Legal Briefs

Nervous TIC

Should you be worried about the future of tax-deferred exchanges?

By Mark Lee Levine, CCIM, JD, LLM (tax) |

For many years I have written articles on the implications if tenant-in-common interests are determined to be securities. One such concern is whether TIC interests can be employed in tax-deferred exchanges. Historically, a taxpayer might have exchanged TIC interests per Internal Revenue Code Section 1031, but such a decision depended, in part, on whether the TIC interest would constitute a security.

If a property is held to be a security, it will not qualify for a tax-deferred exchange under IRC Section 1031. Thus, a court decision ruling that a TIC, even though it is real estate, constitutes a security, is a very important exchange issue.

In July, the Montana Supreme Court determined that a TIC is a security — a decision that may have ramifications for commercial real estate investors and advisers who have participated in tax-deferred exchanges where TIC interests are involved.

What Is a Security?

According to theSecurities Act of 1933, a security can constitute notes, stocks, evidence of indebtedness, and a number of other items, including what has turned out to be the very important label of an “investment contract.”

The term investment contract was created in the 1933 statute, but not defined until 1946 when the U.S. Supreme Court decided the case of SEC v. W.J. Howey Co. That ruling created the Howey test of the four necessary elements for an investment contract: an investment of money or other property; a common enterprise; an intent to make a profit; and the intent to use the expertise of someone other than the investor.

Redding Case

The most recent TIC securities decision is from the Montana Supreme Court case of Billie L. Redding v. Montana First Judicial District Court.

Billie Redding, an elderly widow who had worked on the family ranch for most of her life, sold the ranch in 2004 for $3.3 million. To avoid tax liability on the sale, Redding was guided to enter into a tax-deferred exchange transaction.

Redding relied on the advice of her longtime accountant who was a shareholder in the accounting firm Anderson Zur-Muehlenn & Co., P.C. He guided Redding to invest in TIC interests in a separate entity known as DBSI Housing. Redding purchased four TIC interests in 2004, via a tax-deferred exchange. The Redding interests were brokered by Acquiron, a subsidiary of Anderson ZurMuehlenn. She paid about $4.6 million for the TIC interests, contributing her real estate equity position of approximately $2.2 million and assuming debt of about $2.4 million.

Ultimately, DBSI collapsed, and in 2008, it filed for bankruptcy. A receiver determined that there was a Ponzi scheme involved. After the DBSI collapse, Redding brought action against Anderson ZurMuehlenn, alleging unlawful sale of securities, among other counts. She sought general damages of more than $4.6 million plus punitive damages.

Determining that there was no common enterprise between DBSI and Redding, the Montana First Judicial District Court found that the DBSI TIC interests were not securities under Montana law. Redding asked the Montana Supreme Court to review to case.

The Supreme Court said it defines a security quite broadly. It cited various authorities, such as the 1979 Montana securities case State v. Duncan.

The Supreme Court said: “…we conclude DBSI’s TIC investment scheme was a common venture under any measure.” It cited the Howey decision and noted how the factual circumstances are important, concluding “… in reality DBSI sought out passive investors and that Redding, regardless of the rights she retained in the written agreements, was not expected to exercise any meaningful control over her investment, nor did she expect to exercise meaningful control over her investment.”

Anderson ZurMuehlenn argued that under Revenue Procedure 2002-22, the TICs were not securities.

However, the Supreme Court of Montana made one of the strongest findings in any decision on this issue: “[Anderson Zur
Muehlenn], however, has not shown that in 2004 the IRS or anyone else believed that the TICs were not securities. Revenue Procedure 2002-22 simply provides guidance for TIC sponsors and owners to avoid having TICs classified as partnerships. It does not say TICs are not securities.” (Emphasis added.)

The Supreme Court of Montana, therefore, concluded that the statement by Anderson ZurMuehlenn that the TICs were not securities in 2004 is incorrect: “TICs would have been considered securities in 2004.”

Finally, the Supreme Court of Montana stated the foundation of its important decision: “Based on the tests and principles of law discussed above, the TICs here are securities.”

The Redding decision means that a TIC in this setting can be a security. This means that there are many areas of potential liability for many advisers who, as attorneys, CPAs, real estate brokers, or otherwise, have counseled their clients that the transaction was not a security.

Mark Lee Levine, CCIM, JD, LLM (tax), is a professor and past director of the Burns School of Real Estate and Construction Management, Daniels College of Business, University of Denver. Contact him at mlevine@du.edu.