Why Tenants in Common (TIC) structure is advantageous for 1031 exchange investors
The limited liability company (LLC) is a relatively young creature created by State statutes. By contrast, the concept of owning an asset as “tenants in common” (TIC) is centuries-old, much of it dating back to English law. In a May/December romance, LLC and TICs merge into what is often the single best structure for multi-owner investment real property.
The LLC as liability protection for real estate investors
- These entities are easy to create and manage.
- They separate out the risk of owning the property, thereby protecting the other assets of the members (owners).
- Members can own various percentages of the LLC according to their contribution.
For multiple-member LLCs, the entity obtains a Federal EIN and files a partnership tax return with tax incidents reported to the members on form K-1.
Problems with LLC ownership structure in a 1031 Exchange
LLC ownership can create unforeseen problems when the property sells for a gain. In the simplest scenario, real property owned by an LLC can sell at a gain and the LLC may perform a 1031x at the partnership level. In that case, the LLC sells the relinquished property and the same LLC buys the replacement property.
Unfortunately, we often see that members of the LLC have different goals. When the relinquished property sells, different factions want to go their separate ways. This is tough pull off in a 1031 exchange, and there are plenty of sub-optimal solutions floating out there:
– The members that want to stay together buy out the departing members.
But this takes new cash. It also concentrates risk in this asset for those staying in. Finally, it prevents the departing members from doing their own 1031x.
– The LLC dissolves. Each member is deeded their fractional interest in the real property prior to sale.
Here, each owner decides whether or not to perform their own 1031x. The 1031 industry refers to this as a “drop and swap.” But whether such 1031x transactions will be honored by the IRS remains an open question. These transactions require special reporting to the IRS (lines 13 and 14 of Form 1065). Moreover, the State of California scrutinizes these transactions, questioning whether it meets the “held for investment” requirement.
– The members that want to stay together do so, maintaining the LLC as an intact entity, but with fewer members.
The departing members are deeded their respective fractional interests in the real estate. The property sells with the LLC performing the 1031x. For their part, the new co-owners of the real property cashing out and recognizing (paying) income tax. This solution creates problems when the sale doesn’t go through.
Other problems can arise when a single uncooperative member of an LLC objects to any change in LLC ownership structure. Moreover, none of these suggestions work when an LLC sells only one of several properties that it owns.
Why a modified Tenants In Common (TIC) structure is better for a 1031 exchange
Remember, a 1031x requires the swap of like-kind real estate. Under IRC section 1031, all real property is “like kind” to all other real property — as long as it meets the qualified use test. Necessarily, a tenant in common interest in one property can be 1031 exchanged into a tenant in common interest in another property.
However, the laws governing TICs (also called co-tenant laws or co-ownership laws) imbue the co-owners with certain cumbersome rights. This is especially true when the tenants in common are not related by blood or fealty.
- substantially raise taxes on high-income earners (households making over $1 million)
- increase in the top marginal income tax rate
- increases in capital gains tax rates, with high-income households paying ordinary income tax rates on long-term gains
- eliminate 1031 exchanges for any asset with $500,001+ in capital gains
- eliminate the “step-up” in basis for gains in excess of $1 million
- increase the corporate tax rate from 21% to 28%
- eliminate the so-called “carried interest” practice for compensating fund managers in the private equity space
- expanding the application of the 3.8% net investment income tax
How would this impact 1031 exchanges?
According to the White House summary, the American Families Plan would change the Internal Revenue Code to disallow any like-kind tax treatment under Section 1031 for real estate that has more than $500,000 in capital gains.
To the extent we have good data on this, a $500K cap is well above the average exchange value. Economic impact studies, most notably those produced by Barker, Ling, and Petrova, suggest the average market value of properties included in tax-deferred exchanges is less than $500,000.
Those in the commercial real estate space are more likely to be effected, since commercial assets are, on average, larger and more valuable than residential assets.
This will also more likely affect properties that are part of multi-exchange events (e.g. selling a property that was acquired as part of a prior 1031 exchange).
Of course, more details will emerge over time.
Tenants in common have the right to
- occupy the property,
- sell or mortgage their share of the property,
- force the sale of the whole property (partition)
- and no obligation to share in expenses unless specifically agreed.
Now, all of these rights are inimical (i.e. detrimental) to investors combining their funds to buy investment real property. So you can 1031 exchange TIC interests, but members must restrict their rights in order for the investment goals of the group to be met.
The IRS published Rev. Proc. 2002-22 to assist with this problem. Herein, the IRS sets forth 15 criteria by which a TIC agreement, which limits the rights of tenants in common, will be judged. Failure to satisfy enough risks the tenants in common being treated as having formed a partnership. Now the government taxes the TIC as a partnership; it must do 1031 exchanges at the partnership level.
The most important of these 15 criteria are:
- Each tenant in common must hold record title ownership.
- No more than 35 tenants in common.
- No filing of any partnership tax return.
- Tenants in common can be forced to offer their interest to the other tenants
- Management agreements cannot last more than one year.
- Any sale, leasing or mortgaging of the whole property must be unanimous
- TIC members share profits and losses according to fractional ownership.
- Tenants in common limited to investment activity; not engaged in business.
Rely on the Single Member LLC to limit liability
But, what about the limited liability afforded by LLCs?
A TIC ownership structure, by itself, does NOT separate the risk of property ownership. Likewise, it does NOT protect the other assets of the tenants in common. Again, we can use another IRS rule as a workaround; single-member LLCs are “disregarded entities” for tax purposes.
“Disregarded” means that a single member LLC does not need an EIN. Nor does it need to file a separate tax return!! Instead, the tax incidents of any real property owned by a single member LLC report directly on the individual tax return of the member.
Now you have the flexibility and limited liability
By combining ownership of property as a single member LLC with a tenant in common agreement, you achieve maximum 1031 exchangeability with limited liability.
Real estate investors entering multi-member structures often overlook their 1031 exit strategy. To achieve limited liability with 1031 exchangeability, real property investments can be structured with several single-member LLCs as tenants in common operating under a TIC agreement. This perfectly complies with Rev, Proc. 2002-22 — and everyone enjoys a good romance.
Are you ready to discuss strategies for your 1031 exchange?
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