Articles

Preserving Wealth through the Use of IRS Code 1031 and Tenant-in-Common Investment Property

By: Neil L. Friedman

In today's turbulent real estate market, the need for a quality alternative investment strategy for replacement property has never been greater. Many real estate investors would consider selling their highly appreciated, actively managed property if only they were assured they could find a reliable source of suitable replacement property necessary to complete a 1031 exchange.

Active real estate investors who are tired dealing with tenants, toilets and trash; farmers who are selling land in the path of progress; entrepreneurs who are selling their business real estate holdings - all can preserve their hard-earned wealth by completing an IRS Code section 1031 tax-deferred exchange. With the help of a qualified intermediary, a taxpayer can exchange one property for another "like kind" property and defer the 15 percent federal capital gains tax, the 8 percent state of Minnesota income tax and the 25 percent depreciation recapture that would otherwise be due.

Those looking to take advantage of a 1031 exchange must be aware of its strict timelines, though. Investors must not only scramble to identify replacement properties of equal or greater value within the first 45 days of the exchange period; they must also hope to close on one or more of those properties within the remaining 135 days.

Since the overall 180 day exchange period is relatively short, some investors have discovered the tenant-in-common (TIC) market as a ready source for suitable replacement property. At first, TICs were used primarily as a fallback position by exchangers who feared their identified property would either get snatched up by other investors or would fail due diligence. However, over time, the popularity of this fallback strategy evolved into an accepted primary reinvestment alternative.

Savvy investors came to realize that by reinvesting in TIC properties, they could also employ the same diversification strategy that applied to their stock portfolios. Real estate investors look to reposition their holdings to take advantage of asset allocation by both geography and asset class. For example, an investor can exchange his property in Minnesota and acquire part of a mini-storage facility in Seattle, Wash., part of an apartment complex in San Antonio, Texas, and part of a medical office building in Atlanta, Ga.

TIC replacement properties are institutional grade and typically have a value larger than individual investors could acquire on their own. In addition to diversification, TIC investors also achieve relief from property management responsibilities, but still enjoy all the benefits of ownership, appreciation, depreciation, cash-on-cash return, debt reduction, and interest expense write-off. TIC properties typically range in value between $10 million and $75 million. Because of the TIC property's asset quality and tenant rent roll, sponsors are able to secure non-recourse financing in the range of 50 percent to 66 percent loan to value. The remaining equity value of the property is then offered to up to at most 35 investors in fractional interests, not all of which need to be equal. The sponsor remains involved in the investment through a master lease. The sponsor, as the master lessee, collects the monthly rent and pays the debt service and other administrative expenses, and then distributes the net income to the 1031 investors. Since this tenancy-in-common interest represents the ownership of real property, the investors get a deed and title insurance policy from the sponsor to evidence their fractional ownership interest.

It is important to assemble a team of professionals to assist with a tax-deferred exchange and a TIC reinvestment. First, an investor must select a qualified intermediary to facilitate the exchange of properties. Look for a national intermediary, like the First American Exchange Company, which offers a high level of safety and security of exchange funds. This is evidenced by the company's substantial Fidelity Bond, Errors and Omission Insurance, the written guarantee of a Fortune 500 corporate parent and status as a member in good standing of the Federation of Exchange accommodators. Next, select an investment advisor who works for a broker dealer who specializes in TIC investments. They will be invaluable in helping you identify and evaluate individual TIC sponsor offerings. Finally, always consult your trusted professionals, including your real estate attorney and tax advisor, before making any investment decisions.

Neil Friedman is the assistant vice president regional business development manager for First American Exchange Company. Inquiries can be directed to Neil at 612-437-2490 / 877-262-1031 or nfriedman@firstam.com