ABCs of Tenants in Common (TIC) 1031 Exchanges

**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**

If you are looking to reinvest in:

  • high-quality institutional property,
  • multiple properties to diversify your holdings,
  • low maintenance real estate free of tenant headaches,
  • or perhaps all of the above

A tenants in common 1031 tax-deferred exchange may be the answer. As a TIC co-owner, you’ll share ownership in properties of your choosing.

We’ll explain the basics, the benefits and risks, and now a TIC can work for you. Let’s get started with an overview.

 

What Is a Tenants in Common 1031 Exchange (TIC)?

TICs mean that two or more investors share ownership and fractional interest in properties purchased through a 1031 like kind exchange. These combined TICs/1031 Exchanges are used by investors for wealth-building, portfolio diversification, and lowering maintenance burdens on themselves.

Despite certain similarity, TIC ownership is not the same as having  a share in a real estate investment trust. You can learn more about the latter from our Guide to Delaware Statutory Trust (DST) 1031 Exchange.

The 1031 Exchange is utilized to defer any capital gains, depreciation recapture, state, and Alternative Minimum Tax (ATM) taxes. This requires selling one or more investment (relinquished) properties currently owned by you and acquiring one or more new like kind replacement properties.

At closing on replacement(s), you as a co-owner will hold a separate deed for your undivided percentage property interest. You’ll have an undivided interest in the property and may withdraw without other owners’ approval.

Co-owners may hold unequal shares that can be separately sold or mortgaged. Generally, without other owners’ approval, you can sell, transfer or encumber your interest. Sometimes however TIC Agreements limit co-owners’ transfer rights. Restrictions may include:

  • granting other owners the right of first refusal on any sale and
  • provisions granting co-owner the right to review and ultimately reject proposed sales.

All owners will generally have equal rights to and benefits of the property. Co-owners may however agree to:

  • limit their access to certain areas (e.g. specified office space or apartment units) and
  • further agree to designated exclusive rights to income generated from those assigned spaces.

With the death of tenants, their interest will pass to heirs. There are no rights of survivorship. Co-owners could provide in their will that ownership interests pass to the other TIC owners.

TICs popularity rose markedly with IRS’ Revenue Ruling 2002-22. It established qualifying guidelines for exchanging relinquished for replacement property under 1031 Exchange rules.

Ruling 2002-22 stipulates all owners:

  • can number no more than 35,
  • must be TIC-title holders under local law,
  • cannot file a partnership tax return,
  • retain the right to transfer their investment interest,
  • must have satisfied any debt before properties are sold and proceeds distributed,
  • may not obtain loans from anyone involved with the property,
  • must make 1031-sponsor payments for services rendered at fair market value,
  • may enter into annually renewable TIC management agreements, and
  • must share all costs and proceeds from the investment in proportion to their ownership.

These rules effectively instituted an IRS safe harbor approach to completing these exchanges. Nonetheless, with TIC and 1031 Exchange complexities so great, investors often retain a sponsor (syndicator).

Sponsors are either individuals or companies specializing in this TIC-1031 Exchanges boutique industry. These firms typically play a major role in completing the exchange. Services range from advisory to carrying out the entire operation on the ground. They locate and acquire investment property for investor groups.

Assistance with financing is offered and due diligence provided to ensure your investment and its tax-deferral status are preserved. Managing relinquished properties during the 1031 exchange property holding period and subsequently selling them are often undertaken, as well.

Sponsors typically structure TICs as escrowed property offering for sale. Purchasers will become co-owners in that TIC property. Once that property’s asking amount is reached via investor contributions, the sale goes to closing.

In a variation to this approach, sponsors themselves purchase properties directly. Post-closing fractional interests are offered for sale to investors as replacement properties.

 

Pros and Cons of a 1031 Exchange into Tenants in Common Property

Summary of Factors to Consider

These exchanges offer a great opportunity for financial gain. As with most investments, there are potential risks, as well. With considerable expertise required, you or your tax advisor should review all aspects of a proposed TIC-1031 Exchange.

Tenants in Common 1031 Exchange Pros and Cons

 

7 Pros of Sponsored Tenants In Common 1031 Exchanges

#1. Access to High Quality Real Estate

You’re able to join other investors owning otherwise unaffordable institutional-quality real estate investment property. A large Class A apartment house valued over $10M, e.g. would be out of reach to many investors. But 30 co-owners investing an average $400,000 would have $12M at their disposal through Tenant in Common ownership.

 

#2. Investment Diversification

With investment minimums under $100,000, you can potentially acquire multiple TIC properties. This should reduce the risk of single property ownership.

A primary benefit is monthly rental receipts. Investing in several properties reduces reliance on any single tenant, as well.

 

#3. Reliability

Well established, deferred capital gains/other taxes enable you to retain capital working for other investments that otherwise would be taxed away. A sponsor’s legal and accountancy professionals provide assurance that 1031 exchange qualifications are being met.

Due diligence in general is undertaken in-house on every property and the surrounding market. Credit worthiness, debt structure, profit/loss and appreciation projections, rent history, et al are analyzed by attorneys and accountants.

 

#4. Less Hassle

If you are a passive investor uninterested in daily property management duties, it’s ideal (another alternative is a “1031 exchange” into REIT with the section 721). A contracted property management team relieves you of active property management. Routine maintenance duties include leasing, collecting rent, and mortgage servicing.

The arduous 45 day replacement identification process is mitigated. You can select replacement(s) from syndicated properties accompanied by pre-arranged financing.

Also, TIC properties can be reserved post 45-day 1031 exchange replacement property identification period. They can serve as fill-ins should your preferred properties fall through. That’s critical when unavailable property could fail the entire exchange.

 

#5. Inheritors’ Benefits

Automatically left to any beneficiary, on inheritance previously deferred capital gains (but not depreciation recapture) tax liability is eliminated. Inheritors receive the benefit of a stepped-up basis.

 

#6. Minimal Closing Costs

Closing, deed recordation, appraisals and other related costs are minimal if any. However, expect TIC property acquisitions to cost more than buying on your own. They could even conceivably outstrip investment tax benefits on occasion. A cost/benefit analysis in advance makes sense.

 

#7. Quick Process

Without the negotiation, loan qualification, credit checks, and appraisal processes, a TIC exchange may be completed within a few weeks if not days.

 

Cons of Sponsored Tenants In Common 1031 Exchanges

#1. Higher Loss of Equity to Taxes

A challenge to the exchange’s tax deferral status is always possible. Gains could be subject to the deferred capital gains/other taxes. On large gains the loss of equity to taxes would be substantial.

 

#2. Illiquidity

Investors should be prepared to hold their interests until disposition of the property. TICs’ holdings are real estate after all and are considered illiquid. Yes, investors have the right to sell their interest at any time. However, there is no ready secondary market.

TIC properties may lose value as with any real estate investment. Economic cycles are inevitable, especially in a speculative marketplace such as this. Property values may slip. No secret, returns are likely to be great in an up market and disappointing in a down market. Being unable to sell your interest quickly can result in a loss.

 

#3. Lack of Control

There’s no opportunity for you to act unilateral on TIC matters. IRS Revenue Ruling 2002-22 requires a vote on material TIC decisions. Nor do TIC owners have any direct control of the day to day operations.

 

#4. Dependence on the Co-owners’ Ability to Pay the Mortgage

In the case of a default, lenders may seize the holdings from all investors. Should one or more investors stop making mortgage payments, the remaining borrowers must make payments in full to avoid foreclosure. The best defense may be having investors take title to their shares as a single member limited liability company (SMLLC). Such ownership provides liability protections.

 

#5. Higher Cost

You should expect TIC property acquisitions to cost more than buying on your own. They could even conceivably outstrip investment tax benefits on occasion. A cost/benefit analysis in advance makes sense (learn more about how much it costs to do a 1031 exchange in general).

 

#6. No Right of Survivorship

No right of survivorship means that on the death of co-owners, their interests pass to heirs by will or inheritance laws. Or co-owners may opt to have ownership interests passed to the other TIC owners.

 

#7. Access Limit

You may be required to limit your access to specified areas of the property by Agreement.

 

#8. Buyer Approval

By Agreement you may need a proposed buyer approved by your co-owners. This could potentially preclude accepting a best offer.

 

#9. Summary

Investor due diligence is called for, especially as investments grow. Prospective investments must be examined carefully for financial and tax risks.

  • Replacement(s) could be speculative and involve the risk of property value losses.
  • TIC assets are not generally liquid investments. Restrictions on transfers apply.
  • Cash distributions are not guaranteed to continue.
  • Business plans may fail to execute successfully.
  • Property’s value may not increase within the planned time frame.
  • The various fees paid to the TIC manager and sponsor are significant.
  • The manager exercises significant control over the investment. Co-owners aren’t involved in routine TIC activities carried out by the manager.
  • This is considered both a plus and minus by most investors.

 

How Does a 1031 Exchange into TIC Work?

How to Get Started

Included in Revenue Procedure 2002-22 is an invitation to request a Private Letter Ruling. Receiving IRS’ approval provides assurance your exchange will qualify for tax deferral. It’ll require full compliance with the terms set forth in your letter.

Situations may arise amidst the exchange however that require adjustments to your plan. Given the strict deadlines 1031 exchange rules impose, there’s little time to seek additional IRS guidance.

Again, you or your tax advisor should have a full understanding of Revenue Procedure 2002-22 guidelines. Full compliance is your best assurance of an unimpeded exchange with tax-deferral.

 

Forming a 1031-TIC

The typical investor’s goal is a highly-productive but simple as feasible TIC investment. You’ll want to retain as much control over your interest in replacement(s) as possible. The bottom line is that your investment must be safeguarded and capital gains/other taxes deferred.

Given the complexities involved and severity of missteps, sponsorship may be the best option. Sponsors typically employ standardized terms and conditions applicable to all participants.

The 1031 exchange process into a TIC property starts with a TIC Agreement prepared by you, other investor(s), or a sponsor retained by investors. This agreement generally delegates the rights and duties of all parties and dictates conflict resolutions to resolve potential conflicts.

It may contain critical Revenue Procedure 2002-22 guideline modifications. The right to transfer your investment interest, e.g. may be restricted. Or the right to share all costs and proceeds in proportion to your ownership amended. Two concerns are apparent here, i.e. Agreement modification’s impact on your ROI and the added risk when departing from 2002-22 guidelines.

The Agreement provides direction on:

  • outlining decision making processes including agreeing upon levels of approval required to resolve various issue categories, e.g. unanimous approval for proposed buyer of co-owner’s interest,
  • calculating ownership interests,[1]
  • specifying how the property expenses overall would be managed, i.e. whether in house or be contracted out to a third-party,
  • assigning owners’ maintenance duties for both their and common areas,
  • assigning co-owner property access both as to exclusive and common areas,
  • allocating shared costs such as real property taxes, utilities and insurance,
  • allocating shared deductible tax expenses to co-owners
  • all finances including whether co-owners are parties to one group loan or each co-owner has an individual loan,
  • dictate the rights of co-owners to transfer interests, stipulating applicable conditions such as right of first refusal and potential buyer approval, and
  • stipulate the rights of lenders to set borrowing conditions such as collateral provisions

The TIC is effectively formed when co-owners take title to a property with deeds designating each owner’s percentage interest. In the absence of an Agreement, the TIC will be modeled after state statutes and common law. Any desired exceptions to boilerplate statute and common law provisions won’t be included in the TIC. For example, there’ll be no restrictions on co-owners having the right to:

  • full access to the entire property,
  • transfer their interest without consent, and
  • share income and expenses equally.

With the Agreement in place, property acquisitions are orchestrated under 1031 like kind exchange rules. Once acquired, joint property management responsibilities are assumed by all co-owners unless outsourced per Agreement.

New owners can join over time. Should you own an apartment building, e.g. TIC interests could be sold one at a time to buyers. They’d simply be assigned access rights to single units. The Agreement would outline the details.

Again, the tenants in common 1031 tax deferred exchange is often orchestrated by a sponsor. Alternatively, you among other buyers can develop a TIC structure and Agreement independently. You would assemble an investor group to:

  • employ a licensed real estate agent to find investment property,
  • settle on each member’s fractional ownership percentages/units[1] and
  • work with an attorney and a Qualified Intermediary to carry out the 1031 Exchange [2]

[1] As a co-owner, your fractional interest in a replacement property must be specified in percentage terms. Without it your exchange could fail.
[2] Learn more about what qualified intermediaries aka 1031 exchange companies do from our guide All About 1031 Exchange Accommodators (aka Facilitators or Qualified Intermediaries).

 

Example of a Tenants in Common 1031 Exchange

Let’s say you receive a $600,000 offer on your small apartment building. You’re planning a major investment, but those sale proceeds won’t be enough to purchase a high-quality property.

However, by investing in a Tenants in Common 1031 Exchange, your $600,000 would acquire a 20% interest in an office tower worth $3M.

Here individually you couldn’t afford the tower but co-owning with a group of investors makes it possible. In this tenants in common 1031 tax deferred exchange:

  • your relinquished apartment’s debt and equity rolls over with partial interest in the tower and
  • the remaining balance due on the purchase is picked up by the other investing co-owners.

 

Disposing of a TIC-1031 Exchange Property

One or more co-owners may dissolve the TIC with a buy out of the other members. Joint agreement is required when co-owners hold opposing expectations for:

  • the property’s use
  • improvement
  • want to sell the property.

In the absence of agreement, property partitioning may occur either voluntarily or by a court order, as necessary. A partition in kind is typically used to divide property in non-adversarial cases. In this legal proceeding, each member may move forward apart from other members.

In adversarial cases, co-owners may sell the property. Proceeds are divided among the co-owners in relation to their interest in the property.

 

Can You Exchange Your TIC Interest for Another One or a Separate Property?

Under 1031 Exchange rules, a tenants in common interest in one property can be included in another:

  • tenants in common 1031 tax deferred exchange or
  • 1031-qualifying like kind property apart from TICs.

IRC section 1031 provides for the exchange of like-kind real estate, i.e. qualified relinquished and replacement properties. Meeting qualified 1031 use tests, your TIC-1031 interest qualifies for TIC-1031 Exchanges.

This presumes there’s no Agreement restraint on property ownership transfer or other legal obstacles. You might have difficulties finding a buyer, e.g. that co-owners are willing to approve as stipulated.

Then there are practical considerations. In the Pros and Cons section, #2 under Cons notes:

  • TIC-property is considered illiquid with no public or secondary market for selling fractional ownership and
  • investors should be prepared to hold their interests until disposition of the property.

So yes, investors have the right to sell their interest at any time. However, there is no ready market.

Note also that not all proceeds from the sale of relinquished property must be reinvested. Of course, such funds constitute a boot and will be recognized as taxable income (learn more about how boot is taxed in a 1031 exchange and about partial 1031 exchanges). Capital gains and other taxes may be imposed.

Within 45-days of selling relinquished property, you must acquire the replacement(s) under 1031 Exchange rules. Along with making the new purchase in the same name as the relinquished property, all other rules apply.

 

How to Comply with All TIC-1031 Exchange Property Rules?

Tenants in Common 1031 Exchanges can be rewarding in many ways, but compliance is daunting and time-consuming. Missteps are often unforgiving, risking an exchange failure altogether.

A reputable 1031 exchange company with tax attorneys on their team will consult you and your tax advisor/CPA and guide you through each step of the 1031 exchange process. Before the exchange, they will review your situation and advise on whether your plans satisfy the IRS requirements or need adjustments to perfectly comply with the rules.

PropertyCashin is an all-in-one platform for commercial real estate investors that maintains relationships with top-rated 1031 exchange firms in all locations of the USA. To get connected with the best professionals and have your exchange processed safely and effectively, fill out the form below.

About the Author
Sam McGrath

As the Lead Commercial Real Estate Analyst at PropertyCashin, Sam McGrath is responsible for the company’s national sales strategy. Prior to his position with the company, Sam served as a Surface Warfare Officer in the United States Navy. Further, Sam was the National Recruitment Manager at Maxim where he expanded the Maxim healthcare brand nationally. He has over 8 years of experience in creative real estate investing. In addition, Sam has bought and sold commercial and residential property in over 42 states. Sam has a bachelor’s degree in business administration and marketing from Texas State University.

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