A CCIM expert takes time out to discuss tenancy-in-common strategies.
he explosion of tenancy-in-common transactions has been a hot topic
among commercial real estate professionals for several years now. TIC investors
will purchase between $5 billion and $10 billion of real estate in 2006 alone,
industry observers estimate. While some commercial real estate professionals
have jumped at the business opportunities TIC transactions can provide, others
have chosen to sit back and study this phenomenon as it unfolds. Regardless of
where you fall along the continuum, the path to executing TIC deals can be
bumpy if it's not navigated properly.
Commercial Investment Real Estate spoke with Gene Trowbridge, CCIM, JD,
owner of Trowbridge & Associates in Lake Forest, Calif., about some of the
key issues commercial real estate professionals should consider when working
with TIC transactions. Trowbridge, who teaches CCIM designation courses on a variety
of investment topics and has extensive experience in the TIC arena, offers
insight on some fundamental issues commercial real estate experts should
consider. Visit Trowbridge's Web site at www.groupsponsor.com for additional
information on structuring TIC transactions.
: What are the key issues a commercial real estate pro should
consider when deciding to sponsor a TIC investment?
There are two issues commercial investment brokers acting as
TIC sponsors absolutely must consider: Internal Revenue Service rules and
federal and stat
If your clients are interested in executing a tax-deferred exchange, the
transaction must be structured so that at the closing each tenant in common
receives a deed ind
icating a fractionalized ownership interest of the property.
After receiving the deed, the tenants in common record a written agreement
detailing how the group will operate. So sponsoring a TIC real estate
investment is much more than a brokerage function.
CIRE: How does a TIC differ from a traditional 1031 exchange?
Even after receiving a deed to real estate, a tenant in
common may not have accomplished the goal of tax deferral. The IRS has treated
some TIC ownership interests like partnerships, and Internal Revenue Code
Section 1031 excludes partnership interests from tax deferral.
Historically, taxpayers have been advised to request Private Letter
Rulings stating that the IRS would not take a position in an audit that a group
would be treated as a partnership. But as the market heated up several years
ago, these requests so overwhelmed the IRS that it issued a Revenue Procedure
prohibiting investors from requesting PLRs for this purpose. As you can
imagine, this situation was unacceptable to many investors.
Then in 2002, the IRS issued Revenue Procedure 2002-22, which identified
a method by which investors could once again request PLRs prior to investing as
a tenant in common.
CIRE: What key components of Rev. Proc. 2002-22 should commercial real
estate pros understand?
While there are 15 specific sections to address in TIC
agreements to avoid IRS recognition as a partnership, there are two broad
concepts that commercial real estate pros must consider.
First, the agreement must allow each tenant in common the ability to
treat its fractional property interest the same as it would if it owned the
property individually. This differs from a partnership, in which investors
generally give up certain rights to make individual decisions with regards to
the investment. A properly drafted TIC agreement does not allow this
The other concept is that no party can profit from the operation of a
TIC ownership interest other than the tenants in common. A sponsor cannot share
in the annual cash flows or proceeds from TIC property refinancing or disposing
of TIC interests. However, sponsors may provide brokerage activities to the
group through contractual agreements that are separate from the ownership
It's important to consult a qualified attorney and accountant to ensure
that the TIC ownership agreement is prepared in accordance with the
requirements outlined in Rev. Proc. 2002-22.
CIRE: Explain how a commercial real estate agent can profit from
sponsoring a TIC investment.
The most common way is for a broker to acquire a property
and sell it to tenants in common. However, all of the sponsor's expenses and
profits must be included in the list price of the property. Another way to
profit from a TIC transaction would be to act as a facilitator and manage the
fractional interest sales to the tenants in common, collecting a brokerage
commission and providing contractual services for a fee.
CIRE: If a client wants to execute a TIC 1031 exchange, how can a broker
structure the deal so that the tax deferral is accomplished and the broker
still is compensated for services?
This is where a good understanding of securities law is
critical. Federal law defines what a security is and most states have adopted
the definition. In brief, the U.S. Supreme Court established a test to
determine what defines a security in the case SEC v. W.J. Howey Co. In the
case, Howey Co. sold parcels of land in its Florida citrus orchard. Investors
were told that the company would harvest the fruit, process it, and sell it,
sharing the profits with the landowners. The citrus business failed, the
landowners were foreclosed on and they sued, citing that what they had
purchased were securities, not real estate. The court agreed and established
the test to determine when an investment is a security. The Court's definition
of a security is an investment of money in a common enterprise with the
expectation of profits through the efforts of a third-party sponsor or
promoter. In the case ruling the court agreed that even though the investors
purchased real property, they really were investing in the enterprise of a
citrus business that they expected Howey Co. to run profitably.
CIRE: Explain how this set of rules applies to TIC investments.
After the transfer of real estate deeds, tenants in common
enter into an agreement establishing how the business of the property will be
operated. If the agreement sets up an arrangement where a third party, such as
the sponsor, will be responsible for the profitability of the business, it is
very likely the IRS will consider the investment a security. For instance, if
the investors in Howey had been TICs, the Supreme Court probably still would
have declared the transactions securities.
CIRE: One of the most talked-about topics in the industry is the fact
that some TIC investments are sold as securities and some are sold as real
estate. What is the difference?
The difference is in the terms contained in the agreement
that the tenants in common structure. If there are provisions that state a
separate party is responsible for making the business of the real estate
profitable, it may be deemed a security. For example, a self-storage project
with 1,000 storage units or a multitenant retail center can be considered more
than just real estate - they can be considered businesses. If the agreement
among the tenants in common gives the responsibility to run the business to a
third party, it is likely to be considered a security.
CIRE: How can a sponsor set up an arrangement among multiple TIC owners
to ensure that it is not considered a security?
Generally, TIC interests that are sold as real estate are
structured to contract with unrelated third parties to run the business. The
tenants in common must unanimously approve a contract at inception and
unanimously ratify the contract annually. Usually the tenants in common can
cancel these contracts without cause.
One common method is for sponsors to arrange for an asset management
company to run the property, including contracting out the management and
leasing activities. A sponsor could provide brokerage activities that are
governed by the traditional types of agreements signed between property owners
and real estate agents.
Another method is for sponsors to arrange for an unrelated party to
engage in a master lease covering the entire property. The master lessee then
runs the business.
This issue really circles back to Rev. Proc. 2002-22. While the ruling
was sanctioned by the IRS and not the Securities and Exchange Commission,
following it may very well provide for an agreement among tenants in common
that allows unrelated third parties to handle the business of the real estate
on contractual arrangements outside of the ownership agreement and, as a result,
avoid the security issue.
CIRE: Do commercial real estate brokers need a securities license to
sell TIC investments?
It depends. First, in the real estate world, you can sell
your own investment property without a real estate license, but you can't sell
someone else's investment property without a real estate license. In the
securities world, generally you can sell the securities you issue without a
securities license, but you cannot sell the securities separate parties issue
without a securities license. In many instances, commercial real estate
professionals sell TIC interests they sponsor without a securities license.
However, if an agent wanted to sell TIC interests from other sponsors and the
TIC interests were structured as securities, a securities license is necessary.
If the deal is structured as a real estate transaction, the agent needs a real
It's also important to note that securities companies do not share fees
with real estate agents. This makes sense as most real estate laws and
securities laws prohibit licensees from sharing commissions with unlicensed
The discussion of legal and tax issues in this article is for
informational purposes only. Readers are advised to consult tax and legal
advisers for specific advice relating to TIC and other investments.