Tenant-In-Common Investments: A Risk Worth Taking?

April 9, 2013 0
Tenant-In-Common Investments: A Risk Worth Taking?

Selling one’s real estate and investing in a “tenant-in-common” (TIC) transaction is inherently risky. However, if done cautiously, it can be an effective way to engage in a like-kind exchange.

Looking for a safe real estate investment with minimal tax ramifications, a Hawaii couple recently took their broker’s advice and invested in Hawaii Self Storage 1, LLC. This deal was structured as a TIC investment, whereby the couple sold their existing real estate, deferred the income tax, and then joined a group of other investors in the ownership of a new property. When their investment didn’t work out, the couple sued their broker for bad advice, and a FINRA arbitration panel granted the couple $300,000. All things considered, this couple fared alright, but it just goes to show how vital it is to consult tax advisors, accountants and estate planners before jumping into a TIC investment.

According to San Francisco attorney Christine Tour-Sarkissian, in this current marketplace, it is difficult for investors “to find a triple-net-leased property occupied by a creditworthy tenant for less than $5 million. Thus, many investors are forced to exchange for more expensive property, causing significant negative cash flow.” TIC investments solve this problem rather easily; you do not need to find a replacement property within 45 days after selling your relinquished property. In fact, you don’t have to worry about finding a replacement property at all. During a TIC transaction, you simply sell your old property, link up with a reputable sponsor, and then purchase as many TIC units as needed in order to avoid a taxable gain from the disposition of your old property.

Advantages

With TIC investments, you no longer have to play “beat the clock” to facilitate a 1031 exchange.

history-of-1031-tax-deferred-exchange

No Identification Issue
Rather than engaging in a typical 1031 exchange and scrambling to identify a comparable replacement property within 45 days, investors can enter into a TIC transaction and let the sponsor do the due diligence for them.

Sponsor Does the Legwork
It is important to have a knowledgeable and trustworthy sponsor, as the sponsor is responsible for drafting all of the requisite materials: the TIC agreement, purchase agreement, escrow instructions, property management agreement, tax opinion letter, etc.

Even more importantly, the sponsor must qualify all the other investors in the property. If any of the investors in a TIC syndication were to file for bankruptcy, this could adversely affect the entire tenancy-in-common. It is vital that the sponsor perform financial due diligence on all investors to ensure all investors are trustworthy and solvent.

Tax Free Exchanges
As long as the sponsor assembles the TIC properly, the investment property qualifies as a like-kind exchange, thus ensuring that no capital gain is due on the investors’ respective relinquished properties.

Financing Made Simple
As part of the legwork, the sponsor will usually arrange for a lender who is already familiar with the deal. Sometimes, sponsors are able to lock in nonrecourse loans from the lender as well.

No Management Responsibilities
Investors looking for truly passive investments love TIC arrangements. The sponsor takes care of all the logistics, and a professional management company manages the property. In theory, TICs are completely headache-free and hands-off for the investors.

Hefty Returns
For a relatively modest sum, investors can acquire a portion of an institutional-grade property that may offer a sizeable return over time.

Disadvantages and Risks: 

Incompetent Sponsors
The sponsor has an enormous amount of influence on the project, so it’s vital that you perform due diligence on the sponsor and the sponsor’s management company before you join a TIC syndication. If the sponsor is a REIT or a subsidiary of a REIT, be sure to perform background checks on all of the REIT’s principals. Also, review the agreements and the pro forma financial projections.

The best sponsors will receive tax opinions from reputable attorneys and/or advance rulings from the IRS that a TIC property does, in fact, qualify for a 1031 like-kind exchange.

Recharacterization by the IRS
A huge concern of nearly every TIC investor is that the TIC arrangement will be treated as a partnership by the IRS, thus nullifying the 1031 like-kind exchange status. As long as the sponsor structures the TIC properly, the IRS will consider the TIC to be real estate for tax purposes. However, there is a fine line between a TIC and an LLC, so it’s crucial that the sponsor structures the deal carefully.

As a caveat, although the IRS considers TICs to be real estate for tax purposes, the Service considers TICs to be securities for securities law purposes.

Liquidity Challenges
The exit can be challenging. Most sponsors claim to have access to a secondary market for TIC units, and that they’ll be able to sell your TIC units to a buyer when the time comes; however, by no means is this a certainty.

In addition to the challenge of finding a new buyer to take over your ownership interest, sometimes lenders have lockups and charge prepayment penalties.

Bankruptcy
All of the investors are grouped together in one pool, so if a creditor places a lien on one investor’s interest in the property, it could affect the marketability of the entire project. Likewise, if one insolvent investor files for bankruptcy, there’s a risk that the trustee in the bankruptcy case will terminate the TIC agreement in order to collect funds. In some bankruptcy cases, the TIC is even forced to sell the property.

Market Risk
As with all real estate investments, the income stream is market driven and dependent on the performance of the tenant(s) in the underlying property. In addition to changing interest rates and cap rates, there’s always the risk that the tenants will not perform.

Revenue Procedure 2002 – 22
This procedure outlines the requirements necessary for the IRS to make an advance ruling that a TIC is, in fact, a TIC and not an LLC. Although it doesn’t create a safe harbor, Rev. Proc. 2002 – 22 does provide a guideline for sponsors to follow to ensure that a TIC won’t be considered a partnership by the IRS.

Like this post? Subscribe to the Storage Facilitator newsletter


* = required field