Insights

TenantsinCommon_390x288

As it turns out, tenants-in-common arrangements may become the subject of 1031 exchanges. If you’re a real estate investor considering using your tenants-in-common property in an exchange, it’s helpful to know the specific 1031 exchange rules.

 

Tenants-in-Common Property 1031 Exchange Rules: Determining Section 1031 Eligibility

Jun 08, 2017

I was talking recently with my neighbor about a timeshare he owns near Sacramento. His work schedule had been intense for years, and the property offered a getaway spot for him and his family. Now that he was retired, though, his family had less of a need for the property, and he was considering selling it. He didn’t know it was possible to relinquish the property (assuming he holds legal title to the property) under section 1031 and exchange it for a commercial real estate investment. As we talked, it got me thinking about how many investors don’t know how co-owned real estate fits into the 1031 exchange process, but they should.

When people think of real estate ownership, generally they think of just a single owner to a fixed piece of property. Ownership by a sole individual is the most common kind of ownership, so it’s no great surprise this is the image that comes to mind for most people. But though this type of ownership may be the most common, it is certainly not the only kind of ownership relevant to you and other investors.

As it turns out, other ownership methods—such as tenants-in-common (TIC) arrangements—may become the subject of 1031 exchanges. In fact, TICs are becoming more and more likely to be used as part of a 1031 exchange. If you’re a real estate investor considering your TIC in an exchange, it’s helpful to be familiar with the tenants-in-common property 1031 exchange rules and how you can determine if your property is eligible for section 1031 treatment.

It’s also important to know that state law may impact TICs in more specific ways. A TIC 1031 exchange in California, for example, will often be shaped by both federal and state laws.

Understanding Tenants-in-Common Property Arrangements

A TIC is an ownership arrangement in which multiple owners share an undivided fractional interest in a piece of real estate. An undivided fractional interest basically means that, although each owner shares ownership with every other co-owner, co-owners share the same rights as those of single owners.

Co-owners of a TIC share in the net income generated by the TIC, and each co-owner receives a separate deed for his or her specific percentage of the property. In a TIC arrangement, co-owners have the right to alienate 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. TIC co-owners may hold an unequal interest in the property and may acquire their interests at various times. This is not the case with other joint ownership arrangements.

It is extremely important that you be aware of the distinction between TICs and partnerships. If a piece of real estate is classified as a partnership rather than a TIC it is generally not eligible to be exchanged under section 1031. Whether a given arrangement is classifiable as either a TIC or partnership is a case-by-case determination because oftentimes an arrangement overlaps with other arrangements.

For now, the key idea you should take away is that the IRS treats TICs differently because under a TIC arrangement, individual co-owners can transfer—and, therefore, exchange—their specific interest in real property freely, whereas this is typically not the case with other arrangements.

Revenue Procedure 2002-22 Minimizes Risk for Tenants-in-Common 1031 Exchanges

In response to a range of cases that dealt with section 1031 and co-owned real estate, the IRS issued Revenue Procedure 2002-22. Revenue Procedure 2002-22 is a series of conditions you must meet before you can request a “private letter ruling” from the IRS regarding the eligibility of your TIC for section 1031 treatment. The understanding is that, if you meet the conditions listed in this document, you will most likely be eligible to partake in a 1031 exchange and defer your capital gains and depreciation recapture tax liability.

The 15 conditions provided by 2002-22 are summarized in the table below:

Each co-owner is required under local law to hold title as a TIC.

Co-owners must be able to freely transfer, partition, or encumber their undivided fractional interest without prior consent from any other person.

Activities performed by co-owners must be consistent with those generally associated with ownership of rental property.

There can be no more than 35 co-owners.

Debt secured by the property following a sale must be paid and any remainder must be distributed to co-owners.

Management agreements with sponsors or co-owners cannot exceed one year and cannot be made directly with a lessee; agreements must be made unanimously among co-owners and manager compensation cannot exceed fair market value.

None of the co-owners can identify as an entity (essentially meaning none can file partnership or corporate returns).

Co-owners must share in the costs and revenue of the property in proportion to their interests.

All leases must be genuine leases for tax reporting purposes and rents must be set at rates consistent with the fair market value of the property.

Co-owners may enter into an agreement regarding the rights of co-owners to sell their interest prior to first offering their interest to other parties.

Co-owners must share in any indebtedness associated with the property in proportion to their interests.

Lenders that provide financing for the property to a co-owner may not be related to any co-owners, sponsors, managers or any lessee.

Co-owners must retain the right to approve property managers and also financing decisions concerning the property.

Any option to purchase made by a co-owner must have a price that is consistent with fair market value.

The amount paid to the sponsor to obtain an ownership interest in the TIC must not be inconsistent with the fair market value of the property.

 

These are just rough approximations of the provisions; they do not capture every nuance or detail.

If a TIC owner abides by all of these guidelines, they may request a ruling from the IRS. Although you should be aware that such requests can be quite expensive and time-consuming. In any event, be sure to seek out expert counsel on the likelihood of your TIC being eligible to receive 1031 treatment to avoid any unpleasant surprises.

What’s more, you need to familiarize yourself with the particular state laws that inform TIC 1031 transactions in the event that your transaction triggers state regulation.

How State Law Informs Tenants-in-Common 1031 Exchanges in California

As one example, California state law may impact a 1031 exchange that involves a TIC if the TIC is classified as a securitized offering rather than a real estate offering. A TIC may be used in a 1031 exchange in two different ways: It may be used as a securitized offering or as a non-securitized, straight real estate offering. For a variety of reasons, it is usually in your best interest to have your TIC packaged as a securitized offering when participating in a 1031 exchange transaction.

If your TIC is packaged in this way, your transaction will have to comply with both federal and California state securities regulations. You will also need to make sure that your intermediary has a securities license in addition to a real estate license. In short, California state (securities) law will apply in the event that your TIC is classed as a securitized offering.

Of course, Californians are not the only people in the United States who face state law issues when dealing with TICs. Many states have unique requirements. Working with a real estate investment management partner that specializes in 1031 exchanges and that has experience in your state can be a good way to ensure the transaction goes smoothly.

TICs are becoming increasingly popular real estate investments in the marketplace. As an investor, you should take the time to consider them as an option. CWS Capital Partners has a great deal of experience with TICs as part of 1031 exchanges and has helped investors in many states, including California and Texas. We would be glad to assist with your TIC 1031 exchange. Contact us today to get started.

 

The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.

All investments involve risk including the possible loss of principal. You should familiarize yourself with all risks associated with any investment product before investing.

Advisory services are provided by CWS Capital Partners LLC, a registered investment advisor.

Securities offered by CWS Capital Partners LLC are through an affiliated entity, CWS Investments. CWS Investments is a registered Broker Dealer, member FINRA, SIPC.


If you would like to receive an e-alert when a new blog article is posted, please sign up below.

E-Alert Lists