Beware of Tenant-In-Common Schemes with 1031 Exchanges

The market for fractional ownership of commercial real estate (popularly known as Tenants-In-Common or TICs) is expanding its reach -- and look out!

These new ownership programs allow individuals, who normally may not have access to the institutional real estate market, to buy interests in large scale commercial real estate. In March, 2002, the IRS released Revenue Procedure 2002-22 which set forth the conditions and guidelines under which the IRS will allow a small group of single owners to invest into large real estate projects such as: office buildings, apartment complexes, shopping centers, even the neighborhood Wal-Mart store. But there are some inherent drawbacks, such as no established secondary market for selling your TIC interest, resulting in a less liquid investment.

As soon as the ruling came out, TIC promoters began appearing out of the wood work. It sometimes seems as if a new promoter climbs out from under a rock every day. It has gotten so bad that at times it feels like the old tax shelter days from the early 80s. I've been helping clients with taxes and investments my entire adult life, and I'm always amazed that when it comes to paying taxes, a person's common sense and normal sense of caution are immediately forgotten.

It's time for investors to put the brakes on and approach these schemes with caution. Let me discuss the ruling first, and then I'll tell you how to avoid the pitfalls.

First, the ruling merely sets forth the guidelines for applying to the IRS for approval. It does not give automatic approval to these types of schemes, a fact that most promoters gloss over. In addition, each investor must hold fee simple title to their interest. This makes them a tenant-in-common with the other investors. You are not allowed to hold title as a partner in a partnership, or any other investment entity set up by the promoter. Yet I've seen a number of deals where the lender requires the property to be held by a single asset entity, which forces each investor to become a part of the lender's single asset entity to obtain financing. Either the developer claims that this is OK'd by the ruling (which it is not), or they have the investor take fee simple title and then immediately flip that interest into the lender-required single purpose entity, which is also fatal. (Remember, for a successful 1031 exchange you cannot immediately sell or change how the title is held -- or the exchange will be disallowed -- saddling you with taxes, interest, and possibly penalties.)

The ruling also requires that each investor have the right to sell their unit without restriction from the other investors, and must annually approve the promoter's management agreement. Yet again, I've seem some deals in which the investors can not get out of the project for a minimum length of time, some where they must sell back to the promoter, and many where there is no way to get rid of the promoter. These, too, can be fatal flaws.

The list of problems goes on and on, but I think you get the drift. So how do you protect yourself? First and foremost, use common sense. Ask yourself: "If this is such a great deal, how come they need a little investor like me to make it work? Why didn't the promoter just buy the property themselves?" I know one large promoter that is owned by a real estate company. They buy a building from the seller thereby earning large real estate commissions. Then they sell the building at a marked up price to TIC investors, earning a large profit and more commissions. Their management division manages the property which earns more fees. And they even have a 1031 intermediary division, which earns more fees and interest for handling the transaction. Who pays for all of this? You do!

The other problem I have with most of the promoters is that they push only one product. For example, they only sell office buildings built by one builder and managed by one management company. When you look at their TIC program, you only see their products with nothing to compare it to. You have no way to compare the cash flow or appreciation history of their product to that of similar properties with another promoter, or a different type of investment.

Some promoters offer a smorgasbord of investment opportunities and have schedules that compare the different products so you can zero in on the one that is best for you. An experienced 1031 exchange specialist should be able to guide you to some of these alternative TIC promoters. Do your homework and use caution before you invest in one of these schemes.