CCIM Q&A

TIC Talk

A CCIM expert takes time out to discuss tenancy-in-common strategies.

By Jennifer Norbut |

T 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.

CIRE : What are the key issues a commercial real estate pro should consider when deciding to sponsor a TIC investment?

Tro wbridge: There are two issues commercial investment brokers acting as TIC sponsors absolutely must consider: Internal Revenue Service rules and federal and stat e securities laws.

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?

Trowbridge: 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?

Trowbridge: 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 arrangement.

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 agreement.

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.

Trowbridge: 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?

Trowbridge: 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.

Trowbridge: 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?

Trowbridge: 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?

Trowbridge: 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?

Trowbridge: 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 estate license.

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 persons.

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.