The real estate boom has created vast amounts of wealth for investors nationwide. As those investors seek to capitalize on that appreciation by selling properties, they will often reinvest in other real estate in order to delay the related tax bill through a likekind exchange.
Code Section 1031 allows taxpayers to defer income taxes on the sale of property if the proceeds are reinvested in similar or “like-kind” property. In the case of real estate, nearly all real property is considered to be “like-kind” to other real estate.
The pool of potential replacement properties began to increase significantly in 2002 when the IRS issued guidelines on an alternative ownership structure known as tenants-in-common, or TICs. TICs allow individuals to directly own a fractional share of real property, rather than through a partnership or corporation.
This distinction allows TICs to qualify as like-kind property and has spawned a burgeoning industry that grew to nearly $10 billion in 2005 and shows no signs of slowing.
In a relatively short period of time, TICs have evolved from an obscure niche into a common alternative investment vehicle. TIC opportunities are typically offered through sponsors as a tax-friendly alternative to other investments.
TIC properties are generally institutional-grade properties valued at between $10 million and $50 million. From 2001 to 2004, there were nearly 400 sponsored TIC transactions with an average property value in excess of $20 million.
Access to these types of investment properties has historically been limited to only the wealthiest individuals and institutional investors. However, through a TIC structure, direct ownership in such properties can be offered to individual investors, allowing them to own a percentage of the property. TIC sponsors usually require a minimum investment of between $250,000 and $1 million.
In addition to the potential tax benefits, TIC investors are also seeking opportunities to divest themselves of managementintensive properties and acquire more passive investments.
Accordingly, the majority of TIC transactions involve high-quality, investment grade properties with solid-credit tenants with long-term leases. The sponsor typically has executed a master lease that effectively shifts all of the operational and management issues to them or another third party. These factors reduce the risk generally associated with direct real estate investment. The investment returns on TIC investments reflect this risk reduction and result in projected cash-on-cash returns between 6 percent and 8 percent.
Another sign that is indicative of a maturing industry is the increased emphasis on adequate disclosure and adoption of sector-wide best practices. The Tenant-In-Common Association was formed by TIC sponsors, real estate professionals, securities broker/dealers and other industry professionals to increase the profile of the industry and promote high standards. Although not a regulatory body, TICA has developed and implemented a code of ethics and other guidelines to protect investors and the industry.
There has been considerable discussion regarding the treatment of TICs as securities for regulatory purposes. Treating TICs as securities has significant implications for investors and advisors.
Securities are regulated by the SEC and NASD. Both of these organizations have stringent information-disclosure requirements for all securities.
Most sponsored TIC deals are sold as Reg. D Private Placement Securities. A Private Placement Memorandum is distributed to each potential investor and includes extensive information regarding the real estate, tenant, sponsor and transaction structure.
The classification as a security also affects fees associated with TIC transactions. The SEC does not permit TIC sponsors to pay commissions or other referral fees to real estate brokers who advise their clients to invest in TICs.
The sponsors can, however, compensate securities broker/dealers for referring their clients. Because of this disparity, investors may receive different advice regarding TIC investments depending if they are talking to their investment representative or their real estate broker. The IRS has stated that, as long as sponsors follow published IRS guidelines, TICs will be treated as direct interests in real estate even if they are classified as securities for SEC and NASD purposes.
TICs are not completely without risk. Although PPMs contain a great deal of information, potential investors must still conduct their own due diligence regarding the property, sponsor, tenants and other economic factors.
With property values at all-time highs in many markets, increasing interest rates could cause a decline in real estate values. Sponsor and broker/dealer fees can easily exceed 5 percent to 10 percent, reducing that value of the investment from day one.
Additionally, although the volume of TIC transactions is expected to continue its rapid growth, the exit strategies for current owners of TIC interests are limited. A secondary market for reselling TIC interests exists but is limited, and sellers can expect to sell their interests at significant discounts. With long-term capital gain tax rates at 15 percent, investors considering TICs as a vehicle to defer income taxes must consider whether these potential risks exceed the tax benefits.
Fritton is the principal in charge of the real estate team at Indianapolis-based Somerset CPAs PC.Views expressed here are the writer’s.