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Tenancy in Common Transactions: Practical and Tax Issues of Investing in Real Estate’s Hot New Investment



Investments in tenancy-in-common interests ("TIC") in real estate have been exploding. While TIC investments provide significant benefits, including preserving the ability to dispose of or acquire such properties as part of a Section 1031 tax-free exchange, they also present many practical and legal issues that a TIC investor must consider before signing on the dotted line.

A typical TIC investment in real estate involves a number of individuals, generally unknown to each other, who each own an undivided tenancy-in-common interest in real property. The advantages of such an investment are significant. Ownership of a TIC allows the investor to own, for a relatively modest sum, a fractional interest in a large, institutional-grade investment property. Such properties are typically professionally managed. Thus, instead of owning separate rental houses and dealing with emergencies and late-night tenant phone calls, a TIC investor might simply own an interest in an apartment complex whose maintenance and rent issues are handled professionally.

Another advantage is the potential for tax-free exchange treatment. Although TIC interests in real estate have been around for years, interest in them has dramatically increased since 2002, when the IRS provided guidance in the area. The IRS issued a revenue procedure that year which 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. Thus, an investment in a TIC has a significant advantage over an investment in a real estate partnership. Sales or purchases of partnership interests cannot, without risky structuring, qualify for tax-free exchange treatment. The real estate industry 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.

In recent years TIC investments have been developed and marketed by promoters. Such transactions are often sold through traditional real estate brokers. Depending on the structure, TIC interests might be deemed a security (like a stock or a bond) under federal and state securities laws. If so, the TIC interests must be (1) registered under applicable securities laws (unless an exemption from registration is available), (2) documented as a sale of a security, and (3) offered for sale and sold by a licensed securities broker.

In contrast with a partnership, a TIC investor actually owns the underlying real property. In a partnership, the investor merely owns an interest in a legal entity (the partnership) which in turn owns the real estate. The relationship among TIC owners of a property is generally controlled by a tenancy-in-common agreement ("TIC Agreement"). A TIC Agreement is analogous in many ways to a partnership agreement. In fact, if a TIC Agreement is not carefully structured, the IRS can recharacterize it as creating a partnership for tax purposes. When that happens, the ability to exchange on a tax-free basis into or out of a TIC is destroyed. In making such a recharacterization, the IRS looks at factors such as whether the TIC Agreement permits voting among the owners to make major management decisions. The IRS also considers whether profits are distributed among the TIC owners in proportion to their ownership interest in the property. The 2002 revenue procedure sets out a list of provisions for a TIC Agreement that would avoid recharacterization.

An investor should engage tax counsel to review a TIC Agreement to see whether it will be treated as a partnership for tax purposes. If so, investments in that TIC will not qualify for tax-free exchanges.

As with any real property investment, tax issues are only one factor among many to consider. An investors must also obtain and examine due-diligence information about the property. Such materials would include property inspection reports, environmental reports, title reports, a property survey, and a financial analysis of the prior operation of the property.

Investors must also consider the ability to resell their interest in the TIC. It is possible, for example, that 10 percent TIC investments sold separately could sell at discount to 10 percent of the current value of the entire property.

Another significant consideration is the management of the property. Decisions to sell, borrow funds, lease, or hire a property manager are controlled by the TIC Agreement. The IRS has clearly signaled that it will treat voting on major decisions in a TIC Agreement as a basis to treat the TIC as a partnership. If unanimous approval for such decisions is not required, one recalcitrant TIC owner could block the will of the other owners. Careful drafting of the TIC Agreement can at least partially solve this problem by allowing TIC owners to purchase the interest of a single owner who is thwarting the will of the others.

Finally, investors must realize that each owner in a TIC can force a sale of the property by filing a partition action. A partition action is essentially a complaint to a court stating that the owners cannot agree on how to manage the property and that the property should be either split into parts (which is not possible for most improved properties) or sold. Waiving the right to partition in the TIC Agreement, however, may cause the IRS to treat the TIC as a partnership for tax purposes. One solution that most TIC Agreements utilize is to give the other owners a right of first refusal to purchase the interest of an owner before he or she can file a partition action.

We have been involved in hundreds of millions of dollars in TIC transactions. A wide variety of TIC Agreements are in use, many of which have questionable provisions from a practical point of view, and some of which would undoubtedly be treated as partnerships for tax purposes, thus destroying any hopes of completing a tax-free exchange.

By allowing investors to invest in substantial properties through a tax-free exchange, TIC investments offer huge advantages. But investors must carefully consider three separate aspects of such transactions. First, they must examine these transactions as real estate investments. Second, they must look at each practical issue involved in managing these properties under the TIC Agreement. Finally, the TIC Agreement and related documents must be examined to make sure that the TIC will not be treated as a partnership for tax purposes.

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