Completing a 1031 Exchange: Tenants-in-Common Replacement Properties Becoming Increasingly Popular

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By Joseph P. Pirrello, JD, CPA

More investors are taking advantage of one of the best tax deferral options available when selling a property. Taxes on the gain from the sale can be deferred by investing in a like-kind property according Internal Revenue Code Section 1031. Until recently, taxpayers have been reluctant to take advantage of it because of the difficulty in finding a replacement property. This changed when the IRS released Rev. Proc. 2002-22, which clarifies the qualifying criteria of a tenants-in-common (TIC) interest as a real estate investment. Since then, the use of a TIC as a replacement property in a 1031 Exchange has been increasing in popularity.

A TIC replacement is a great tool for people who want to get out of the daily grind of property management, but still favor the benefits of real estate investment. Maybe you’re tired of being a landlord or just want to slow down. Or you want to cash out while the market is high, but the local market has a limited inventory of like-kind properties. In any case, a TIC replacement could work to your advantage.

A TIC is a fractional ownership interest in a commercial property that is run by a property manager. The owner holds a deed representing his or her percentage of ownership and shares in all revenues and expenses based on his or her proportionate share. Net cash is usually paid out monthly to the TIC owners.

The advantages of using a TIC as a replacement property are considerable. The most obvious is the ability to defer tax on capital gains from the sale. A property owner can then roll that gain into another property (or properties) to satisfy different investment desires. For example, a TIC investment can be structured to encompass varying degrees of investment risk by using more than one TIC investment to close a 1031 transaction. Alternatively, one could invest in a larger, more attractive property that could not be afforded as a sole owner. In all situations, the property owner is relieved of the daily responsibilities of property management.

Completing a 1031 Exchange hinges on the identification and closing of the replacement property within prescribed time limits. The IRS requires identification of potential replacements properties within 45 days of the sale and closing within 180 days. Replacement properties identified cannot exceed three properties or two-hundred percent (200%) of the value of the relinquished property. The growing TIC market makes finding and closing an acceptable like-kind property significantly easier, as many TIC Sponsors offer pre-packaged investment alternatives that often include financing and preparation of closing documents.

A potential buyer is well advised to perform the usual due diligence associated with any investment. Some considerations include:

  • ROI – A TIC interest may not provide as great a return as sole ownership (a trade off for less hands-on management).
  • Liquidity - Since the TIC market is just gaining ground, the population of buyers is limited, and liquidity may be uncertain.
  • Ownership arrangement – In order for a TIC to qualify, it must adhere to IRS rules strictly governing the ownership structure, management and rights.

With any investment strategy, one must consider many variables in addition to tax issues. Depending on your goals, you might want to pay the capital gains tax and be done with it. But for those investors wishing to remain in real estate, using a TIC property can be an attractive option.

Joseph P. Pirrello, JD, CPA, is a Partner in the Tax Services Group at WISS & Company, LLP. Mr. Pirrello can be reached at 973-994-9400 or jpirrello@wiss.com.

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