Advantages and Risks of Tenancies in Common
Tenancy in common (“TIC”) arrangements are an increasingly popular option for real estate investors looking to participate in a 1031 Exchange. Internal Revenue Code Section 1031 generally allows real estate owners the opportunity to exchange property that has been held for productive use in a trade, business or for investment purposes and defer gains and taxes if they acquire “like-kind” replacement property of greater or equal value. Common examples of “like-kind” properties include apartments, condominiums, duplexes, bare land, rental homes, and commercial properties. In many instances, acquiring a tenancy in common interest in real estate may be a convenient way for investors in real estate to benefit from income tax deferral under Section 1031.
TIC arrangements allow investors to acquire a fractional interest in real estate (e.g., residential, commercial or industrial property). In addition, property owners may complete a 1031 Exchange by becoming a tenant in common owner in the replacement property. The central characteristic of a TIC is that each co-owner is deemed to own an undivided fractional interest in the entire property. For example, a TIC arrangement is created where five investors pool their resources to purchase property for $1,000,000, with each investor contributing $200,000 to acquire an undivided 1/5 interest in the entire property as a tenant in common. Additionally, each co-owner has a right to a proportionate share of rents or profits from the property, to transfer their respective interest, or to demand a partition of the property.
ADVANTAGES OF A TIC ARRANGEMENT
TIC arrangements offer many advantages to real estate owners looking to engage in a 1031 Exchange. TICs provide an opportunity to pool funds, secure greater financing, and potentially acquire superior property, without the burden of active property management. TICs are attractive options for smaller investors (typically, $500,000 or less) who wish to engage in a 1031 Exchange, or larger investors with limited proceeds remaining from a 1031 Exchange for replacement property.
RISKS OF A TIC ARRANGEMENT
While TIC arrangements may offer attractive business opportunities, TICs are complex in nature and real estate investors should be aware of the potential risks associated with this investment option. If not properly structured, TICs may not qualify as an investment in real estate, as required by Internal Revenue Code Section 1031. For example, if the arrangement is not properly structured and documented, it may be classified as a partnership interest or an investment in a security. Section 1031 expressly prohibits the exchange of investment property for “interests in partnership”, “stocks, bonds, notes”, or “other securities.” Accordingly, an exchange for replacement property that qualifies as a partnership interest or other form of security will result in the loss of preferential tax treatment.
IS THE TIC ARRANGEMENT A PARTNERSHIP?
One area of concern for anyone looking into TIC arrangements is the potential that the structure of the TIC too closely resembles a partnership, rather than a tenancy in common interest in real estate. Revenue Procedure 2002-22, issued by the IRS on March 22, 2002, specifies 15 requirements that the IRS considers to distinguish TIC arrangements from partnerships. Most significant among these requirements are the following:
- That the co-owners hold title to the real property as tenants in common under local law;
- TIC co-ownership is limited to 35 co-owners;
- TIC does not file a partnership or corporate tax return, conduct business under a common name, or execute an agreement identifying all of the co-owners as partners, shareholders, or members of a business entity, or hold themselves out as such;
- TIC co-owners share in all revenues generated by the property and all costs associated with the property in proportion to their undivided interest in the property;
- The co-owners’ activities are limited to those customarily performed with the maintenance and repair of rental real property.
IS THE TIC INTEREST A SECURITY?
Another area of concern for an investor looking to enter into a tenancy in common arrangement is the potential that the TIC interest may constitute a “security” for purposes of state and federal securities laws. Common types of securities include stocks and bonds, while lesser-known forms of securities include investment contracts, partnership interests, and certain forms of indebtedness. An investment contract typically consists of an investment of money in a common enterprise with an expectation of profits to be garnered primarily from the activities of others. Thus, if not properly structured, a TIC arrangement where several investors pool their assets to acquire a real estate investment with the expectation of profits from the managerial or entrepreneurial activities of others may qualify as a security interest rather than an interest in real estate. A TIC interest that is structured as a security, rather than an interest in real property, risks disqualification for tax deferred status under Section 1031 of the Internal Revenue Code, and the promoter of such an interest may have inadvertently violated either state or federal securities laws, which can bring significant liability. In conclusion, due to the complex nature of 1031 Exchanges involving TIC interests, it is important to seek legal guidance to determine whether a particular arrangement satisfies the very detailed requirements of the IRS, if it will qualify for income tax deferral, and whether it would be classified as a security.
If you have any questions regarding tenancy in common arrangements, please contact our office.