Sample Property and Construction Law Update
Summer 2006
Want To Invest In Real Estate? As of Now the Clock is TICking
By Allen Wheeler
Right now, there is more money seeking property than at any time in recent history. With most institutional investors actively purchasing property, how can a small business or a single investor with limited financial assets acquire quality real estate investments? One method is to purchase an interest in a Tenancy In Common, more commonly known as a TIC. Local papers and trade magazines have recently heralded the potential allure of this investment vehicle, but its mechanics and limitations can be complicated.
What Is a TIC?
TIC ownership, though recently fashionable, particularly for 1031 investors, is actually centuries old. A TIC is a collection of two or more parties who each own an undivided fractional interest in a single piece of property. That is, each owns a percentage of the whole rather than a specifically described portion of the property. This is to be contrasted with a condominium, in which each owner owns a specifically described piece of the property (their residence or office) plus an undivided interest in the common areas.
Advantages
If created correctly, owners can buy into and sell out of TICs and qualify for “like kind” treatment under Section 1031 of the Internal Revenue Code. Thus, transfers that would normally be taxable are not taxable and gains otherwise recognized on sales are deferred as long as the investor reinvests those gains properly. Also, TIC ownerships are usually structured as passive investments so the owners don’t have to worry about operational responsibilities.
Typical Structure
In one of the most common TIC structures, a “sponsor” buys a property, drafts a TIC Agreement (or Co-Owners Agreement) that is signed by all the TIC owners, secures strong anchor tenant(s) for the property, arranges for the property’s long-term management, and begins to sell TIC shares. After all the co-ownership interests are sold, the newly formed TIC owns the property, a property management firm is retained to manage the property on behalf of the TIC, the tenant(s) pay their rents directly to the management company, and the management company pays the owners their proportionate share of revenues (or bills them proportionately for any losses).
Partnership or TIC?
In 2002, the IRS issued Revenue Procedure 2002-22, which identifies the differences between TICs and partnerships. This distinction is critical because if a partnership is created rather than a TIC, the investor will not qualify for “like kind” treatment under Section 1031. Revenue Procedure 2002-22 describes 15 distinguishing features of a TIC. Some of the more important features of a TIC are:
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NUMBER OF CO-OWNERS: Limited to no more than 35 persons.
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CO-OWNERSHIP AGREEMENT: There must be a co-ownership (or TIC) agreement that establishes the rights and obligations of the co-owners with respect to each other.
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VOTING: The co-owners must retain the ability to make all major decisions affecting the property, such as: (i) hiring a property manager; (ii) entering into leases; (iii) selling the property; and (iv) mortgaging the property. In addition, certain decisions must be authorized by a unanimous vote of the co-owners.
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RESTRICTIONS ON TRANSFER: In general, each co-owner must have the right to dispose of its undivided interest in the property without the approval of any party.
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PROPORTIONATE SHARING OF PROFITS AND LOSSES: Each co-owner must share in all revenues generated by the property and all costs associated with the property in proportion to the co-owner’s interest in the property.
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PROPORTIONATE SHARING OF DEBT: The co-owners must be liable for any indebtedness secured by a blanket lien in proportion to their undivided interests.
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MANAGEMENT AND BROKERAGE AGREEMENTS: The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually, with an agent who may be the sponsor or a co-owner but who may not be a tenant.
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PAYMENTS TO THE SPONSOR: In general, the amount paid to the sponsor for the acquisition of the TIC interest (and the amount of any fees paid to the sponsor for services) must reflect the fair market value of the acquired interest (or the services rendered) and may not depend, in whole or in part, on the income or profits derived by any person from the property.
Concluding Considerations
Potential investors should consider several factors when evaluating a TIC:
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LOOK FOR AN IRS APPROVED TIC. That is, make sure the TIC satisfies the requirements of Revenue Procedure 2002-22 and is a TIC rather than a partnership.
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EVALUATE THE SPONSOR. Investigate the sponsor’s track-record. How many other deals has the sponsor completed? Talk with co-owners of those deals if possible to see if they are satisfied with the sponsor.
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EVALUATE THE FINANCIAL STABILITY OF ANCHOR TENANTS. Can you depend on these tenants for a steady, predictable cash flow? If there is a large vacancy or if the lease of any major tenant will expire in the near future, scrutinize the sponsor’s (or management company’s) assumptions regarding when another tenant (or tenants) will be secured. Are these assumptions reasonable given the condition of the local real estate market?
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REALIZE THAT THE MORE CO-OWNERS THERE ARE, THE MORE DIFFICULT DECISION-MAKING WILL BE. Make sure you are comfortable with the methods described in the TIC Agreement for making decisions and resolving conflicts.
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LOOK FOR CONFLICTS OF INTEREST. Is one of the co-owners the sponsor? Is the management and/or brokerage company an affiliate of the sponsor or another co-owner? These types of arrangements are not necessarily bad. If they exist, however, make sure the TIC Agreement is drafted to mitigate against any overreaching by these potentially conflicted entities or persons.
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MAKE SURE THAT THE TIC AGREEMENT PROVIDES FLEXIBILITY. At some point, you may need an exit strategy; make sure you review the applicable terms of the TIC Agreement to be sure you have the flexibility you need.
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UNDERSTAND THE COSTS. The TIC Agreement should define the costs, fee structure and annual equity disbursement procedures. Make sure you’ve looked at these provisions closely.
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ENGAGE THE HELP OF YOUR LAWYER AND TAX PROFESSIONAL. A knowledgeable attorney or tax professional can assist you in evaluating the soundness of the investment and structuring the deal to protect your interests.
If you have questions, contact Allen Wheeler at 612.672.8390 or allen.wheeler@maslon.com.
