Tenant in Common 1031 Exchange

Real estate investments have been a popular choice for investors looking to diversify their portfolios and generate passive income. However, managing a property can be time-consuming and demanding, and selling a property can come with hefty tax implications. This is where a 1031 Exchange comes in handy. It allows investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into another suitable replacement property. One type of 1031 Exchange is the Tenant in Common (TIC) 1031 Exchange.

While many accredited investors are leaving TIC exchanges for another kind of 1031 exchange, it can still be useful to know the structure and how it works in the context of a 1031 exchange.

 

What Is a Tenant in Common 1031 Exchange?

A Tenant in Common 1031 Exchange refers to a specific type of investment structure that allows multiple investors to hold undivided fractional interests in real property. Each property owner has the right to use and possess the common property, and their common ownership share can be passed on to their heirs. In a TIC 1031 Exchange, real estate investors can pool their resources to purchase a replacement like-kind property that meets the requirements of a 1031 Exchange. The investors become tenants in common of the new property, and each ownership percentage is proportionate to their investment. The TIC structure allows investors to diversify their portfolios, invest in larger properties, and share management agreements and maintenance responsibilities.

A TIC 1031 Exchange is similar to a regular 1031 Exchange, but instead of owning the replacement property individually, the investors own a fractional interest from the entire property alongside other investors. The exchange is structured through a TIC agreement outlining each investor’s rights and responsibilities.

For example, John and Jane want to sell their rental property and reinvest the proceeds into a larger commercial property. However, they do not have enough funds to invest in another expensive property on their own. They decide to partner with two other investors, Bob and Sue, to purchase the commercial property through a TIC 1031 Exchange. Each investor owns a 25% interest in the property, and the rental income and expenses are shared proportionately.

 

 The Kinds of Tenant in Common Structures

The specifics of a TIC agreement depend on a number of variables, including the nature of the property, the number of investors, and the requirements of the co-owners. In a typical TIC structure, a number of investors possess undivided fractional interests in a piece of real estate, with each investor owning a fixed percentage of the whole. Here are some common types of TIC structures:

• Investment TIC – This type of TIC structure is primarily used for investment purposes. Multiple investors pool their resources to acquire and manage income-producing properties, such as apartment buildings, office buildings, retail centers, or business properties. These TIC structures often involve a sponsor or property management company to handle the property’s day-to-day operations and management.
• Residential TIC – In a residential TIC structure, co-owners hold fractional interests in a single-family home, condominium, or multi-unit building. This arrangement allows multiple parties to share ownership of a residential property, which can make homeownership more accessible and affordable. Residential TICs may involve co-owners living in the same property or renting out their individual units.
• Commercial TIC – This TIC structure involves multiple investors owning undivided interests in commercial properties, such as office buildings, retail centers, or industrial complexes. In this structure, investors may rely on professional property management or a TIC sponsor to manage the Theytypically receive income from rents and other revenue streams generated by the property.
• TIC 1031 Exchange -This type of TIC structure is specifically designed for investors who wish to participate in a 1031 Exchange, which allows them to defer capital gains tax on the sale of an investment property by reinvesting the proceeds in like-kind property. In a TIC 1031 Exchange, investors purchase fractional interests in a qualifying exchange replacement property, enabling them to defer capital gains tax and potentially enjoy other benefits, such as diversification and passive income.
• Co-housing TIC – Co-housing TICs involve a group of individuals or families who purchase a property together with the intention of living in a shared community. This type of TIC structure often emphasizes communal living and shared decision-making, with co-owners participating in the property’s management and maintenance. Co-housing TICs can be an attractive option for those seeking an alternative to traditional homeownership or rental arrangements.

 

Potential Advantages of TIC 1031 Exchange

There are several possible benefits of participating in a TIC 1031 Exchange, including:

• Tax deferral – The primary benefit of a Common 1031 Exchange is the deferral of capital gains tax, which can potentially save investors a significant amount of money. By reinvesting the proceeds from the sale of real property into a TIC, investors can defer the capital gains tax on the sale, allowing them to keep more of their profits for reinvestment.
• Diversification – TIC investments allow investors to diversify their real estate portfolios. By pooling resources with other investors, individuals can access larger, higher-quality properties that might have been out of reach if they were investing independently. This helps mitigate the risk of owning a single property and provides exposure to different types of real estate assets.
• Shared management responsibilities – In a common structure, property management is typically handled by a professional property management company or the TIC sponsor. This can alleviate individual investors’ day-to-day responsibilities of property ownership, allowing them to focus on their broader investment strategy.
• Passive investment – TIC properties often generate income through rents or other revenue streams, providing investors with a potential source of passive income. This can be particularly attractive for those looking to supplement their retirement income or build wealth over a period of time. This provides access to high-quality properties that generate significant rental income.
• Preservation of equity – When an investor sells a property and uses the proceeds to invest in a TIC, they are preserving their equity in real estate, which can be beneficial for long-term wealth building and appreciation.

Remember that while there are numerous potential benefits to participating in a TIC 1031 Exchange, there are risks and drawbacks to consider, such as illiquidity, the potential for disputes among co-owners, and reliance on third-party management. As with any investment, it’s essential to carefully weigh the pros and cons and consult with a financial or tax professional to determine if a common 1031 Exchange is suitable for your financial goals and risk tolerance.

 

Eligibility Requirements for TIC 1031 Exchange

To qualify for a 1031 Exchange, the sold and replacement properties must be of like-kind property type. This means they must be held for investment purposes or used in a trade or business. Generally, most real estate is considered like-kind if it’s not primarily held for personal use or as inventory. Other eligibility criteria for a Common 1031 Exchange include the following:

• For the replacement property to qualify as a TIC under a 1031 Exchange, it must meet certain requirements set forth by the IRS in Revenue Procedure 2002-22. Some of these requirements include the following:
  • Tenants in a common structure must hold the property, and each co-owner must hold an undivided fractional interest.
  • The number of co-owners should not exceed 35.
  • Co-owners must unanimously approve certain major decisions related to the property, such as sale or refinancing.
  • Each co-owner’s interest in the property must be freely transferable. There should be no restrictions on a co-owners right to sell, assign, or encumber their interest, subject to standard conditions.
  • Co-owners should receive a share of the property’s net income, gain, or loss proportional to their ownership interests.
• A 1031 Exchange involves strict timing requirements that investors must adhere to:
  • The investor has 45 days from the sale of the relinquished property to identify up to three potential replacement properties or more if certain valuation rules are met (identification period).
  • The investor has 180 days from the relinquished property’s sale to complete the replacement property acquisition (exchange period).
• Investors must be accredited, which means they meet certain financial requirements, such as having a net worth of at least $1 million (exclusive of their primary residence) or an annual income of at least $200,000 (single) or $300,000 (married) for the past two years with reasonable expectation of that income continuing. Accredited investors are deemed to have sufficient financial knowledge and experience to understand the risks associated with TIC ownership.
• A 1031 Exchange must be facilitated by a Qualified Intermediary (QI), also known as an Exchange Accommodator. The QI handles the transfer of funds and ensures that the exchange process complies with IRS rules. The investor must not receive the sales proceeds from the relinquished property directly, as doing so could disqualify the exchange.
• The taxpayer who owns the relinquished property must also be the one who acquires the replacement property. In the context of a TIC 1031 Exchange, this means that the same taxpayer must hold the undivided fractional interest in the TIC property.

 

Identifying Replacement Properties for TIC 1031 Exchange

Identifying replacement properties is a crucial step in a TIC 1031 exchange. Investors must identify potential replacement properties within 45 days of selling their relinquished property. There are three identification rules that investors must follow:

• Three Property Rule – Investors can identify up to three potential replacement properties, regardless of their fair market value.
• 200% Rule – Investors can identify more than three potential replacement properties as long as their aggregate fair market value does not exceed 200% of the sale price of the relinquished property.
• 95% Exception Rule – Investors can identify any number of potential replacement properties as long as they acquire at least 95% of the total value of the identified properties.

 

Structuring a TIC 1031 Exchange

Structuring a TIC 1031 Exchange involves several steps:

• The investor must sell their relinquished property and use a Qualified Intermediary (QI) to hold the sale proceeds.
• The investor must identify potential replacement properties within 45 days of selling their relinquished real property.
• The investor must select an exchange replacement property from the identified properties and enter a purchase agreement.
• The investor must form a co-ownership agreement with the other investors that outlines the rights and responsibilities of each party.
• The investor must close on the replacement property within 180 days of selling their relinquished property.

 

Financing Options for TIC 1031 Exchange

Financing options for a TIC 1031 Exchange can be more complex than traditional real estate financing due to the fractional ownership structure. However, there are still various options available to investors. Some of the common financing options for a TIC 1031 Exchange include:

• Cash investment – Investors can use their own cash or proceeds from the sale of the relinquished property to acquire their fractional interest in the TIC property. This can be an attractive option for those looking to avoid taking on additional debt, but it may not be feasible for all investors.
• Non-recourse loans – A non-recourse loan is a type of financing where the lender’s only recourse in case of default is the collateral (the real estate investment property), and they cannot pursue the borrower’s personal assets. Many TIC properties are financed with non-recourse loans, as they offer protection to individual investors from potential liability in the event of a loan default. TIC sponsors or property managers usually negotiate and secure non-recourse loans on behalf of the TIC investors.
• Cross-collateralized loans – In some cases, investors may choose to cross-collateralize multiple properties to secure a loan for the TIC 1031 Exchange. This involves pledging multiple properties as collateral to obtain financing. While this can be a flexible option for financing a TIC acquisition, it may also significantly increase the risk associated with the loan. The investor’s other properties could be at risk if they default on the loan.
• Seller financing – In certain cases, the seller of the TIC property may be willing to provide financing to the investor. This can be an attractive option for investors who may not qualify for traditional financing, but it is relatively rare and typically involves higher interest rates than other financing options.
• Partnership or syndication – In some instances, investors may choose to form a partnership or syndicate to pool their resources and jointly finance the acquisition of a TIC property. This approach can make it easier for investors to obtain financing, as the combined financial strength of the group may be more attractive to lenders. However, it can also introduce complexity in terms of management and decision-making.
• Master Lease Financing – The investors can lease the property to a master tenant who is responsible for making the mortgage payments. The investors receive a portion of the rental income, and the master tenant is responsible for managing the property.

Financing options for TIC 1031 Exchanges can vary depending on the specific property, the investor’s financial situation, and the overall market conditions.

 

Tax Implications of TIC 1031 Exchange

A TIC 1031 Exchange allows investors to defer capital gains taxes on the sale of their relinquished property as long as they reinvest the proceeds in like-kind property within the specified time frame. However, there are several tax implications investors should be aware of:

• Depreciation Recapture – Investors may be subject to depreciation recapture taxes when they sell their TIC interest. This is because the depreciation taken on the property reduces the cost basis.
• Basis Carryover – When participating in a 1031 Exchange, the investor’s tax basis from the relinquished property is carried over to the replacement property, including the TIC interest. This means that the deferred capital gains tax and depreciation recapture will eventually be due when the replacement property is sold in a taxable transaction. However, the investor can continue to defer these taxes by engaging in subsequent 1031 Exchanges.
• Passive Income Taxation – Investors in a TIC structure have the potential to receive income from the property, such as rent or other revenue streams. This income is generally considered passive income and is subject to taxation at the investor’s ordinary income tax rate. However, certain deductions, such as depreciation and interest expenses, may offset some of this taxable income.
• Passive Loss Limitations – TIC investors may be subject to passive loss limitations. This means they may be unable to deduct losses from their TIC investment against other income.
• Passive Loss Limitations – TIC investors may be subject to passive loss limitations. This means they may be unable to deduct losses from their TIC investment against other income.
• Estate Planning Considerations – When an investor passes away, their TIC interest receives a step-up in basis to the fair market value at the time of their death. This can reduce the tax liability for their heirs.

Before deciding if a TIC 1031 Exchange is right for you, it is essential to consult with a qualified tax professional and financial advisor to understand the eligibility requirements, risks, and tax implications.

Real estate investments have been a popular choice for investors looking to diversify their portfolios and generate passive income. However, managing a property can be time-consuming and demanding, and selling a property can come with hefty tax implications. This is where a 1031 Exchange comes in handy. It allows investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into another suitable replacement property. One type of 1031 Exchange is the Tenant in Common (TIC) 1031 Exchange.

While many accredited investors are leaving TIC exchanges for another kind of 1031 exchange, it can still be useful to know the structure and how it works in the context of a 1031 exchange.

 

What Is a Tenant in Common 1031 Exchange?

A Tenant in Common 1031 Exchange refers to a specific type of investment structure that allows multiple investors to hold undivided fractional interests in real property. Each property owner has the right to use and possess the common property, and their common ownership share can be passed on to their heirs. In a TIC 1031 Exchange, real estate investors can pool their resources to purchase a replacement like-kind property that meets the requirements of a 1031 Exchange. The investors become tenants in common of the new property, and each ownership percentage is proportionate to their investment. The TIC structure allows investors to diversify their portfolios, invest in larger properties, and share management agreements and maintenance responsibilities.

A TIC 1031 Exchange is similar to a regular 1031 Exchange, but instead of owning the replacement property individually, the investors own a fractional interest from the entire property alongside other investors. The exchange is structured through a TIC agreement outlining each investor’s rights and responsibilities.

For example, John and Jane want to sell their rental property and reinvest the proceeds into a larger commercial property. However, they do not have enough funds to invest in another expensive property on their own. They decide to partner with two other investors, Bob and Sue, to purchase the commercial property through a TIC 1031 Exchange. Each investor owns a 25% interest in the property, and the rental income and expenses are shared proportionately.

 

 The Kinds of Tenant in Common Structures

The specifics of a TIC agreement depend on a number of variables, including the nature of the property, the number of investors, and the requirements of the co-owners. In a typical TIC structure, a number of investors possess undivided fractional interests in a piece of real estate, with each investor owning a fixed percentage of the whole. Here are some common types of TIC structures:

• Investment TIC – This type of TIC structure is primarily used for investment purposes. Multiple investors pool their resources to acquire and manage income-producing properties, such as apartment buildings, office buildings, retail centers, or business properties. These TIC structures often involve a sponsor or property management company to handle the property’s day-to-day operations and management.
• Residential TIC – In a residential TIC structure, co-owners hold fractional interests in a single-family home, condominium, or multi-unit building. This arrangement allows multiple parties to share ownership of a residential property, which can make homeownership more accessible and affordable. Residential TICs may involve co-owners living in the same property or renting out their individual units.
• Commercial TIC – This TIC structure involves multiple investors owning undivided interests in commercial properties, such as office buildings, retail centers, or industrial complexes. In this structure, investors may rely on professional property management or a TIC sponsor to manage the Theytypically receive income from rents and other revenue streams generated by the property.
• TIC 1031 Exchange -This type of TIC structure is specifically designed for investors who wish to participate in a 1031 Exchange, which allows them to defer capital gains tax on the sale of an investment property by reinvesting the proceeds in like-kind property. In a TIC 1031 Exchange, investors purchase fractional interests in a qualifying exchange replacement property, enabling them to defer capital gains tax and potentially enjoy other benefits, such as diversification and passive income.
• Co-housing TIC – Co-housing TICs involve a group of individuals or families who purchase a property together with the intention of living in a shared community. This type of TIC structure often emphasizes communal living and shared decision-making, with co-owners participating in the property’s management and maintenance. Co-housing TICs can be an attractive option for those seeking an alternative to traditional homeownership or rental arrangements.

 

Potential Advantages of TIC 1031 Exchange

There are several possible benefits of participating in a TIC 1031 Exchange, including:

• Tax deferral – The primary benefit of a Common 1031 Exchange is the deferral of capital gains tax, which can potentially save investors a significant amount of money. By reinvesting the proceeds from the sale of real property into a TIC, investors can defer the capital gains tax on the sale, allowing them to keep more of their profits for reinvestment.
• Diversification – TIC investments allow investors to diversify their real estate portfolios. By pooling resources with other investors, individuals can access larger, higher-quality properties that might have been out of reach if they were investing independently. This helps mitigate the risk of owning a single property and provides exposure to different types of real estate assets.
• Shared management responsibilities – In a common structure, property management is typically handled by a professional property management company or the TIC sponsor. This can alleviate individual investors’ day-to-day responsibilities of property ownership, allowing them to focus on their broader investment strategy.
• Passive investment – TIC properties often generate income through rents or other revenue streams, providing investors with a potential source of passive income. This can be particularly attractive for those looking to supplement their retirement income or build wealth over a period of time. This provides access to high-quality properties that generate significant rental income.
• Preservation of equity – When an investor sells a property and uses the proceeds to invest in a TIC, they are preserving their equity in real estate, which can be beneficial for long-term wealth building and appreciation.

Remember that while there are numerous potential benefits to participating in a TIC 1031 Exchange, there are risks and drawbacks to consider, such as illiquidity, the potential for disputes among co-owners, and reliance on third-party management. As with any investment, it’s essential to carefully weigh the pros and cons and consult with a financial or tax professional to determine if a common 1031 Exchange is suitable for your financial goals and risk tolerance.

 

Eligibility Requirements for TIC 1031 Exchange

To qualify for a 1031 Exchange, the sold and replacement properties must be of like-kind property type. This means they must be held for investment purposes or used in a trade or business. Generally, most real estate is considered like-kind if it’s not primarily held for personal use or as inventory. Other eligibility criteria for a Common 1031 Exchange include the following:

• For the replacement property to qualify as a TIC under a 1031 Exchange, it must meet certain requirements set forth by the IRS in Revenue Procedure 2002-22. Some of these requirements include the following:
  • Tenants in a common structure must hold the property, and each co-owner must hold an undivided fractional interest.
  • The number of co-owners should not exceed 35.
  • Co-owners must unanimously approve certain major decisions related to the property, such as sale or refinancing.
  • Each co-owner’s interest in the property must be freely transferable. There should be no restrictions on a co-owners right to sell, assign, or encumber their interest, subject to standard conditions.
  • Co-owners should receive a share of the property’s net income, gain, or loss proportional to their ownership interests.
• A 1031 Exchange involves strict timing requirements that investors must adhere to:
  • The investor has 45 days from the sale of the relinquished property to identify up to three potential replacement properties or more if certain valuation rules are met (identification period).
  • The investor has 180 days from the relinquished property’s sale to complete the replacement property acquisition (exchange period).
• Investors must be accredited, which means they meet certain financial requirements, such as having a net worth of at least $1 million (exclusive of their primary residence) or an annual income of at least $200,000 (single) or $300,000 (married) for the past two years with reasonable expectation of that income continuing. Accredited investors are deemed to have sufficient financial knowledge and experience to understand the risks associated with TIC ownership.
• A 1031 Exchange must be facilitated by a Qualified Intermediary (QI), also known as an Exchange Accommodator. The QI handles the transfer of funds and ensures that the exchange process complies with IRS rules. The investor must not receive the sales proceeds from the relinquished property directly, as doing so could disqualify the exchange.
• The taxpayer who owns the relinquished property must also be the one who acquires the replacement property. In the context of a TIC 1031 Exchange, this means that the same taxpayer must hold the undivided fractional interest in the TIC property.

 

Identifying Replacement Properties for TIC 1031 Exchange

Identifying replacement properties is a crucial step in a TIC 1031 exchange. Investors must identify potential replacement properties within 45 days of selling their relinquished property. There are three identification rules that investors must follow:

• Three Property Rule – Investors can identify up to three potential replacement properties, regardless of their fair market value.
• 200% Rule – Investors can identify more than three potential replacement properties as long as their aggregate fair market value does not exceed 200% of the sale price of the relinquished property.
• 95% Exception Rule – Investors can identify any number of potential replacement properties as long as they acquire at least 95% of the total value of the identified properties.

 

Structuring a TIC 1031 Exchange

Structuring a TIC 1031 Exchange involves several steps:

• The investor must sell their relinquished property and use a Qualified Intermediary (QI) to hold the sale proceeds.
• The investor must identify potential replacement properties within 45 days of selling their relinquished real property.
• The investor must select an exchange replacement property from the identified properties and enter a purchase agreement.
• The investor must form a co-ownership agreement with the other investors that outlines the rights and responsibilities of each party.
• The investor must close on the replacement property within 180 days of selling their relinquished property.

 

Financing Options for TIC 1031 Exchange

Financing options for a TIC 1031 Exchange can be more complex than traditional real estate financing due to the fractional ownership structure. However, there are still various options available to investors. Some of the common financing options for a TIC 1031 Exchange include:

• Cash investment – Investors can use their own cash or proceeds from the sale of the relinquished property to acquire their fractional interest in the TIC property. This can be an attractive option for those looking to avoid taking on additional debt, but it may not be feasible for all investors.
• Non-recourse loans – A non-recourse loan is a type of financing where the lender’s only recourse in case of default is the collateral (the real estate investment property), and they cannot pursue the borrower’s personal assets. Many TIC properties are financed with non-recourse loans, as they offer protection to individual investors from potential liability in the event of a loan default. TIC sponsors or property managers usually negotiate and secure non-recourse loans on behalf of the TIC investors.
• Cross-collateralized loans – In some cases, investors may choose to cross-collateralize multiple properties to secure a loan for the TIC 1031 Exchange. This involves pledging multiple properties as collateral to obtain financing. While this can be a flexible option for financing a TIC acquisition, it may also significantly increase the risk associated with the loan. The investor’s other properties could be at risk if they default on the loan.
• Seller financing – In certain cases, the seller of the TIC property may be willing to provide financing to the investor. This can be an attractive option for investors who may not qualify for traditional financing, but it is relatively rare and typically involves higher interest rates than other financing options.
• Partnership or syndication – In some instances, investors may choose to form a partnership or syndicate to pool their resources and jointly finance the acquisition of a TIC property. This approach can make it easier for investors to obtain financing, as the combined financial strength of the group may be more attractive to lenders. However, it can also introduce complexity in terms of management and decision-making.
• Master Lease Financing – The investors can lease the property to a master tenant who is responsible for making the mortgage payments. The investors receive a portion of the rental income, and the master tenant is responsible for managing the property.

Financing options for TIC 1031 Exchanges can vary depending on the specific property, the investor’s financial situation, and the overall market conditions.

 

Tax Implications of TIC 1031 Exchange

A TIC 1031 Exchange allows investors to defer capital gains taxes on the sale of their relinquished property as long as they reinvest the proceeds in like-kind property within the specified time frame. However, there are several tax implications investors should be aware of:

• Depreciation Recapture – Investors may be subject to depreciation recapture taxes when they sell their TIC interest. This is because the depreciation taken on the property reduces the cost basis.
• Basis Carryover – When participating in a 1031 Exchange, the investor’s tax basis from the relinquished property is carried over to the replacement property, including the TIC interest. This means that the deferred capital gains tax and depreciation recapture will eventually be due when the replacement property is sold in a taxable transaction. However, the investor can continue to defer these taxes by engaging in subsequent 1031 Exchanges.
• Passive Income Taxation – Investors in a TIC structure have the potential to receive income from the property, such as rent or other revenue streams. This income is generally considered passive income and is subject to taxation at the investor’s ordinary income tax rate. However, certain deductions, such as depreciation and interest expenses, may offset some of this taxable income.
• Passive Loss Limitations – TIC investors may be subject to passive loss limitations. This means they may be unable to deduct losses from their TIC investment against other income.
• Passive Loss Limitations – TIC investors may be subject to passive loss limitations. This means they may be unable to deduct losses from their TIC investment against other income.
• Estate Planning Considerations – When an investor passes away, their TIC interest receives a step-up in basis to the fair market value at the time of their death. This can reduce the tax liability for their heirs.

Before deciding if a TIC 1031 Exchange is right for you, it is essential to consult with a qualified tax professional and financial advisor to understand the eligibility requirements, risks, and tax implications.