The Howey Test, a way to determine whether a transaction is an investment contract and, therefore, a security, is an important element in a tenants-in-common (TIC) 1031 exchange. Since TIC agreements pass the Howey Test, they must receive a “private letter ruling” from the IRS before they can be used in a 1031 exchange. Investors entering into TIC agreements should understand the significance of the test for them and keep in mind the importance of registering their agreements properly.
What Is the Howey Test?
The Howey Test resulted from the case of the SEC v. Howey, which was heard by the U.S. Supreme Court in 1946. The case established criteria to define an investment contract, which is a security (i.e., an investment product that can be exchanged for value and involves risk) according to the Securities Act of 1933 and the Securities Exchange Act of 1934. Securities are subject to SEC regulation, and it is a crime to sell securities in the United States that have not been registered with the SEC.
Under the Howey Test, which is applied on a case by case basis, a transaction is an investment contract if it meets three criteria:
- It is an investment of money in a common enterprise.
- The investment is made with the reasonable expectation of profits.
- Those profits are derived from the entrepreneurial or managerial efforts of others.
The test was formulated to filter out investment contracts on the basis of economic reality, rather than labels. In other words, regardless of what a transaction is called, if it passes the Howey Test, it is an investment contract.
How the Howey Test Affects Your Tenants-in-Common Agreement
Owners have an undivided fractional interest in a property under a TIC agreement. Co-owners share ownership and have the same rights as a single owner would, even though they may have unequal shares that were obtained at different times. Crucially, TIC properties have managers, so they meet all the criteria of an investment contract under the Howey Test.
A TIC agreement allows smaller investors access to institutional-grade real estate by making it possible for them to own small shares in it. Co-owners of TIC properties can sell their shares without the permission of other co-owners. Additionally, shares can be passed on to heirs when a co-owner dies. These points distinguish a TIC agreement from a partnership agreement.
Use of the TIC agreement increased massively after 2002, when the IRS published a revenue procedure that makes it possible for shares in TIC properties to participate in 1031 exchanges. Prior to 2002, owners could sell their shares in a TIC property, but if those shares were registered as securities, in accordance with the Howey Test, they were ineligible for a like-kind exchange with real estate. Today, an investor can receive a “private letter ruling” from the IRS, provided the TIC agreement meets 15 conditions listed in the revenue procedure. A private letter ruling takes time to prepare and can cost a considerable amount of money.
SEC regulations still apply to a TIC agreement after a private letter ruling, although those regulations are limited to trades made across state lines. State securities laws, often called “blue sky laws,” apply to those transactions as well, and to intrastate trades. State laws on securities vary and can be quite restrictive. To ensure a successful transaction, owners of TIC shares should be aware of the laws of their own state, as well as those of the state where the buyer/exchanger is located.
A tenants-in-common 1031 exchange is an exceptionally complex transaction with multiple steps and risks, and is therefore best entrusted to experienced professionals.
CWS Capital Partners is a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country and employ a team of experts who can help you hone your investment strategy.
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