1031 Exchange and TICs
1031 Exchange – An Introduction
The phrases “1031 exchange”, “like-kind exchange” and “tax-deferred exchange” refer to trading one investment property for another (or several others) under Section 1031 of the Internal Revenue Code. The 1031 exchange tax law allows owners of investment real estate to defer some or all of their capital gains tax by reinvesting their resale proceeds. While this is somewhat of an over-simplification of a complex set of rules, in general one can defer all gains through a 1031 exchange if the cost of the new property or properties is greater than the sale price of the old one, and all cash from the sale is invested in the purchase. Not fully satisfying either or both of these conditions results in “boot”, meaning that some but not all of the tax otherwise due remains owed.
Simultaneous Versus Delayed 1031 Exchange
There are two types of 1031 exchange: a simultaneous exchange and a delayed exchange. In each case, a key requirement is that no cash proceeds from the sale be held or controlled by the seller doing the 1031 exchange. In a simultaneous 1031 exchange, which is by far the more unusual type of tax-deferred exchange, the parties simply exchange deeds. In the more common delayed 1031 exchange, an exchange intermediary or exchange facilitator is used so that the seller (also known as the exchanger) does not receive the sale proceeds and thereby disqualify the transaction from 1031 exchange benefits.
In a delayed 1031 exchange, the replacement property must be identified within 45 days and acquired within 180 days, although a “reverse exchange” (meaning buying before selling) is also possible. Within certain limits, multiple replacement properties may be identified, and it is permissible to close fewer than all properties identified.
1031 Exchange – Requirement That Properties Be Like-Kind
The replacement property (or properties) must be of “like kind” compared with the relinquished property, which has been interpreted to mean that one cannot exchange: (i) from a personal residence into investment property or from investment property into a residence; (ii) from real estate located within the U.S. to real estate located abroad; (iii) from ownership of an entity which owns real estate (such as an LLC or a general or limited partnership) into another such entity; or (iv) from direct, titled ownership into an entity which owns real estate or vice versa. An entity called a Delaware Statutory Trust, or DST, is exempt form the last two rules as discussed later in this article.
Using 1031 Exchange Proceeds To Acquire Co-Owned or Managed Property
Sometimes, 1031 exchange sellers of investment properties would prefer not to buy or own the replacement property or properties by themselves. One reason they prefer to own with others is so that they can share the obligations and risks. Another reason is that owning with others can allow them to acquire more expensive properties, or to diversify their investment into multiple properties. But owning with others creates several challenges. One must first identify others who wish to purchase the same thing at the same time. One must then coordinate acquisition efforts and jointly manage (or arrange for management of) the property.
Not surprisingly, an industry of sponsors and syndicators has developed to serve the needs of 1031 exchange investors who want the benefits of investing with others. In general, these sponsors and syndicators want to use a legal structure that allows them to accomplish five key goals: (i) to make the investment simple, safe and passive for the investor; (ii) to maintain as much control over the property as possible; (iii) to obtain attractive institutional financing; (iv) to be compensated fairly, especially if the investment turns out to be successful; and (v) to preserve the tax-deferral benefit for the 1031 exchange investors they serve.
The problem faced by 1031 exchange investment opportunity sponsors and syndicators is that the first four of these goals generally conflict with the last. The typical way a real estate investment opportunity sponsor or syndicator accomplishes those first four goals is by using an entity structure to own the investment property, such as a limited liability company (LLC) or limited partnership (LP). But preserving the tax-deferral benefit for the 1031 exchange investor requires satisfying the like-kind property requirement which, as noted above, does not allow exchange into an LLC or partnership. 1031 exchange TICs are one of the ways investors, and real estate investment opportunity sponsors/syndicators, have tried to solve this problem. 1031 exchange DSTs, or Delaware Statutory Trusts, are another approach to satisfying 1031 exchange requirements, and are also discussed below.
An Brief Introduction to Investment TICs (Tenancies In Common)
The terms “TIC”, “Tenancy In Common”, “Tenants In Common”, and “Co-Tenancy” all refer to the same type of ownership, but can be confusing because of the many different contexts in which they are commonly used. Saying that an arrangement is a tenancy in common only reveals three things: (i) some asset will be owned, (ii) there will be more than one owner, and (iii) when an owner dies, his/her interest passes to his/her heirs rather than to the other co-owners. But saying something is a tenancy in common tells you nothing about what is owned, the owners’ purposes (tax or otherwise), or how the co-owned property will be used. It is incorrect and problematic to assume that all TICs involve investment property or have investment or profit-making as their primary purpose, and equally incorrect to think that all TICs, regardless of what property is owned and why, receive the same tax treatment.
In other parts of this website, we describe several types of tenancy in common that do not have investment or profit-making as their primary purpose: (i) the “SACO TIC” which mimics condominiums and subdivisions by assigning particular houses, apartments, rooms, offices, stores, or storage spaces to each owner; (ii) the “TACO TIC” (commonly called “fractional ownership” or a “private residence club”), which mimics timeshares and assigns particular usage times or intervals to each owner; and (iii) “equity sharing”, where one owner gets usage rights, and one owner is purely an investor. We also describe informal investment TICs involving groups of family members and friends, sometimes resulting from inheritance. But in this article we will focus on the most well-known type of investment TIC, those organized by real estate investment opportunity syndicators or sponsors to be passive investments and repositories for 1031 exchange proceeds.
1031 Exchange Into a TIC (Tenancy In Common)
For a long time, the similarity between a partnership interest in a real estate-owning general partnership, which would not considered real property for 1031 exchange purposes, and a fractional interest in real estate, which would be considered real property for 1031 exchange purposes, created uncertainty and risk for both tax-deferred exchange investors and 1031 exchange investment sponsors. Then, in 2002, the IRS issued Revenue Ruling 2002-22, which describes circumstances under which a TIC interest in investment real estate will qualify as 1031 exchange replacement property. Although Rev. Proc. 2002-22 provides general guidelines rather than definitive regulations, and potential investors and sponsors are instructed to submit details of a specific transaction to the IRS to obtain a definitive ruling as to 1031 exchange qualification, most lawyers feel 2002-22 creates a “safe harbour”, meaning that arrangements that adhere strictly to its requirements are considered to have a low risk of disqualification from 1031 tax-deferred treatment.
The belief that a “safe harbour” exists for TIC-based 1031 exchanges created a huge and rapidly growing industry of brokers, syndicators and sponsors, and offerings of these investment opportunities became abundant. Nevertheless, many, if not most, of these 1031 TIC offerings deviate from at least some of these requirements of Rev. Proc. 2002-22, because the requirements conflict with many of the basic notions of passive or sponsored investments.
The Requirements of Rev. Proc. 2002-22 For 1031 Exchange TICs
The following is a list of the most important requirements for a tenancy in common arrangement to qualify as 1031 exchange replacement property:
- There must be 35 or fewer co-owners
- Unanimous co-owner approval is required for sale, refinancing, leasing, and management hiring; majority co-owner approval is required for other group actions
- Although co-owners may hire a manager (who may be the sponsor) to operate the property, the manager can be compensated only based on the gross rental income, not based on profits or investor return, and the owners retain final decision-making authority
- Each co-owner must retain the right to borrow against or transfer his/her share, or to partition the property (meaning force sale with proceeds allocated pro rata)
- Co-Owners must share pro rata (by titled ownership percentage) all income, expenses, debt service, profits and cash distributions, and a no one who is not on title (such as the sponsor) may share in these amounts
- The sponsor, broker, or syndicator may be paid reasonable compensation beased on the fair market value of the property, but may not be paid based on profits or investor return.
Owner Liability in 1031 Exchange TICs
Under the Rev. Proc. 2002-22 like-kind tax deferred exchange requirements listed above, a person doing a 1031 exchange into a TIC must be named on the title to the property being acquired, and must be listed as a borrower on any mortgage. This means that each tenant in common investor could be held personally responsible for the full amount of the mortgage, as well as for any debt or loss resulting from environmental contamination, personal injury, or any other property-related problem. And while liability insurance can protect against some of these types of liability, some losses cannot be insured, and even insured losses can exceed policy limits.
One way 1031 exchange TIC investment sponsors/syndicators have attempted to create liability protection for their investors is by converting ownership from a tenancy in common to an entity (such as an LLC or limited partnership) after a waiting period of 6-24 months. But it is unclear whether such a conversion would withstand an IRS audit. No one knows how long a waiting period is required between acquisition of the tenancy in common share and conversion of TIC ownership to entity ownership. Perhaps more important, if an intention to convert has been present from the start, the original TIC structure may be disregarded as a sham. And beyond these tax questions, a converting TIC structure still exposes the investors to heightened liability risk during the period before the conversion occurs.
A better liability protection strategy for 1031 exchange TIC investments is to have each tenant in common take title to his/her TIC share as a single member limited liability company (“SMLLC”). When appropriate forms are filed, an SMLLC is treated as a “disregarded entity” for income tax purposes, meaning that owning in this manner is the income tax equivalent of direct ownership but still provides the liability protection of entity ownership. Note that while any LLC can qualify as a “pass-through entity” for income tax purposes, pass-through entity characterization is different from disregarded entity characterization, and only the latter will satisfy 1031 exchange requirements. An LLC can be considered an SMLLC only when it has one member, or when its only members are a husband and wife who file their income taxes jointly. In certain situations, the single member can be a living trust and the SMLLC will still satisfy 1031 exchange requirements.
Control and Compensation Problems in 1031 Exchange TICs
Even when the liability issues in 1031 exchange TICs are solved through the use of SMLLCs, the requirements imposed under Rev. Proc. 2002-22 create other significant problems. The most important of these is the degree of power and the level of control that must be given to each owner/investor including, as noted above, individual veto power over sale, refinancing, leasing, and management hiring decisions, the free right to borrow against or transfer each ownership share share and, perhaps most problematic, the right (of each owner) to force a sale of the TIC property at any time. If any of these rights are given up or limited under the TIC agreement, then the TIC will probably not satisfy 1031 exchange requirements, and the investor is likely to face back taxes, penalties and interest if he/she is audited.
But preserving these rights for each owner/investor means that the TIC investment syndicator/sponsor no longer has control over the key aspects of the investment. Moreover, each investor/owner is now effectively at the mercy of each of the other investor/owners, meaning that one unscrupulous owner can make decisions or take actions that will benefit him/herself at the expense of the others, or “hold the group hostage” by demanding concessions or special privileges in exchange for cooperation. There have been numerous instances in recent years where “sharks” have acquired interests in 1031 exchange TICs specifically to extract financial concessions or force the other investors to sell the TIC property to the “shark” at a discount. (TICs not formed for 1031 exchange purposes do not have these problems because their TIC Agreements do not give individual owners any of these powers or rights.)
Another 1031 exchange TIC problem created by the Rev. Proc. 2002-22 requirements is that the TIC investment syndicator/sponsor cannot be compensated based on the success of the investment. Paying real estate investment syndicators or sponsors only if the investment is profitable is the norm in most real estate investment deals. Besides being fair to all parties, this approach is generally thought to create an important incentive for the sponsor. But Rev. Proc. 2002-22 specifically prohibits success- or proceeds-based compensation in 1031 exchange TICs.
Fortunately, some relief from the control requirements of Rev. Proc. 2002-22 has been created through subsequent IRS decisions and interpretations. For instance, the TIC agreement may impose rights of first refusal as prerequisites to a forced sale of the property. Perhaps most significantly, variations in the general guidelines are permitted when required by a lender if the lender requirement is consistent with customary commercial lending practices. This last provision has been used by sponsors to justify significant deviations from many of the most problematic parts of Rev. Proc. 2002-22, such as the requirement that each investor be allowed to borrow against the TIC property.
The Delaware Statutory Trust (DST) Exception To Like Kind Exchange Requirements
Revenue Ruling 2004-86 recognized that sellers could exchange their investment property for beneficial interests in a certain kind of trust. These trusts, called “statutory trusts” (or “Delaware Statutory Trusts” or “DSTs” because there are most often formed under Delaware law) own the replacement property. A sponsoring firm organizes the trust, acquires the property under the trust umbrella, and becomes the master tenant and the manager/operator. The seller doing the 1031 exchange never becomes a titled owner of the replacement property and never has any management obligations or control. This means that Rev. Proc. 2004-86 effectively creates an exception to the general rule that a 1031 exchange seller cannot exchange from ownership of an entity which owns real estate into another such entity, or from direct-titled ownership into an entity which owns real estate.
In recent years, largely as a result of the challenges facing the use of TIC structures for 1031 exchanges as discussed elsewhere in this article, the DST industry has almost completely replaced the 1031 exchange TIC industry, and the DST has become the preferred vehicle for 1031 exchange investors seeking a simple, safe and passive harbor for their tax-deferred exchange sale proceeds.
Are 1031 Exchange TICs and DSTs Securities That Must Comply With Securities Offering Regulations?
For many years, it was unclear whether TIC interests offered commercially for 1031 exchanges were securities under federal and/or state law. This question was finally settled in 2009 when the U.S. Securities and Exchange Commission (the SEC) issued a letter ruling under which virtually all sponsored and syndicated tenant in common (TIC) 1031 exchange investment opportunities are subject to federal securities regulations. It is also well-settled that DST 1031 exchange offerings are subject to federal securities regulations. Sponsors or syndicators offering TIC or DST 1031 exchange real estate investment opportunities must comply either by registering for a public offering or, more commonly, by making a “private offering” under SEC regulations. Interestingly, it has recently become possible for a 1031 exchange offering (DST or TIC) to qualify as a private offering under SEC and state blue sky securities laws even if the offering is advertised to the general public. The parties selling or promoting 1031 exchange TICs and DSTs must also meet special licensing requirements which are generally not satisfied by real estate licenses. (You can read more about compliance with securities regulations in the article entitled Securities Law Primer For Real Estate Professionals.)
The application of securities laws to 1031 exchange TICs that are not offered or arranged through traditional sponsors or syndicators is less clear. There is a huge amount of statutory, judicial and administrative law bearing upon the general question of what is and is not a security. The leading case in this area, SEC v. W.J. Howey Co., 328 U.S. 293 (1946), created the well-known “economic realities” analysis under which an interest will be classified as a security only if three elements are concurrently present: (i) an investment of money; (ii) a common enterprise; and (iii) an expectation of profits derived solely from the efforts of the promoter or a third party. The Court emphasized that “form was disregarded for substance and emphasis placed upon economic reality”, meaning that whether or not a security has been created is not going to be determined by whether ownership is deeded real property or shares in an entity such as an LLC or LP. Subsequent court decisions modified the third prong of Howey from “solely” to “substantially”, leaving us with the rather vague notion that the term “security” includes any investment made with an expectation of profits derived mostly from the efforts of a promoter. In practice, the vagueness of the legal definition of “security” means that TIC investment offerings that do not fall under the 2009 SEC letter ruling must be analyzed separately as a potential security, and that there will almost always be room for disagreement. The key question is the extent to which a third party (rather than each of the owners/investors) is/are involved in the planning and operation of the enterprise.
Should You Invest in a 1031 Exchange TIC or DST, or Should You Find and Manage Your Own 1031 Exchange Property?
The advantages of sponsored 1031 exchange TIC and DST offerings need to be carefully weighed against the disadvantages: (i) loss of control over operation and the resulting loss of liquidity; (ii) increased exposure to loss from deceit, theft and mismanagement; (iii) costs associated with compensation to sponsors; and (iv) the risk that over- or under-subscription will prevent the exchanger from completing the exchange on time. In considering the last of these disadvantages, remember that a 1031 exchange requires that the replacement property be identified within 45 days, and acquired within 180 days. The failure to meet either of these deadlines will cause the exchange to fail, potentially resulting in significant tax liability.
About the Author
Since 1984, Andy Sirkin’s law practice has focussed on developing and documenting creative and practical approaches to real estate investing. He is known for his ability to help his clients evolve general concepts and business model ideas into fully developed and detailed business plans by quickly identifying hidden issues and solving seemingly complex problems. He favors reasonable and cost-effective solutions to regulatory challenges, and simple, short, plain-English legal documents. In addition to over 30 years of legal practice experience in the US and overseas, including work with numerous web-based and non-technology startups, he brings extensive experience as a real estate builder/developer, syndicator, brokerage manager, income-property owner, and passive investor.