Understanding TIC structure and the options it provides for individual exchangers.
When people think of investment property, they often picture an individual landlord who owns smaller rental properties, or they think of large corporate owners of diversified real estate portfolios. But there are many ways for individuals to pool their resources to purchase larger investment properties.
Shared ownership structures like an LLC, partnership, or trust can provide investors access to a greater range of available properties, but can also lead to disagreements, especially when it’s time to sell. Certain ownership structures require all parties to be in agreement when it comes to performing a 1031 exchange, but a tenancy-in-common (TIC) structure provides more flexibility. Here’s how a TIC works and some of the benefits it can provide in relation to Section 1031.
How a TIC relationship works
A tenancy in common is a concurrent estate relationship under which multiple investors, or tenants, can own fractional interests in a single property. A TIC can involve anywhere between 2 and 35 investors, with each investor owning a fractional interest proportional to the amount of capital they invest. Investors do not have to put up the same amount of capital or own equal shares.
A TIC differs from joint tenancy, which utilizes undivided interests and includes the right of survivorship, or tenancy by the entirety, which is for married couples. Under a TIC, there is no right to survivorship: if one of the tenants dies, their ownership does not automatically go to the other owners, and instead can be bequeathed to anyone.
Here are a few of the benefits of a TIC, as outlined by Los Angeles Magazine:
“Each tenant has their own loan, and shares of the property might vary (one person might hold 25 percent while another holds 50 percent), but the entire property is owned by all tenants, and property taxes are split. Private tenancy-in-common agreements, which can be adjusted at any time, allow tenants to determine who has the exclusive right to occupy various parts of the property, and which unit each person will live in.”
As this article notes, tenancy in common could be advantageous for property owners who wish to live in individual units, but also provides benefits for those purchasing property as an investment. With a joint tenancy, if one investor wants to sell their portion, the property would have to be sold to a new legal entity, but under a TIC structure, an individual can sell their percentage at any time without affecting the overall structure. This aspect, along with flexibility in bequeathing an ownership stake, makes a TIC structure good for those who wish to own a property together but may have different long-term goals.
It’s also possible that a TIC property could be less expensive to purchase. According to the L.A. Times, when sold as fractional interests of a TIC agreement, “units sell at an 11% to 15% discount relative to comparable condos because a variety of complexities limits the pool of interested buyers.”
There are some noted downsides highlighted by Los Angeles Magazine, one of which is that finding financing can be difficult because each tenant needs their own loan.
“The payment plans available are limited. The shared property taxes can also raise issues—if one person fails to pay, other tenants might be held accountable.”
One of the chief advantages of a TIC is that the individual fractional interest can be used as a like-kind property in a 1031 exchange. While it’s possible for one or more of the tenants to live in the building and use it as a primary residence, in which case their interests would not qualify for 1031, other tenants who rent out their units and use the property as an investment would be able to exchange their fractional ownership under Section 1031.
Performing a 1031 exchange with a TIC
One of the biggest mistakes first-time exchangers make is not understanding the same taxpayer rule, which states that the entity that sells the relinquished property in a 1031 exchange must be the same entity that purchases the replacement property. If you and several other individuals own an investment property through an LLC, you can’t create a new regarded entity to purchase the replacement property, and can’t divide up your shares and perform individual exchanges – in order to qualify for 1031, you must stick together.
If you and the other shared owners all agree to exchange into a new property without altering the business entity, performing a 1031 exchange is possible. The difficulty comes when you and your co-owners have different goals and wish to go your separate ways, or when one member wants to exchange while another wants to sell in a taxable sale.
If your ownership structure is a partnership, you can’t simply sell and use your share of the proceeds to purchase a replacement property because that would violate the same taxpayer rule. It’s possible that your shared ownership might not be classified as a true partnership, in which case an exchange could be possible. Revenue Procedure 2002-22 deals with this and outlines situations where this ruling could apply.
A TIC relationship becomes useful when individual residential units are occupied by owners and therefore don’t qualify for 1031, or when some of the owners don’t wish to sell. In those cases, one investor could perform a 1031 exchange out of the TIC by selling their individual fractional interest, and the other investors are not obligated to sell or exchange.
It’s also possible to perform a 1031 exchange into a TIC by purchasing a fractional interest from one of the owners. As explained by Forbes, “Under a TIC ownership structure, an owner might be able to convey all or a portion of their ownership interest to an incoming investor without changing the ownership levels of the other partners. This allows additional individual investors—even those pursuing a 1031 exchange—to join a preexisting ownership group and become a new TIC owner.”
Forbes also describes how a TIC structure, because it allows for up to 35 investors, can be used to purchase larger commercial properties using a Private Equity (“PE”) sponsor. A PE sponsor can offer a variety of TIC properties that investors can choose from so they can find a TIC that meets their particular needs in order to avoid a 1031 exchange boot.
“By working with a sponsor, the investor can outsource the analysis to a team of professionals who have the capacity to parse through dozens or even hundreds of deals to isolate the deals with the top risk-adjusted returns.”
A TIC with a PE sponsor offers many of the advantages of a Delaware Statutory Trust (DST), including access to quality commercial properties, professional management, and the availability of additional investments to exchange into after the holding period for the current portfolio ends.
However, Delaware Statutory Trusts offer advantages that PE-sponsored TICs do not, one of which is the ability to include up to 500 investors, allowing DSTs to diversify across a greater range of properties and purchase much larger commercial properties. A DST also doesn’t require individual investors to qualify for or take out a loan – instead, the trust takes on non-recourse debt, and can potentially achieve a better interest rate than the individual investor might be able to.
It’s important to note that when you exchange out of a TIC property, you don’t have to exchange into another TIC or a DST. It’s possible to sell a fractional TIC interest and exchange into a 100% interest in a replacement property. This is not possible under a standard partnership, but there is a way to go from an LLC to a TIC for the purpose of a like-kind exchange.
Drop and Swap – how to go from an LLC or partnership to a TIC
If you already own a property as part of a partnership or LLC, there is still hope thanks to the “drop and swap” method. Under this method, the owners can dissolve a partnership and receive proportional tenancy-in-common interests with regards to the current property. This is the “drop” portion of a drop and swap. When the property is sold, each individual can decide whether to pursue a 1031 exchange (“swap”) or cash out.
With an LLC, one person can exit while the other owners keep the LLC intact. The departing individual would receive a deed for a TIC interest in the property equivalent to the percentage of the membership interest being returned to the LLC. That former member would now be a tenant-in-common with the LLC and could perform a 1031 exchange when they sell their TIC interest.
The transition to a TIC relationship must be completed before the 1031 exchange is initiated. There are specific procedures that must be followed, and unique risks associated with this method, which is why property owners must consult with competent legal and financial advisors. They also need to find an experienced Qualified Intermediary (QI) to properly execute the exchange.
JTC’s 1031 exchange team has specific expertise in less-common 1031 scenarios like drop and swap transactions and other exchanges involving tenancies in common. From our many years of experience as a QI, we understand the rules specific to TIC relationships, like how agreements must be structured to allow individuals to perform 1031 exchanges even if other tenants are using the property as a primary residence. Whether you’re considering an exchange into or out of a tenancy in common, JTC has the tools to help you understand your options and successfully complete your exchange.
CTA: Learn more about JTC’s 1031 exchange services here.
