Exchange wrinkle includes popular TICs
By Tom Kelly
Is the warm weather bringing out more TICs?
Unlike the little pests that bother our pets, these TICs can be helpful options for real estate investors.
“I think the popularity has been the run-up in real estate prices around the country,” said Tom Oldfield, a tax-deferred exchange specialist. “Sellers wanted to get out of one property and exchange into another, but they found replacement property was far more expensive than what they could afford.”
The answer for many taxpayers has been the TIC transaction, or tenant-in-common. This strategy allows investors who sell an investment property to buy ownership interests in another property (or properties) instead of buying an entire “like-kind” property to qualify for an exchange and defer capital gains taxes on the sale.
While TICs have been around for years and have been structured by a number of savvy property exchange specialists, they were officially blessed in 2002 when the Internal Revenue Service (IRS) issued a set of 15 guidelines laying out the ground rules for successful TIC deals. Interest increased immediately, especially from investors who had no easy way of locating other investors who wanted — or could only afford — a piece of another property.
Here’s how TICs usually work: A “sponsor” such as real estate investor or broker, will identify and arrange to purchase an apartment building, shopping center or office building. The sponsor will then make available a TIC purchase opportunity to other investors through friends and other brokers. These potential buyers can either buy a TIC interest outright or transfer the proceeds of a previous property sale in order to qualify as an exchange, which allows them to defer capital gains.
TICs have become popular and some big-name sponsors have entered the niche. This activity offers investors diversification location and property type.
“Investors need to properly research any TIC offering and understand what they are accepting,” Oldfield said. “They need to know how the property is going to be managed and if the costs include a commission — which is typically paid by the seller, not the buyer.”
Oldfield said many TIC commercial buildings often are leased to one master tenant who is associated with the TIC sponsor. The master tenant then subleases the building and stands to profit the most when rental rates rise. TIC participants are guaranteed a rate of return but typically none of the additional windfall rents.
A tax-deferred exchange (commonly known as IRS Section 1031 Exchange) is really an arms-length sale and purchase. The transaction will proceed just as a sale for you, your real estate agent and parties associated with the deal. However, provided you closely follow the exchange rules, the IRS will “sanction” the transaction and allow you to characterize it as an exchange rather than as a sale. Thus, you are permitted to defer paying the capital gain tax.
An exchange occurs when you trade real property that is other than your home or second residence for other “like kind” real property that you have held for trade, business, or investment purposes. The like-kind definition is very broad. You can dispose of and acquire any interest in real property other than a home or a second residence. For example, you can trade raw land for income property, a rental house for a multiplex, or a rental house for a retail property.
Section 1031 specifically requires that an exchange take place. That means that one property must be exchanged for another property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax-deferred transaction from a sale and purchase. The exchange is created by using an intermediary (or exchange facilitator) and providing required exchange documentation.
By pooling the proceeds of investors, TICs combine the tax and estate planning benefits available to investors through 1031 exchanges with the potential advantages of owning a share of an institutional-quality investment property. Investors receive their monthly distributions (after expenses) while giving up the maintenance and administration chores associated with managing property.
That task sometimes includes chasing down tenants, with tick-infested pets. Didn’t that rental contract stipulate no pets?
Tom Kelly, former real estate editor for The Seattle Times, is a syndicated columnist and talk-show host.