FEATURE ARTICLE, MARCH 2005
THE TIC DRAWBACK
Involving real estate brokers in TIC sales would be a win-win situation.
Stephen A. Wayner, Esq., C.E.S.
As new real estate investment vehicles evolve, the industry becomes more accessible to investors and more complicated for real estate professionals. Tenancy-in-Common (TIC) investments are a prime example of this in today’s industry. TICs, which make expensive real estate investments accessible to groups of people who couldn’t afford the investments individually, are complicated because they are treated as both real estate and as securities. The conflicting definitions affect the brokers trying to sell TIC shares and therefore affect the pool of buyers interested in TICs.
“TIC” stands for Tenancy-in-Common. When I went to law school some 35 years ago, Tenancy-in-Common was defined as an ownership of real estate between two or more parties (or tenants). In 2002, Internal Revenue Procedure (Rev. Proc.) 2002-22 set out guidelines for a new definition of a Tenancy-in-Common. The IRS redefined the shared ownership of real estate not as a partnership but rather as an ownership in an "undivided fractional interest."
Since the IRS does not like to use the term "syndication," it now allows a "sponsor" to put together a TIC transaction following the guidelines set forth in Rev. Proc. 2002-22. The TIC sponsor acts as the "syndicator" and puts the deal together. The sponsor purchases the real estate that will be divided into individual TIC interests, hires the attorneys to prepare all of the necessary legal paperwork for purchase and securitization, hires and reviews all necessary property inspections, prepares financial projections, hires the necessary sales force to sell the TIC interests, and negotiates all leases and management services.
Each co-owner in a TIC must hold title to the property as a tenant-in-common under state law. The number of co-owners is limited to 35 and the co-ownership may not file a partnership return. The co-owners must collectively retain the right to unanimously approve the hiring or retaining of a manager as well as the sale or lease of all or a portion of the property. Additionally, the co-owners share in the proceeds and liabilities upon the sale of the property as well as all profits and losses.
An investor has less responsibility for managing the property if he is a co-owner in a TIC than he would have if he owned the property outright. In most non-TIC scenarios, the investor personally handles all management concerns relating to his investment real estate. The investor hires the repair personnel; pays the bills; interviews the prospective clients; deals with attorneys, real estate brokers, mortgage lenders and repair companies; collects rents; and deals with tenant evictions. With a TIC investment, the taxpayer/investor generally hires other parties to handle these areas of concern. Additionally, a taxpayer/ investor is usually able to “upgrade” by purchasing a TIC interest in a much larger transaction utilizing a 1031 exchange transaction. For example, a taxpayer/ investor may sell a $600,000 property in the first phase of a 1031 exchange. In the second phase of the exchange, the investor can then purchase a TIC interest for $600,000 and own a 5 percent undivided interest in a larger building valued at $12 million — and the investor reduces the amount of work involved with the ownership of real estate.
Defining TICs: Real Estate or Security?
The IRS defines a TIC as real estate, but defers to individual states’ definitions of real estate. For example, a 30-year lease in the state of Florida is defined as a piece of real estate, while another state may define a 20-year lease as a piece of real estate. However, the Securities and Exchange Commission defines the TIC structure as a security because it produces income through the efforts of others.
As a result of the IRS defining an investment as a piece of real estate and the SEC defining that same investment as a security, there is a conflict. On the one hand, the SEC requires that a securities broker/dealer sell property considered a security. On the other hand, each state has separate requirements relating to the sale of real estate and the licensing requirements therein.
Currently, a TIC sponsor either hires a securities broker/dealer to sell its TIC interests or opens it up to a number of securities broker/dealers to sell the TIC interests. But there is pressure from real estate brokers to make them part of the process. Right now, real estate brokers get a commission when they sell the real estate to the sponsor, but they are left out in the rest of the process. For example, an investor decides to sell the investment real estate he has owned for a number of years. He concludes the sale using a Qualified Intermediary and completes a tax-deferred exchange under Section 1031 of the Internal Revenue Code. Then he decides to purchase a TIC interest as a replacement property in the second phase of the 1031 exchange. The investor may want to enlist the help of the real estate broker, who sold his previous investment, but that real estate broker will not be able to obtain real estate commissions for the purchase of the TIC interest. The sponsor is selling the TIC interest as a security — and only securities broker/dealers can earn commission on the sale of a security. The only real estate commission that would be earned by a real estate broker is when the piece of real estate that has been “TIC'ed” is initially sold to the sponsor. Because the SEC deems the TIC a security, a real estate broker would not earn commission on the sale of the individual TIC interests.
While real estate brokers would clearly benefit from the opportunity to participate in the sale of TIC interests, the TIC industry would probably also benefit. Involving real estate brokers in the process would open up the TIC industry to many more TIC investors. Real estate brokers would be more likely to suggest TIC investments knowing they might see a commission from the transaction.
The TIC industry is in its infancy. Its increase in popularity has intensified during the last 3 years. There are approximately 200 TIC sponsors in the industry now. With real estate brokers involved, that figure could quadruple every couple of months. The industry has already exploded and will be growing either way.
The Exception: An Opinion Letter
Occasionally, TIC interests are treated as real estate rather than as securities. Only about 10 percent are treated as non-security property, but a few TIC sponsors have obtained legal opinions from their law firms stating that the TIC interests they are selling are interests in real estate and not securities. A CPA or attorney can give an opinion letter describing the particular situation at hand and giving an opinion as to how the law will look at that situation. The client can rely on this opinion, and, often, should that opinion be incorrect, the client can seek to obtain damages from the party that gave the opinion.
Generally, a sponsor would rather have its investment property defined strictly as a piece of real estate, bypassing the costly and time-consuming securitization process. As the law exists today, if I were an investor, I would want my CPA and/or tax attorney to give me an opinion as to whether my investment should be considered a piece of real estate or whether it could be interpreted as a security. The majority of TIC sponsors claim TICs are securities and go through the extra paperwork and expense to have their TIC interests qualify as both.
In order to qualify as a security, the project must comply with the rules and regulations set out and governed by the Securities and Exchange Commission. The filing requirements are arduous, expensive and time-consuming. They are very protective of the investor and were initially set up to protect the investor from fraud and misrepresentation. While it is generally safer for an investor to invest in a TIC as a security, it will probably cost less and therefore be more profitable to invest in a TIC treated as real estate.
Securitization is a costly and time-consuming process. If the TIC interest can be qualified only as an interest in real estate and not as a security, the sponsor can save a lot of securitization fees, attorney's fees and costs. The sponsor can offer the product at a lower price and higher profit potential.
Expense is definitely a factor for requesting an opinion letter that allows the sponsor to treat a TIC as real estate and not as a security. It certainly gives the non-security TIC an advantage as to costs on the transaction. Another factor may be the timeframe — it takes more time to complete the paperwork on a security TIC than on a non-security TIC. Finally, it may be easier to sell a non-security TIC as there is not as much paperwork that must be explained to the taxpayer/investor nor as much paperwork that should be reviewed by the taxpayer/investor’s financial advisor.
Changes in the Near Future?
As long the SEC takes the position that TICs are securities, there will always be a need for a securities broker/dealer in the transaction. Right now, only a small number of securities broker/dealers are active in this new industry but they are learning. The same is true for real estate brokers. The more knowledge of the industry, the more pressure from both sides of the equation.
The IRS may try to put pressure on the SEC to allow real estate brokers to be part of the transaction. Alternatively, real estate brokers may take matters in their own hands and obtain securities broker/dealer licenses so they have access to the deals in this new industry.
Stephen A. Wayner, Esq., C.E.S, is vice president of Bayview Financial Exchange Services in Coral Gables, Florida.
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