Is Tenancy in Common Ownership Right for Your Next Real Estate Acquisition?

Ownership of real property as tenants in common ("TIC") has become an increasingly popular way to hold title to real estate for investors, particularly smaller investors, for Internal Revenue Code ("IRC") §1031 exchange purposes. The growth in popularity of these co-ownership arrangements has been driven by real estate economics and favorable IRS guidance relating to tax-deferred exchange treatment.

As individual owners of property find the need to sell their properties for any number of reasons (absence of further available depreciation, desire to avoid property management responsibilities and personal liability, etc.), owners often seek to defer capital gains tax through a tax-deferred exchange under IRC §1031. Owners may also be unable to locate suitable replacement properties for their desired exchange transaction. In 2002, the IRS issued guidance in the form of a Revenue Procedure (Rev. Proc. 2002-22) with respect to the use of TIC ownership interests for IRC §1031 purposes. This allows real estate promoters to develop TIC ownership arrangements giving real estate investors the ability to combine with other investors to acquire properties with the economic and other characteristics desirable for exchange or investment portfolio purposes.

TIC "sponsors" (like syndicators of real estate limited partnerships) enter into a contract to purchase property, obtain a commitment for financing, and arrange for investors to purchase fractional ownership interests in the property by entering into a TIC agreement. The agreement requires that each investor assume a percentage of the purchase contract and a percentage of the loan on the property. The sponsor derives income from fees related to the acquisition and ongoing management of the property. A variety of management arrangements can be structured to provide investors with more or less risk (and more or less reward) with respect to the financial performance of the target property. A TIC investor will usually hold ownership through a special purpose limited liability entity, subject to review and approval of the investor's tax counsel.

In sponsored TIC investments, sponsors will usually have managerial responsibilities for leasing the property, collecting rents, paying bills, and performing administrative duties. Sponsors may also structure contractual arrangements in their TIC agreements to provide for representation of the owners in connection with brokerage activities for a subsequent sale of the property.

Some of the drawbacks of investing in TIC arrangements include risk of low returns caused by poor management, excessive sponsor fees or a master lease structure, faulty due diligence investigation of the property or financial analysis by the sponsor, and the risk of foreclosure and loss of capital. In a poorly structured ownership arrangement, investors may be exposed to risks of uninsured losses resulting in personal liability, the potential complication of bankruptcy or judgment liens of one TIC owner, or complications arising out of the death or divorce of a TIC owner. Financing terms may be complicated and more costly for TIC arrangements. There are also risks associated with the tax treatment claimed in an IRC §1031 exchange transaction as well as possible litigation arising out of alleged securities law violations by the sponsor in the offer and sale of the TIC ownership interests.

The TIC form of ownership is also useful for certain joint venture acquisition or development transactions where IRC §1031 exchange treatment is important to one or more of the parties. In these cases, care must be exercised to protect the interests of each owner from unintended exposure to liabilities and avoidable co-ownership risks.

For investors seeking a TIC investment for their exchange transaction, the TIC agreement and related documentation will need to be reviewed carefully for a full understanding of the proposed TIC ownership structure, fees, investor rights and obligations and the risks associated with TIC ownership. The risks and potentially high cost of sponsorship and management of TIC ownership must be weighed against the advantages of the investment, including convenience of identifying the TIC property as a replacement property for a pending exchange transaction, the qualified analysis and investigation of the target property by the sponsor, absence of managerial responsibilities, and the availability of financing without recourse.

This article was written by Hubert Lenczowski in Gordon & Rees' San Francisco office with the assistance of Richard Clampitt in the San Diego Office. Hubert Lenczowski may be contacted at (415) 875-4141 and Richard Clampitt may by contacted at (619) 230-7753. If you have any questions regarding any real estate legal matter, in San Diego please contact Brian Frasch, Esq. (litigation) at bfrasch@gordonrees.com or Eric Young, Esq. (transactions) at eyoung@gordonrees.com or call us at (619) 696-6700. In San Francisco, please contact Phillip Wang at pwang@gordonrees.com or call him at (415) 986-5900.