FEATURE ARTICLE, JANUARY 2007

SO YOU WANT TO INVEST IN A TIC DEAL?
A look at several issues to consider before investing in a tenancy-in-common property.
Kevin Thomason and Todd Keator

The tenancy-in-common (TIC) marketplace has exploded. A record number of sponsors are offering a record volume of TIC product to investors who seek to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code (1031 exchanges). The following is to provide some insight into issues potential TIC investors should consider.

Capital gains rates (generally 15  percent) are at the lowest levels that anyone can remember. The first question any investor should ask is whether to just pay the tax on the sale of the relinquished property. Investors who sold real estate and are looking to complete a 1031 exchange are limited to acquiring real estate (including oil and gas interests) as replacement property. However, certain non-real estate investments may offer relatively higher rates of returns.  Investors interested in switching to such investments may be better served taking the 15 percent tax hit in exchange for the higher yields they may obtain by investing in non-real estate assets. However, for investors seeking to acquire real estate as replacement property, paying the tax is rarely the right choice.

If you are not ready to pay Uncle Sam, the next question is whether to invest in a TIC (which is essentially an undivided slice of a piece of real property) or purchase a 100 percent interest in a property such as a strip center or apartment complex. A 100 percent investment offers more back-end liquidity to investors because TIC interests can be difficult to re-sell. The primary downsides of 100 percent ownership are the three T’s: tenants, trash and toilets. The advantages of TICs include: high leverage (pre-packaged by the sponsor), institutional properties with credit-worthy tenants, predictable cash-flow, and no management obligations. The primary disadvantages include high loads, lack of liquidity, unscrupulous sponsors, risk of partnership treatment, and the nature of the TIC itself (it can be burdensome). Further, TIC investors generally must be accredited investors, meaning they must meet certain income or net worth thresholds. For many investors, the advantages of TICs outweigh the burdens.

Ideally, you should look at as many TIC options as possible. They are not all the same and vary wildly in terms of property type and class, returns and security. To get in the loop, you need to select a qualified securities broker/dealer (the majority of industry professionals view TICs as a securities, not real estate, due to the pre-packaged nature of the investment). Your broker should have experience with TIC transactions and with real estate investments in general. Proper investigation of a TIC investment can be expensive, and the level of investigation may vary with the level of investment. Considerations include:

• Investor Considerations. Is the investment suitable for you given your risk profile? Are you investing discretionary money or do you need the return to live on? Should you diversify into more than one TIC investment?

• Property Considerations. Are you familiar with the property type being offered? Have you performed due diligence on the property, including reviewing third party reports, visiting the property, talking to the sponsor and reviewing the private placement memorandum (PPM)? Are you satisfied that the economics of the deal are as represented? Have you investigated the leases? Will you receive title insurance for the full purchase price? Have you reviewed the loan documents? What recourse carve-outs have you agreed to? Do not rely exclusively on the PPM, as it is primarily a marketing tool compiled by the sponsor or its representatives. 

• Securities Law. Most TIC deals are sold as securities, meaning the sponsor must either register the offering or find an applicable exemption. At a minimum, you should determine whether you are investing in a securitized or non-securitized TIC.  

• Tax Law. This is a big one. The reason you are purchasing the TIC interest is to complete a 1031 exchange. In order for your exchange to qualify, the TIC interest must be considered real property and not a partnership interest. Key tax considerations include:

1. Compliance with Revenue Procedure 2002-22. Recently, the IRS issued Revenue Procedure 2002-22 as guidance regarding the line between a partnership and a co-ownership arrangement. It is not substantive law, but provides insight into factors the IRS considers relevant. Ideally, a TIC offering should comply with all facets of the Revenue Procedure. However, some deviation is common. At a minimum, you should satisfy yourself that the deal is limited to no more than 35 investors who will hold their interests as tenants in common under state law; that certain material decisions (like selling, refinancing or leasing the property) require unanimous approval; that the investors agree not to treat or report the arrangement as a partnership; that investors share all income, expense and debt on the property in accordance with their undivided interests; that call options are at fair market value; that the investors covenant to undertake no business activities, other than “customary activities,” on the property; and that the sponsor receives no back-end interest in net profits. Most of these items are covered in the TIC Agreement, which you should read thoroughly.

2. The Tax Opinion. The sponsor will receive a tax opinion (preferably from reputable tax counsel) that the interests being offered “should” be considered interests in real property. Investors generally may rely on this opinion. A “should” opinion is the industry standard. A lesser opinion, such as a “more likely than not,” means the investment carries higher tax risk. Investors need a tax opinion in order to avoid penalties if the investment ultimately proves to be a partnership interest. However, due to recent IRS rules, a “marketed opinion,” such as a TIC tax opinion, will contain a disclaimer stating that investors may not rely on that opinion to avoid penalties. This disclaimer largely eliminates any protection from penalties that a tax opinion otherwise provides. To obtain that  protection, consider seeking an opinion from your own tax advisor that your investment in the TIC interest qualifies for 1031 exchange treatment. Your advisor may incorporate the sponsor’s opinion into his analysis.

3. Separate SPEs? The lender generally will require investors to invest through a special purpose, bankruptcy-remote entity (SPE). Married investors who will hold their SPE as community property may use a single SPE to acquire their TIC interest, provided they do not treat it as a partnership for tax purposes. For non-community property marital regimes, each spouse needs his or her own SPE. 

Overall, TICs are a marvelous vehicle for continuing to invest in real estate, deferring tax on the gain from selling real estate, and avoiding the management headaches of owning real estate. However, potential TIC investor should carefully think through the pluses and minuses of a TIC investment. Any investment has its downsides, and you should make sure that the benefits of a TIC investment outweigh those downsides.

Kevin Thomason is a partner and Todd Keator is an associate with Dallas-based Thompson & Knight LLP.

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