Some investors hesitate to perform a 1031 Exchange because the strict 45-day identification requirement that must be met. It can be difficult to identify all replacement properties by the 45th day and it can also be a challenge to locate a backup replacement property of exactly the right type/value needed for a completely deferred exchange.
During the 1990s and early 2000s, most 1031 exchange investors who exchanged properties for partial ownership in large, high-valued replacement properties participated in the Tenant In Common (TIC) structure.
In contrast to a DST (Delaware Statutory Trust), each TIC investor had deeded title of the property. Though this was a popular investment model, it had several drawbacks for investors which are further discussed below. After the recession of 2008, the popularity of TICs decreased significantly because of these drawbacks, and a way was cleared for DSTs to become the new partial ownership structure of choice. Today we will explain how a TIC works and some of the requirements TIC investors must abide by.
Tenants in Common 1031 Exchange
Tenants in Common is a co-ownership agreement under which multiple investors pool their funds and agree to own one joint property. Each contributor owns an undivided, fractional interest in an entire property and they participate in a proportionate share of the net income, tax shelters, and growth.
Each investor receives a separate property deed and title insurance for their percentage interest in the property and has all the same rights and privileges as a single owner. In a TIC arrangement, co-owners have the right to isolate or transfer their ownership interest in the property without obtaining consent from the other co-owners. This is one of the distinguishing features that sets TICs apart from other arrangements.
A Tenants in Common 1031 Exchange allows diversification among several different properties at various geographic locations. Someone can invest in a hospital, warehouse, storage unit facility, a high-end hotel, an office complex, or an apartment building valued in the millions. This diversification may increase the value of a person’s investment portfolio.
Example of a Tenants in Common 1031 Exchange
Let’s say someone receives a $700,000 offer on a small apartment building they own. They have it in mind to make an institutional-grade investment, but with the amount of money from the sale, they don’t think they will qualify to purchase a high-quality property.
However, by investing in a Tenants in Common 1031 Exchange, this person could take this $700,000 in proceeds and feasibly purchase a 15 percent interest in a high-rise office building worth $5 million.
Though individually one might not be able to afford the high-rise property, a group of investors could purchase the property together. In this Tenants in Common 1031 Exchange, all of the debt and equity from the sale of the first property can be rolled over into a portion of the interest in the high-dollar property as a Tenant in Common. The other investors provide the balance of the funds necessary to close the deal.
Some Rules of a Tenants in Common 1031 Exchange
Several general requirements must be met to have a successful TIC 1031 Exchange. Some of them include:
- The number of Tenants In Common cannot exceed 35 persons
- 100% of the proceeds from the first sale must be reinvested and the value of the replacement property must be equal to or greater than the relinquished property.
- The management agreement must be renewable annually and must provide for market-rate compensation.
- The Tenants in Common must retain voting and approval power over aspects of the management of the property and must retain the right to transfer, partition or limit their interest in the property.
- If the property is sold, any debt secured by an overreaching lien must be satisfied, and the remaining sales proceeds must be distributed to the co-owners.
DSTs Reduce TIC Drawbacks
The availability to defer taxes on the purchase and sale of Tenants in Common interests in property opened up many new opportunities for investors in the 1990s and 2000s. However, since the Internal Revenue Service issued Revenue Ruling 2004-86 on August 16, 2004, permitting the use of the fractional ownership structure of the DST to qualify as replacement properties as part of an investor’s 1031 Exchange transaction, the DST structure has gained in popularity for its benefits.
To learn more, check out our blog on “9 Ways DSTs Reduce TIC Drawbacks.”
