The Institutional 1031 TIC Exchange

The Institutional 1031 TIC Exchange Since the 1920's savvy real estate investors have taken advantage of the evolving 1031 exchange rules promulgated by the IRS. Many of you are probably familiar with this concept, if not veterans of the procedure. The ability to defer capital gains and depreciation recapture taxes, as well as the opportunity to "trade up" to larger properties, has benefited property owners for decades. Recent conditions in the real estate market, however, have made it difficult to find good values on replacement properties in many East and West Coast markets. Fortunately, there are alternatives to finding your own properties, especially when you are ready to retire, or want to search for properties outside your region in order to find more favorable cap rates.

Tenants-in-Common ("TIC")
A recent article published in AIM highlighted an alternative form of ownership known as Tenants-in- Common, which is the direct coownership of real estate with the pass through of all profits, debts and liabilities on a pro-rata basis. Going a little further, recent IRS publications have created a strong demand for what are known as Sponsored or Institutional 1031 TIC exchanges. IRS Revenue Procedure 2002-22 Like many great investment strategies, this one is the direct beneficiary of an IRS ruling, Revenue

Procedure 2002-22 ("RP 2002-22"), issued in March 2002. It has spurred a considerable amount of activity among institutional real estate firms to offer 1031 TIC exchange properties to small and mid-size real estate owners. Many of these sponsor firms have traditionally offered indirect investment opportunities through business entities, such as limited partnerships and REITs, which DO NOT qualify for tax deferral under Section 1031.

Prior to RP 2002-22, investing in TIC real estate through an institutional sponsor was often confused with making a passive investment in a business entity. The distinctions between TIC (direct ownership) versus an indirect/passive ownership structure was often blurred because of the participation and oversight of a sponsor firm. Since March 2002, however, the IRS has made the distinction more concrete by specifying the conditions that must be met for the IRS to issue a private letter ruling qualifying a 1031 exchange. This has clarified the specific conditions under which an institutionally sponsored TIC could be considered an undivided co-ownership interest in an investment property, and not a passive investment.

Why Should Any of This Matter to You?
These recent clarifications by the IRS have opened the door to greater flexibility and opportunity for small to mid-size real estate investors. Some of the potential benefits include:
  • Access to institutional quality real estate (e.g., class A office space and retail centers).
  • Regional diversification opportunities in relatively undervalued markets.
  • Institutional financing rates/terms.
  • Non-recourse leverage.
  • Increased cash flow from larger properties.
  • Greater return on investment.
  • Preservation of equity.
  • Continued capital appreciation potential.
  • Triple net leases to credit quality tenants.
  • Release of day to day management responsibilities.
  • Additional depreciation.
What Are Some of the Downsides?
As with any strategy, there will be positive and negative factors to weigh before making an investment decision. A few of the disadvantages and risk factors to consider are:
  • High sales load. Because of the structured nature of this 1031 solution, an institutional TIC exchange is considered a private placement security. As such, the sales load will generally be higher, on a percentage basis, than a comparable self-sponsored exchange. That being said, the scale of an institutional property, combined with additional leverage, makes up for this discrepancy through greater efficiencies and the more favorable cap rates afforded to larger firms, thus enabling higher net income rates.
  • Potentially increased debt load.
  • Loss of day-to-day management control. In addition, properties will often be located in different states, which make it impractical to personally monitor them on a consistent basis.
  • Relative illiquidity. Although individual TIC interests may be bought and sold on the open market as any real property can, it is uncertain how liquid such a market will be in the future. Generally TIC investors will wait 3-10 years for a property to be liquidated in its entirety and the equity proceeds distributed to individual investors. During this holding period, investors will generally receive current monthly or quarterly income.
  • Relative complexity of a private placement transaction.
  • Limited to accredited investors only.
  • High level of due diligence required. Many groups with less than stellar and/or short track records have entered this market. It behooves each investor to perform a certain level of due diligence on each potential sponsor.
So Who Should Consider an Institutional 1031 TIC Exchange?
This type of exchange alternative is ideal for pre-retirees, or any owner who no longer wants to manage property. It allows an investor to continue holding real estate, while generating healthy tax efficient income for pre or post-retirement needs. Additional leverage and the TIC structure enables access to larger properties that will generally be more stable and profitable over time. Diversification, both regional and property-type (e.g., apartment to office, retail to apartment, etc.), can be achieved more easily through an institutional offering as well. Finally, if structured correctly, the TIC form of ownership can facilitate inter-generational estate planning for those investors who are concerned about their legacy.

We have given you a brief introduction to the concept of Sponsored or Institutional 1031 TIC Exchange. It is critical, however, to keep in mind that in addition to the potential benefits, a good number of potential risk factors must be considered carefully before entering into a transaction. We recommend that you consult with your financial, legal and/or tax advisor(s) to find out if this type of structure may be appropriate for your specific situation.

Advisor is a Managing Director and Registered Principal with Harvest Financial Services, LLC, a full service financial, insurance and group benefits firm. Members of Harvest Financial offer Securities and Invest-ment Advisory Services through Centaurus Financial, Inc. Member NASD/SIPC and Registered Investment Advisor.