, the property, from a real estate view, and the 15 requirements that need to be met, will hopefully give those who read this article, insight to understand a Tenant-in-Common Transaction.
