Broker Check

TIC Talk, or, Another Side of the 1031 Story

5/1/2003

By: Richard Chess,* Regional Vice President of Eastern Markets - Triple Net Properties, LLC

The eighty plus year evolution of like-kind exchanges of real estate under the federal tax code has been covered in a prior issue of this publication by Louis J. Rogers, a partner at Hirschler Fleischer. Deferred exchanges became accepted by litigation in the 1970s and were codified in the late 1980s (45 days to identify, 180 days to close). Use of a tenant-in-common ("TIC") structure to accomplish like-kind exchanges became popular on the West Coast in the mid-1990s. In late 2010, DST's took hold as the leading alternative Real Estate Investment Structure. Work by Rogers, the "Dean of 1031s," and others resulted in official acceptance in 2002 of the TIC structure by the IRS as reflected in the fifteen-point "guidelines" of Rev. Proc. 2002-22. Now, Rogers, Louis is the founder of Capital square Realty Holdings in late 2009 offering properties under the DST structure, codified by IRS into law under Revenue Ruling 2004-86. 

Raising equity in a DST format has become a multi-billion dollar a year business. What are the business and economic forces driving what has been exponential growth over the past three years of TIC like-kind exchanges under Section 1031 of the Internal Revenue Code? How may this "sized to fit" approach to like-kind exchanges impact your legal practice in Virginia? Where are some of the potential "land mines" (e.g., unregulated Qualified Intermediaries) that could derail the TIC business?

A. BUSINESS AND ECONOMIC FORCES

1. Crash of the Stock Market

For more than five years, the rising tide of Wall Street raised the value of most stock portfolios. Since early 2001, when the "crash and burn" of major technology and telecommunications companies was followed by a general weakening of the U.S. economy, nearly all stock portfolios have been dramatically reduced in value.  Investment grade real estate is one of the few investment classes benefiting from the down turn in the stock market (note the strong growth in the price of publicly traded real estate investment trusts ("REITs"). Traditional real estate syndication, thought by many to have died with the 1986 Tax Reform Act, is again a HUGE business. Wells, an Atlanta based real estate firm, raised over $1 billion in 2002 for their private real estate investment vehicles.

2. Real Estate Markets Weaken

The accelerate flow of investment capital into real estate is pushing up the price of institutional quality real estate. This escalation of price is occurring at the same time when the business fundamentals for commercial real estate are weakening. William W. Reynolds, SVP, CB Richard Ellis, notes that, "Office vacancy in A grade' properties has been in the double digit range for the last eighteen months. Vacancy is substantially higher in B' and C' grade office markets." Retail economics have been rocked by high profile bankruptcies (e.g., Kmart). Only two of forty apartment acquisition officers, meeting mid-April in New Orleans at a conference of the National Multi-Housing Council, anticipate growing the portfolio of their firms due to perceived overpriced properties coupled with a flat market due to a lack of job growth in their target markets.

3. Fear and Aging

Recognition by some investors that the "gravy years" of the economy are behind us has resulted in a huge increase in the number of "sub-institutional" size properties (less than $10 million in value) coming to the market. These investors, in the words of one in Alexandria, are determined NOT to be the "last train out of town." They also don't want to lose 20 to 30 percent of their gain on sale to taxes, so a like-kind exchange is attractive. On the other hand, many of these investors are of the "baby boom" generation, where "time to live" has become more important than "portfolio to grow." They don't want to continue to manage a property.

4. Lack of Net Lease Alternatives

For the investor wanting to delay recognition of capital gains and hence a current payment of a capital gains tax, and also wanting to move away from property management, a like-kind into a net leased property (tenant pays for all building related expenses) has been an attractive alternative. Demand for this type property has exceeded availability for several years. Yields have dropped into the low single digit. The bankruptcy of several major retail and pharmacy firms has resulted in some lenders pulling away from this product. The size of the required investment seldom matches exactly the equity available from the investor.

5. DST of Real Estate in a Syndicated Format

A Google search on the internet of "1031" and "like-kind exchange" results in over 1200 listings of firms offering services. The dominate groups are real estate brokers (for direct sale of real estate), qualified intermediaries (required by the IRS to hold the proceeds of the sale), and registered representatives (who sell DST investments in a security format). There are fifteen real estate firms listed which offer access, at least on a regional basis, to syndicated DST investments of commercial real estate. Office building DST sponsors (e.g., Triple Net Properties) offer access to institutional quality multi-tenant properties in a "sized to fit" investment unit. Shopping center sponsors (e.g., Passco) offer access to retail properties typically with an anchor tenant on a long-term lease. Apartment sponsors (e.g., RK Properties) divide their properties into individual building tracts so that the resulting investment unit is sufficiently small to accommodate the investor with less than $200,000 equity. A registered representative may have access, at any given time, to 10-20 properties of different types and in multiple markets and at a range of investment unit sizes. While there are numerous risks to a DST investment (see below), DST sales are rapidly increasing due to an increased demand for real estate investments that fit the size, location, product type, and no management needs of an aging population. Add to that mix a national sales force exceeding 100,000 registered representatives in various investment firms and registered representatives who are searching for a product to replace the income they once received for selling stocks, bonds, and mutual funds and the potential for frenzy in the marketplace becomes apparent.

B. IMPACT ON LEGAL PROFESSION

1. Basic Rules

To accomplish a like-kind exchange, your clients must establish prior to their sale their intention to do a like-kind exchange (typically a paragraph added to the purchase and sale agreement) and to have entered into a written agreement with a qualified intermediary who will hold the proceeds of the sale. Once the sale is completed (of the "Relinquished Property"), your client has forty-five (45) days to identify in writing with specificity (use the address of the property) to the qualified intermediary what properties your client intends to purchase. Generally your client will either identify up to three (3) properties of any value OR they will identify an unlimited number of properties as long as the total value of all the identified properties (or that portion that the client proposes to own) does not exceed twice the sale price (less closing expenses) of the Relinquished Property. Your client must close on properties from the list received by the qualified intermediary within one hundred eighty (180) days of the sale of the Relinquished Property. In order to fully delay recognition of gain on the original sale, the acquired properties in total must equal or exceed the net proceeds, total debt and total cash proceeds received from the sale of the Relinquished Property. Any portion not covered ("boot") is taxed by the federal government 15% on gain due to an increase in value and 25% on gain due to depreciation. Most states (for instance, Virginia) apply a tax on the full amount of the gain.

2. Attorney Disqualified as Qualified Intermediary

The IRS Final Rules and Regulations on Delayed Exchanges (effective June 10, 1991) define what "disqualified person" can NOT serve your client as a qualified intermediary. Specifically disqualified is the investor and broadly defined "related parties." A party is disqualified to serve as a qualified intermediary if, within the two years preceding the sale of the Relinquished Property, they served the investor as their employee, ATTORNEY, real estate broker or agent, investment banker or broker, or accountant. There is an exception to the disqualification if the party only provided routine financial, trust, title insurance, or escrow services, or services solely with respect to the exchange of property.

3. Attorney Role in Selection of Qualified Intermediary

There are five national qualified intermediary firms. Four are associated with title insurance firms (Fidelity, First American, LandAmerica, Stewart Title) and one is exclusively involved in like-kind exchanges (Starker). Several national banks (e.g., Wachovia) have made strong moves to grow in this business. Since there is NO regulation of qualified intermediaries, it may well be best to guide your client to working with a national firm with deep pockets and substantial experience.

4. Attorney Role in Selection of Real Estate

Unless the client is specifically paying the attorney to review the client's real estate investments, the attorney is best served referring the client out to more than one real estate broker and more than one registered representative, and documenting to the client that the attorney is NOT providing assistance to the client in real estate selection. The Virginia State Bar has already received an ethics complaint against an attorney who, the client claims, failed to properly assist the client in the attempted acquisition of replacement property for a like-kind exchange.

5. Limited Transferability of a TIC Interest

While a TIC investor has the right, in a program reflecting the guideline of Rev. Proc. 2002-22, to sell their investment unit, the lender on the property may restrict free transferability. There is no ready secondary market for TIC investment units, so even with lender approval, there may be no buyers or no buyers without a significant discount of price.

6. Limits on Access to TIC Investing

Sponsors of TIC programs require, with few exceptions, that investors be accredited have a net worth in excess of one million dollars or have an annual income for the last two years of $200,000 (or $300,000 including the income of a spouse).

The size of the minimum investment is driven by:

a) the fully loaded cost of the property being acquired;

b) the amount of debt the lender will place against the property;

c) the number of TIC units allowed by the lender; and,

d) in some cases, the number of special purpose entities allowed by the lender.

A loan on a TIC property can be securitized and sold on Wall Street IF the rating agencies are comfortable with the TIC structure (in addition to all their other underwriting criteria). Because of rating agency issues, or if the loan must be carried on the books of the lender, most lenders through third quarter of 2002 limited the number of TIC investors to ten. Increased competition for the loans and some enlightenment of the rating agencies is resulting in some lenders allowing up to the full 35 TIC positions allowed under Rev. Proc. 2002-22.

The strongest demand for TIC investments has been in the $200,000 to $400,000 range. Product sponsors are finding that programs offering investment units in this range, assuming that the underlying real estate and market are attractive, are selling out in less than ten business days. Your client needs to juggle both the forty-five day identification period imposed by the IRS and an access to product timetable (whether TICs, net lease properties, or other direct ownership of assets) which at times can be daunting.

C. POTENTIAL LAND MINES

1. Qualified Intermediaries

The fees for a standard deferred like-kind exchange have dropped for most companies to the point that, without significant volume (over one thousand exchanges a year), it has become difficult to justify being in the qualified intermediary business except as a "lost leader" to acquire other business. A few investors have experienced single person qualified intermediaries disappear with the proceeds from the sale of the Relinquished Property. Some smaller qualified intermediaries have gone to becoming a registered representative and selling TIC product directly to their customers. A bill has been introduced in Congress which proposes to eliminate the forty-five day identification period and the need for a qualified intermediary.

2. Delaware Statutory Trust

A Delaware Statutory Trust ("DST"), if designed to meet the requirements of Rev. Proc. 2002-22, could solve the rating agency issue raised above. For the purpose of the loan, there would be one entity, and the loan would likely be underwritten as any other loan for securitization purposes. The Trust would need to be a pass through entity that did not exist for tax purposes. The IRS has given assurance in direct meetings with counsel for sponsors that a DST, properly structured, could be an acceptable vehicle to accomplish a like-kind exchange. Unfortunately, in a public meeting in February 2002, a regional representative of the IRS stated that use of a DST would result in an audit and a likely disallowance of the tax deferral. A Rev. Proc. regarding the DST issue is anticipated from the IRS by the end of first quarter 2004. In the interim, demand a strong detailed legal opinion from the counsel for the sponsor.

3. TIC Property Issues

The pool of institutional quality real estate which will work for a TIC transaction is limited. Above a certain size, the fully loaded purchase price less the debt the investing public will accept (generally around 60%), results in an investment unit size too large for most investors. Smaller properties may solve the investment unit size challenge, but generally do not have high quality tenants with long-term leases. If a property is encumbered with debt which has previously been securitized, it is unlikely that the current holder of the debt will approve transfer to a TIC group of investors.

Only a handful of the TIC sponsors have a track record which includes the SALE of properties. In commercial real estate, until a sponsor demonstrates an ability to repeatedly take the properties full cycle (buy, lease, manage, and then sell), it is impossible to determine their ability to replicate success with the subject offering.

The TIC sponsor, under Rev. Proc. 2002-22, may NOT participate in the back end increase in value of a property as they would if they were a sponsor of a limited partnership. Are the fees structured in a TIC program where the TIC sponsor earns its fees primarily when the TIC investors make the money (e.g., a real estate brokerage fee on sale can align the interests; a flat asset management fee, on the other hand, is paid no matter how well the property is operated)?

D. SUMMARY

Your clients are looking for an alternative to paying capital gains taxes on the sale of their real estate held for investment. Investing in a TIC ownership of real estate may give them the "sized to fit" investment unit they need and provide that investment within the time frames set by the IRS to identify properties. Progress on the DST format will further fuel the growth of this means of solving the like-kind exchange challenge.

*Richard B. Chess is Of Counsel at FutureLaw, L.L.C. in Richmond, Virginia and Director of the 1031 Transactions at Triple Net Properties, a Santa Ana, California based real estate firm. He serves as an Area Representative and a Subcommitte Member for the Commercial Real Estate Subcommittee, Land Use and Environmental Subcommittee, and Programs Subcommittee of the Real Property Section of the Virginia State Bar.