Exploring the Frontier of Non-traditional Real Estate Investments: a Closer Look at 1031 Tenancy-in-common Arrangements

• Publication year: 2022

40 Creighton L. Rev. 271. EXPLORING THE FRONTIER OF NON-TRADITIONAL REAL ESTATE INVESTMENTS: A CLOSER LOOK AT 1031 TENANCY-IN-COMMON ARRANGEMENTS

Creighton Law Review

Vol. 40

BRADFORD UPDIKE

Special Dedication: The author would like to dedicate his time and efforts in writing this work to the memory of University of South Dakota Professor Frank Slagle, LLM, JD, who passed away on September 24, 2006. Professor Slagle was an accomplished educator, tax practitioner, and speaker who presented in many tax-planning workshops in the Midwest, including the Great Plains Federal Tax Institute held in Ne braska. Professor Slagle's dedication and service to the tax planning industry were greatly appreciated by those of us who had the pleasure to work and study under his guidance.

I. INTRODUCTION

Despite the economic benefits that can be achieved by owning real estate (e.g., asset growth, income, and tax-deferral), many investors nearing retirement will soon come to the realization that they simply do not want to maintain a high level of involvement in managing their property.(fn1) With the benefits of real estate ownership also come the duties of keeping the property in a habitable condition for their tenants.(fn2) Roofs have to be repaired, electrical wiring and plumbing have to be maintained, and common access areas have to be kept safe to the public on a daily basis. In spite of these problems, many real estate owners may have also come to the realization that their retirement savings are less than what they had planned on. After all, the investment growth experienced by many in the stock market of the late 1990s has been followed by a problematic bear market.(fn3) For understandable reason, investors seeking income for retirement as well as diversification within their asset portfolios may want to maintain a certain amount of their wealth in real estate.(fn4)

Some real estate investors face other planning issues. Some might hold lofty aspirations of becoming owners in an institutional-grade commercial real estate project, but they might also lack the financial resources on their own to accomplish this. Others, who have undertaken the task of trying to exchange real estate on a tax-deferred basis, may have learned the hard way that the real planning problem lies within the timing deadlines for identifying and closing on the replacement real estate. The first problem is trying to locate a property that makes economic sense within forty-five days of the sale on the original real estate.(fn5) Assuming one gets that far, the second problem is closing on the replacement property within 180 days of the sale.(fn6) Unfortunately, environmental problems, structural defects, pre-existing tenant rights, and zoning issues are just a few of the potential set-backs that can derail the taxpayer's plans.(fn7) In the wake of these issues, the solution, as set out in the like-kind exchange rules of I.R.C. § 1031, is not really as simple as it appears.

These are the cases that tenancy-in-common arrangements (also referred to as "TICs") organized under I.R.C. § 1031 are intended to address. TICs can help some investors stay invested in real estate on a passive basis, and they can help others meet the stringent timing deadlines that must be followed for deferred exchanges.(fn8) Additionally, TICs can provide an opportunity to own a piece of a high-grade commercial investment, which might not otherwise have been available through a direct purchase.(fn9) One really does not have to look much further than the Internet itself to appreciate the substantial marketing efforts to promote the purchase of TICs.(fn10) These marketing efforts are paying off, too.(fn11) For example, the amount of annualized TIC sales was $167 million in 2000 and has risen to $3.7 billion through 2004.(fn12) One source claims the level of investment might reach the $40 to $50 billion mark by the end of 2010.(fn13)

As the popularity of TICs continues to grow significantly, a careful understanding of the tax consequences and investment suitability factors of these investments is critical. Aside from the touted tax-deferral advantages, a practitioner needs to think seriously about whether the proposed TIC deal a client is inquiring about will qualify for like-kind exchange treatment. Many do - but some do not. Assuming the deal meets the various like-kind exchange requirements, a second and more critical line of inquiry should be undertaken to determine whether the deal makes sense from an economic planning perspective.

To this end, the remaining sections of this Article will take a careful look at TICs from both of these perspectives. The next section of this Article will provide a general discussion of the federal income tax rules that apply to like-kind real estate exchanges. As the primary tax objective for purchasing a TIC investment is often premised upon the TIC's qualification under the like-kind exchange rules, it is important for readers to have a good familiarity with these rules. Outside of the TIC arena, practitioners and tax students alike, who are just becoming familiar with the like-kind exchange rules, should find this section to be a very helpful resource. Sections III through VI of this Article will address a number of structural, operational and tax-qualification issues that apply to TICs. Section III provides a general discussion about how these arrangements are structured and operated, and Sections IV and V discuss the all-important partnership classification rules and how they can affect a TIC's qualification for like-kind exchange treatment. As the exclusionary provisions of the like-kind exchange rules make specific reference to securities, Section VI will take a closer look at the effect federal securities laws might have upon the like-kind exchange treatment of TICs. Section VII provides an overview of some general tax consequences of TIC arrangements, and Section VIII provides a discussion of some important investment suitability considerations that investors need to consider prior to purchasing a TIC investment.

II. I.R.C. § 1031

Before we address TIC exchanges, we will review some basic principles of like-kind exchanges, which are found in I.R.C. § 1031. Although it is not the purpose of this Article to provide an all-inclusive treatise on like-kind exchanges, a general discussion of some important requirements is in order. For discussion purposes, references to relinquished property refer to the real estate the exchanging taxpayer is giving up, and references to the replacement real estate refer to the real estate the taxpayer ultimately ends up with once the exchange is completed.

Under the like-kind exchange rules, an owner of business or investment rental real estate can exchange its property for another investment in income-producing real estate of equal or greater value and defer the payment of capital gains taxes.(fn14) Looking to a simple example of this, if we assumed a certain taxpayer purchased a downtown commercial office building in 1970 for $100,000, the building today could be worth $10 million or more. The outright sale of the property of course would cause the taxpayer to incur federal capital gains taxes on the profit.(fn15) However, if the taxpayer exchanged the building for other commercial or investment real estate of the same or higher value, the taxpayer would defer paying these taxes.(fn16) If we were to assume that the $9.9 million appreciation was subject to a federal capital gains tax of fifteen percent, the taxpayer owner would continue to keep an additional $1.485 million invested and working under the tax rates that are in place today.(fn17) This is money that would have otherwise been paid in federal income taxes had the real estate investment been cashed out.

Although the like-kind rules speak in terms of an exchange of properties, virtually all of these transactions are conducted on a deferred basis through a fictional exchange with an assigned-in seller/buyer known as an intermediary.(fn18) As long as the property exchanged is like-kind in nature and the transfer of the relinquished and replacement properties is structured in a form that is consistent with the operational rules set forth in the regulations, the exchange will be respected.(fn19) Thus, the like-kind exchange rules are perhaps one of the few places within the Internal Revenue Code ("Code") where form truly prevails over substance.

Like-Kind Requirement. The like-kind provisions require non-recognition of realized gains and losses when property held for business or for investment use is exchanged solely for property of a like-kind that is also held for such purposes.(fn20) To aid us in understanding what types of property are like-kind in nature, two broad categories of property should be differentiated: 1) real property, and 2) personal property. Certain types of property are not eligible for non-recognition treatment and are thus categorically excluded from the like-kind exchange provisions. A list of the excluded categories of property includes stock-in-trade and property held primarily for resale (inventory), stocks, securities, evidence of indebtedness, partnership interests, certificates of trust, and choses of action.(fn21)

In the case of real property, the term like-kind refers to the nature or character of the property, rather than its grade or quality.(fn22) Therefore, no...