FEATURE ARTICLE, SEPTEMBER 2005

THAT CREATIVE GENIUS CALLED THE IRS
In the past few years, the IRS has changed the 1031 market by inventing TICs and DSTs.
Joseph B. “Jay” Darby III

When you identify the creative geniuses whose ideas and inventions drive the modern economy, you don’t normally think of the Internal Revenue Service (IRS).

Yet a strong case can be made that the IRS has been the dominant, innovative force that almost single-handedly created the multibillion dollar like-kind exchange industry. Move over Thomas Edison and Henry Ford: The commissioner’s in town.

What the IRS did, starting with the so-called “Starker” regulations in 1991, was to liberalize dramatically the mechanical requirements of a tax-free like-kind exchange under code section 1031, and thus make it increasingly easy for taxpayers (especially real estate-owning taxpayers) to complete tax-free reinvestment transactions.

Before 1991, the conventional wisdom was that like-kind exchange transactions had to be structured as true “exchanges,” which generally meant that you had to convince the buyer of your property, or the seller of the property you wanted to purchase, to “help out” by purchasing and transferring a property he had no interest in owning, while agreeing to sign, as your surrogate, deeds, promissory notes, mortgages and all kinds of other scary documents. Talking another party into playing this role was no easy task: It was like trying to convince someone you barely knew to donate a kidney.

The Starker regulations largely eliminated this problem by letting taxpayers hire a “qualified intermediary” who, for a fee, could accept the assignment and transfer of your existing property (the relinquished property), sell it, and then use the sale proceeds to buy your new property (the replacement property). Implementing a like-kind exchange went from hopeless to easy almost overnight.

However, in many cases a taxpayer needed to acquire a replacement property before he had found a buyer for the relinquished property, a transaction known as a “reverse Starker.” An unsolvable problem? Not to those outside-the-box thinkers at the IRS. In Rev. Proc. 2000-37, the IRS provided guidance on how to implement a reverse exchange, also known as a “parking lot transaction,” by permitting a taxpayer to hire an “exchange accommodation titleholder” to take title of either the replacement property or the relinquished property and hold it while the taxpayer negotiated and closed the other leg of the transaction.

After the IRS gave its blessing to reverse exchanges, perhaps the biggest remaining obstacle to completing a like-kind exchange of real estate was finding a suitable replacement property. In like-kind exchange parlance, all real estate is “like kind” to all other real estate, and so (unlike almost all other property exchanges) the challenge is not finding “like kind” but rather “right size.” In particular, taxpayers are generally seeking replacement real property with the following characteristics:

1. It must be a good investment property.

2. Most exchangers are looking to invest the smallest amount in replacement property that is required to entirely avoid recognizing any taxable gain in the exchange. This means, for example, that if a taxpayer sells the relinquished property for $1,386,472.95, he generally wants to acquire a new (replacement) property with a purchase price of — take a wild guess — $1,386,472.95.

Complicating this exercise is the fact that there are two “boot” rules that need to be met simultaneously in order to avoid all gain on the exchange. First, all proceeds from the sale of the relinquished property need to be reinvested in the replacement property, or otherwise spent on qualifying expenses. Second, the mortgage debt on the replacement property has to be equal to or greater than the debt on the relinquished property.

Thus, if a taxpayer sold relinquished property worth $2 million and carrying a $1.2 million mortgage, he would net $800,000 in proceeds, and would then need to acquire new (replacement) property with at least $800,000 of equity and at least $1.2 million of debt – and, of course, would need to select a good investment, identify it in 45 days and close in 180 days. Closing the replacement leg of an exchange is rarely easy, especially in today’s tight real estate market. An estimated $4 billion in like-kind exchanges were “blown” in 2004 because exchangers could not identify and close on suitable property within the 45-day/180-day limits. 

As any problem solver will grasp, one obvious solution to finding suitable replacement real estate is to fractionalize, meaning to create a fractional interest in a larger parcel of real estate that meets both the quality requirements and reinvestment parameters of the exchanger. There are plenty of tried and true methods of fractionalizing real estate, from limited partnership interests to LLC interests to REITs. The problem is that code section 1031 expressly bars from exchange treatment virtually all the common methods of fractionalized real property, including stock, bonds, notes, securities, debt, interests in a partnership, certificates of trusts or beneficial interests, and chose in action.

Enter the Edisons of the IRS.

In 2002 and 2004, the IRS basically invented two distinct methods of fractionalizing real estate that work for 1031 purposes, the first involving tenancies in common (TICs) and the second involving Delaware Statutory Trusts (DSTs). Both are new, innovative techniques that can be used to create right-sized products to meet the high demand for 1031-eligible replacement property.

The TIC structure was addressed by the IRS in 2002, and thus far it has been the more developed and tested alternative in the market place. In Revenue Procedure 2002-22, the IRS provided guidelines on factors it would require to rule that an arrangement qualified as a TIC. For the first time, taxpayers had substantial guidance on how a large group of co-owners (up to 35) could co-own and operate real estate and still be viewed as a co-ownership and not as a partnership.

Rev. Proc. 2002-22 offers helpful information, but is by no means a free pass. TIC interests are both complicated to create and awkward to own, with reams of paperwork and an operating structure that has plenty of potential for instability and risk.

Given the insufficiencies of the TIC structure, the IRS put back on its thinking cap and, in 2004, issued Rev. Rul. 2004-86, a ruling in which the IRS concluded, on specific facts, that a beneficial interest in the DST holding real estate would be treated as qualifying real property for 1031 purposes.

Which of these two innovations is the better approach? The quick answer is that each of them is a bit of a Frankenstein. Neither is particularly easy to implement, and each has distinctive characteristics that may be suitable in one situation and not in another. Therefore, it is useful to describe each fractionalization method in more detail and then address their respective uses.

TICs Under Rev. Proc. 2002-22

In 2002-22, the IRS outlined 15 specific criteria that it would require in order to rule that an arrangement was a TIC. Some of the important requirements include the following:

• Each co-owner must hold title as a tenant in common under local law.

• The number of co-owners cannot exceed 35.

• Co-owners cannot file a partnership tax return or hold themselves out as partnership.

• Owners can enter into a co-ownership agreement, but it must meet a variety of requirements, including that major decisions such as selling, leasing the property, or negotiating mortgage debt must require unanimous approval of all co-owners. Most lesser decisions can be made by majority vote.

As a practical matter, TICs are cumbersome because each owner possesses (and indeed must possess) the rights of a tenant in common, including the right to seek a partition of the property. The banks financing TICs generally require each TIC investor to invest through a single-member LLC (a disregarded entity for federal income tax purposes) that is structured as a special-purpose entity to prevent the property and the loan from becoming ensnared in a bankruptcy of the underlying owner. As a practical matter, most TIC deals find that the right level of participation is approximately 15 to 20 participants, in part because of the desire to keep the group from becoming any larger and more unwieldy than necessary.

To prevent TIC co-owners from holding each other hostage, the TIC agreement typically grants options so that co-owners can be bought out at fair market value under certain circumstances. For example, if 80 percent or more of the TIC owners vote to sell the property, they can buy out the dissenters. Nonetheless, TIC investors do have a significant ability to create ripples if they are dissatisfied.

DSTs Under Rev. Rul. 2004-86

The DST performs the same essential functions as a TIC — fractionalizing real estate — but in a dramatically different manner.

A DST holds title to real property in the name of the trustee. Thus, where a TIC may have 15 to 20 co-borrowers on the loan, with each holding title as a co-tenant, a DST has a single title holder and borrower — the trustee. The value of this difference can be measured at the closing, almost literally with a ruler: The closing binder on a TIC deal is probably triple the size on a DST deal.

The principal drawback of a DST is its lack of operating flexibility. The DST has to be an “investment trust,” which means the trustee cannot have the power to vary the investment. This means that, as a practical matter, the real estate held by the DST must be leased to a third party under a triple-net lease for a term equal to the term of the DST, and the deal is thereafter set in concrete.

A DST is barred from taking advantage of market opportunities. Thus, if there is an opportunity to refinance the mortgage at a lower cost or renegotiate the master lease on more favorable terms, the trustee must forego the opportunity. Even more alarming is the fact that, if there is a distress event, for example, if the master lessee is in financial trouble or default, the trustee cannot take normal prudent actions to renegotiate the lease or work out the relationship. The current solution is to provide for a so-called “springing LLC” whereby the assets of the DST are dropped into an LLC (or other entity) so that the parties can then take remedial actions to protect the property. This is hardly an ideal operating arrangement.

Finally, here is very little IRS guidance on a number of issues that arise in the practical implementation of a DST, since the DST ruling is only about a year old.

Which is Better?

Neither the TIC nor the DST is particularly flexible, and it is fair to conclude that neither would be a popular real estate vehicle absent the limitations in code 1031, which exclude partnership interests from eligibility in like-kind exchanges. That said, TICs and DSTs are both practical, or at least potentially workable, in specific circumstances:

1. TICs holding property under a management agreement allows the investors to enjoy the full income from a property, subject to the management fees, and generally produces a better return than a triple-net master lease (which is required for a DST).

2. TICs can also deal directly with distress situations. By contrast, DSTs limit the trustee’s powers, and force the use of “springing” arrangements to address emergencies.

3. TIC owners have rights to partition, and various other powers, which some investors feel gives them more control compared to DSTs.

4. DSTs, on the other hand, are inherently simple pass-through structures where the investors own real estate but essentially are buying the credit worthiness of a long-term master lessee. DSTs work well if the property is leased to a strong tenant under a long-term lease, such as 10 or 15 years.

5. Conversely, the DST structure does not work well if the property is likely to have management challenges, risk of distress, or other factors that would require some type of management or ownership response.

In summary, both TICs and DSTs are works in progress. As usual, good inventions are picked up and advanced by others in an ongoing process of improvement: The Wright Brothers, after all, invented the airplane but not the jumbo jet. Today, many capable people in the real estate industry are working hard to take the IRS’s two latest inventions and adapt them to the needs of the marketplace.

Jay Darby is a tax attorney with Boston-based firm Greenberg Traurig.

©2005 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.