While finding an appropriate independent property worth $1 million may be difficult, there are always opportunities available to invest in a larger property as a tenant-in-common to defer capital gains tax.
Situation: Your client had acquired commercial real estate many years ago and is now ready to sell the property at a substantial profit. He is aware of the stipulations of an Internal Revenue Code Section 1031 exchange and has found two replacement properties.
However, he cannot find another property to apply the last $1 million in profit. The client would prefer not to pay any tax on gains and wonders whether owning an interest in a property as a tenant-in-common would satisfy the exchange requirement.
Solution: While finding an appropriate independent property worth $1 million may be difficult, there are always opportunities available to invest in a larger property as a tenant-in-common to defer capital gains tax.
In being a TIC, your client would own an undivided interest in a professionally managed, institutional grade property along with several other investors. Each investor is entitled to a share of the income and appreciation as well as contributing to expenses and taxes. If structured properly, a TIC property will satisfy the 1031 exchange requirement for a like-kind property.
The advantages of a TIC are many. Since the property is already professionally managed, there are no management hassles involved. TIC properties also tend to be flexible in size to match the investment needs of your client — whether your client has a sizeable or moderate amount to invest. As long as they have the minimum required by the specific TIC, they can vary the size of their investment. This means they can also diversify their investment into more than one property if they wish. There will also be pre-arranged financing that allows the property to be identified and closed in a timely manner.
Capital gains deferral
In using a TIC in a section 1031 exchange and deferring capital gains tax, your client will have more money to put to work in the replacement property rather than using it to pay taxes.
One aspect of a TIC that must be considered is that no individual investors are listed as owners. Often, a requirement of a TIC ownership is that your client will be required to form a special purpose entity. Such an entity usually takes the form a limited liability company which ensures an extra layer of liability protection for your client, the other TIC co-owners and the lender.
While a TIC ownership may provide a solution for your client, there are some possible negative consequences that should be considered. Since your client will be only one of several owners, liquidity may become an issue as all decisions regarding the property will require unanimous approval of all owners. Entering into a TIC may also be initially more expensive than a traditional 1031 exchange due to increased costs such as loan points, legal fees, and commissions to brokers and fees to the sponsor.
Another issue to consider is that while many will find the lack of hands-on management to be an advantage of a TIC property interest, others may feel the limited control of managing their investment is a negative point.
Finally, if the TIC property being offered is structured properly and your client’s circumstances and actions are correct in adhering to the 1031 rules, your client has the ability to sell their highly appreciated property and defer (though not avoid) the capital gains tax.
While TIC ownership may provide a satisfactory solution to a client who is having trouble finding an appropriate 1031 exchange property, there are requirements that must be met for it to be considered a like-kind exchange for tax purposes. As such, your client should be aware he should always consult with a tax adviser before entering into a TIC agreement.
