Real Estate Tenants in Common-Up, Up and Away?

Robert J. Walner, W. Rob Hannah III, and Greg Paul
Illinois Real Estate Journal
April 1, 2005

The Tenants in Common (TIC) structure is becoming a popular arrangement to complete tax-free exchanges involving real estate, but regulatory challenges continue to make this investment option a conundrum of legal technicalities. In the commercial real estate context, TIC, under Section 1031 of the Internal Revenue Code, means that title to real estate is conveyed collectively to a group of co-owners who each hold title to a fractional, undivided interest in the real estate as a tenant in common with the other co-owners. The TIC structure is suitable for investors who have sold other interests in real estate at a profit and are seeking to defer recognition of the capital gain from such sale by investing passively in another interest in real estate through completion of a 1031 transaction without the typical responsibilities that are involved with ownership and management of real estate.

A high degree of regulation from three different regulators often overlap and conflict, creating tension for sponsors of investment programs to appropriately structure and complete TIC 1031 transactions in compliance with such regulations. First, if TIC involves the ownership of real property interests, the sale can be subject to state real estate license laws. In most states, including Illinois, anyone who sells, exchanges, purchases, rents or leases real estate for a third party in return for compensation must have a real estate license. Some states may have "finder's fee" or referral fee exemptions. Illinois does not. Real estate brokers in Illinois and most states cannot share their commissions with an unlicensed person.

Second, while the use of the TIC structure in 1031 transactions has been utilized for several years, it was uncertain whether it would be deemed as qualifying replacement property for the completion of a tax-free exchange by the IRS under Section 1031 of the Internal Revenue Code, or whether it would be deemed a partnership for income tax purposes. In 2002, the IRS issued guidelines (not a safe harbor) for obtaining a private letter ruling pursuant to Revenue Procedure 2002-22 (Rev Proc) by which properly structured TIC transactions could be used in 1031 transactions. Pursuant to the procedure, among other things, TIC co-owners must be passive, must be able to vote by unanimous consent on matters of property management, sale, lease or refinance (and by majority vote of the outstanding undivided, fractional interests on other matters), but may not participate in property operations except for customary maintenance and repair activities. The arrangement among TICs must not be deemed an interest in a business entity, such as a partnership, and there cannot be more than 35 co-owners.

Non-recourse loans to co-owners from the sponsor, the property manager or the other co-owners to meet expenses of the property are prohibited. However, commercial lenders object to this constraint and usually require that borrowers consist of bankruptcy remote entities. This has raised concern within the TIC industry because this IRS condition cannot be complied with by borrowers when obtaining commercially reasonable financing. Furthermore, prudent investors would not be willing to enter into a transaction with numerous unknown parties where full recourse and the resulting bankruptcy risks exist. Hence, the transactions in the market today, and the tax opinions issued with them, have disregarded this condition as impractical and therefore irrelevant. Restrictions on alienation of the TIC interests (including the right to transfer, partition or encumber) are generally prohibited unless required by a lender. This "lender exclusion" has allowed TIC sponsors to become more comfortable with other constraints. It may be very difficult for TIC sponsors to comply strictly with the IRS guidelines. Only two private letter rulings have been issued under the procedure to date. Much more reliance has been placed upon tax opinions and it is likely this will continue.

Third, and to make things more confusing, a TIC interest may constitute a security subject to federal and state securities laws. Many TIC structures may involve an investment contract, a type of security. Pursuant to a famous 1946 U.S. Supreme Court case, SEC v. Howey Co., and later cases, an investment contract involves (i) an investment of money, services or property, (ii) in a common enterprise, (iii) with profits expected to come from the undeniably significant efforts of a third party. For example, limited partnership interests are typically viewed as investment contracts. Arguably so are many TIC structures.

Pursuant to the Securities Act of 1933 (Securities Act) and most state laws, a security must be registered with the SEC and in each and every state in which offers and sales of the security will be made unless there is an exemption from registration of the security. One popular transaction exemption is the private placement exemption under Section 4(2) of the Securities Act and Regulation D, a safe harbor. Sponsors of investment programs commonly prepare a lengthy book containing material information about the transaction, called a private placement memorandum, which accompanies offers of the securities to potential investors. Offers and sales of securities are then typically made to a small number of rich and smart people (accredited investors), and in some instances to a small number of non-accredited investors, and a filing is made with the SEC and in most states on Form D. Among other requirements, there can be no general solicitation or general advertising utilized in connection with the offering. Most states have a similar transaction exemption to Regulation D.

In addition, each person who offers or sells the securities must be registered as a securities broker/dealer or a securities salesperson with the SEC or the NASD and in each and every state in which the securities are to be offered and sold, unless there is an exemption from broker/dealer registration. A securities broker under the Securities Exchange Act of 1934 (the Exchange Act) includes "any person engaged in the business of effecting transactions for the account of others." Traditionally the SEC does not consider a company that sells its own securities directly to the public (an issuer) to be a broker because it is not selling "for the account of others." However, employees and related persons of the issuer who assist in the selling effort may be brokers, especially if they are paid for this effort and have little other duties.

In 1985, the SEC created a safe harbor for associated persons of issuers. Under this safe harbor, any natural person who is a director, partner, officer or employee of the issuer or a corporate general partner of a limited partnership issuer, along with other persons who meet certain tests, are exempt from registering as a broker/dealer. Among other things, such persons (i) cannot have committed certain "bad-person" acts, (ii) cannot have been a broker/dealer or have been associated with a broker/dealer for a certain period of time, (iii) cannot be compensated for selling the securities and must perform substantial duties for the Issuer other than the sale of securities, and (iv) cannot participate in selling securities for any Issuer more than once every 12 months. If the safe harbor is not met, one can try to find other exemptions but that is very difficult. Many states have similar exemptions. Illinois exempts officers of the issuer provided no commission or other compensation is paid for the offer or sale of the securities. Securities brokers may not share their commissions with unlicensed persons, directly or indirectly. There is a Federal "finder's fee" exemption that is very difficult to meet. Some but not all states also have such exemption.

This "perfect storm" of a regulatory web makes it difficult for sponsors of TIC 1031 transactions to comply with certainty with all of the various regulatory requirements. Sponsors that are regularly involved in 1031 TIC transactions that are securities must either register as a broker/dealer (a solution that is facing significant scrutiny right now from the SEC and the National Association of Securities Dealers) or sell the securities through a third-party registered broker/dealer. In order to comply with IRS guidelines the investors must be passive, which tends to make the transaction a security. Real estate brokers and securities brokers may not share their commissions with one another.

Sponsors of TIC transactions have created an association, the Tenant In Common Association, to assist sponsors with regulatory hurdles and other matters. The association and the National Association of Realtors have had discussions with the SEC and the NASD in an effort to reduce the securities regulatory hurdles by providing an exemption from registration as a broker/dealer and providing more emphasis on state real estate regulation instead. One TIC sponsor has filed an SEC “no-action” request seeking relief. If granted by the SEC as submitted, it would allow a very specific method for real estate brokers to participate in TIC transactions. On March 1, 2005 Utah passed a bill that places TIC transactions under the regulatory control of the Utah Department of Real Estate and specifically deems them not to be securities. While this may impact transactions involving only Utah property sold to Utah residents, the NASD carefully pointed out that state legislation has no effect or impact whatsoever on Federal securities laws or regulations.

So this "perfect storm" is brewing for investors, their advisors and the different regulatory authorities on a federal and a state level. As the TIC industry grows, with over billion having been sold in 2004, it may be worthwhile for the real estate industry to protect its niche in this marketplace. The critical question is whether the industry will be successful in convincing regulators to appropriately modify laws and regulations that have been in effect since 1933 and exist to protect the investing public.

Tenancy In Common deals fulfills an essential need and unlike its predecessor cousin, the real estate limited partnership, it is not based solely on an unusual tax benefit. Section 1031 of the Internal Revenue Code has been in place since 1921 and is quite relevant today as a vehicle through which the United States can help ensure that a significant quantity of U.S. real estate (including the land under some of our biggest businesses and even our government) remains in the hands of U.S. owners. Its continued viability is also necessary for us to support one of the largest segments of our economy. That said, the greatest benefit of TIC transactions may lie in the future. Never before could the average investor own commercial real estate in the same manner that he or she owns mutual funds or a 401-k account. This ownership method has created a new investment asset class and brought it to the general public in bite size pieces. Keep your eyes open, the best may be yet to come.