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.
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
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
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
What Are Some of the Downsides?
- 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
- Greater return on investment.
- Preservation of equity.
- Continued capital appreciation
- Triple net leases to credit quality
- Release of day to day management
- Additional depreciation.
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:
So Who Should Consider an Institutional 1031 TIC Exchange?
- 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
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
- 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
- Relative complexity of a private
- 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.
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.