The famous author Mark Twain once stated "...that the difference between a tax collector and a taxidermist is that a taxidermist only takes your skin." Savvy real estate investors throughout the country are turning to IRC Section 1031 tax deferred exchanges as way to defer capital gain taxes on the sale of any property held for investment or business purposes. The key advantage of a 1031 exchange is the ability to sell a property, without paying any capital gain taxes, allowing the earning power of the deferred taxes to work for the benefit of the investor, instead of the government.
A Challenge - Finding Replacement Property within 45 Days
One of the problems some investors are facing in the real estate market today is locating a suitable replacement property for their 1031 exchange within the 45-day Identification Period. (The 1031 exchange rules require that an investor meet two time requirements: 1) Identify the replacement property or properties within 45 days from closing on the sale of a relinquished property and 2) Close on the replacement property by the earliest of either: 180 calendar days after closing on the sale of the relinquished property or the tax return due date for the year the property was sold (unless an automatic filing-extension has been obtained). The lack of appealing replacement property options has resulted in some investors either paying unnecessary taxes or not even selling at all.
A Solution - Tenant-in-Common Ownership
An increasingly popular replacement property solution is what is known as tenant-in-common (TIC) ownership. This is the co-ownership of a property by up to 35 unrelated investors. Each TIC investor owns an undivided fractional interest in the real estate and receives their proportionate share of net income, tax benefits and appreciation. Essentially, a TIC investor has the same rights, benefits and risks as a single owner of property, but their share in the property is generally equal to the percentage of their equity participation. Most TIC ownership programs consist of institutional-grade properties, such as apartments, industrial properties, office buildings, shopping centers and warehouse/distribution properties ranging form $5 million to over $100 million in value. TIC properties are generally managed by a professional management company as outlined in a Master Lease or Management Agreement. A properly structured TIC ownership program provides a pre-packaged 1031 exchange replacement property solution. Last year, this growing niche of the commercial market closed on over $1.5 billion in TIC transactions.
Advantages of TIC Ownership Programs
- Provides a viable source of 1031 replacement property
- Elimination of active management responsibilities
- Superior institutional grade commercial property
- Diversification and risk reduction
- Flexibility for 1031 exchanges
- Maximize monthly cash flow
- Back-up property within the 45-day identification period
Limitations of a TIC Ownership Program
- Lack of liquidity
- Not a clearly defined exit strategy in many cases
- Rate of return
- Costs and fees
- Short-term debt structure
TIC Ownership - Security or Real Estate?
There is currently a tremendous amount of confusion as to whether TIC ownership is a security or a real estate transaction. This issue is an important one that still needs to be resolved in the industry because a security transaction must be handled by a licensed registered security representative while a real estate transaction must be handled by a licensed real estate professional.
While TIC ownership is considered an investment in real estate, the actual transaction is often viewed as a securities transaction, meaning that the people promoting the purchase of a TIC ownership property must have the necessary securities license. A landmark case dates back to 1946 in the SEC v. Howey. Howey and others argued in court that the fractional interests of their orange grove was not a security, and instead was real property. This court case has created what is often called the "Howey Test", which helps to make clear whether a regulatory body, such as the SEC, will view an investment as a securities transaction. The test has three prongs:
•1. An investment of money in a common enterprise.
•2. The investment is made with the expectation of return.
•3. The return is based on the entrepreneurial efforts of another.
If all three "prongs" are met, it is generally thought that the transaction will be viewed as a security transaction. At this time, it is important to realize the issue of whether TIC ownership is real estate or a security is still being actively debated. In November, 2004, the Commercial Legislation and Regulatory Subcommittee of NAR met to discuss this issue. To learn more about this and other TIC issues, visit the TIC industry's trade association's website, www.ticassoc.org.
Real estate investors should explore the tax deferral benefits of 1031 exchanges and wide range of "like-kind" replacement properties available. The opportunity for full tax deferral, coupled with the advantages of TIC ownership, provide a unique and powerful investment alternative for investors with highly appreciated real estate.
Another important part of a 1031 exchange is that clients should seek the advice of their tax and legal advisors to determine if a 1031 exchange is right for them.
Greg Schowe is MO, KS and Southern IL Division Manager with Asset Preservation, Inc. Questions regarding 1031 exchanges or contents in this article can be directed to 1-800-282-1031 or info@apiexchange.com.
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