Taxpayers who are seeking to exit active management of their properties often consider the possibility of entering into a Section 1031 Exchange through Tenant-In-Common (TIC) or Delaware Statutory Trust (DST) opportunities. If the transaction qualifies, any capital gains taxes that would otherwise be due can be deferred until the sale of the replacement property. Among other requirements, a 1031 Exchange requires the seller to exchange the property for a property of “like-kind” in order to be eligible for 1031 Exchange treatment. Many savvy investors are utilizing fractional ownership of TICs or DSTs to diversify their holdings, round out the remainder of unused exchange proceeds or shift to a more passive approach to their real property holdings.
Tenants-in-Common 1031 exchanges allow property owners to defer capital gains when replacing a fractional interest in a cash flowing property. It is a form of direct ownership that is not affected by the IRC §1031(a)(2)(D) exclusion as long as the co-tenants or owners are not treated as partners for income tax purposes. Tenant In Common Interests, is one way that an investor can take part in ownership of a property that they would potentially not be able to afford on their own, such as a portion of commercial strip mall or building leased to Walgreens.
It is important to note that most TIC investments require the “Accredited” Investor status, meaning that your net worth exceeds $1,000,000 (excluding your personal residence) or your income exceeds $200,000 in each of the last two years or, if applying jointly with your spouse, your income must exceed $300,000. Though they differ from Delaware Statutory Trusts, they share many commonalities.
In 2004, the IRS released Rev. Rul. 2004-86, which allowed Delaware Statutory Trusts to acquire real estate where the beneficial interest is treated as direct interests. This allowed for the utilization of Delaware Statutory Trusts (DST) to qualify for 1031 exchange treatment. DSTs differ from TICs as they have no voting authority but also do not require the forming of a single member LLC to participate. The number of investors is unlimited and determined by the structure of the DST, whereas a TIC is limited to up to 35 investors.
There are a bevy of options that include special interest DSTs that focus on health care, senior living or retail properties. The key advantage to a TIC or DST interest as replacement property is their passive nature. They are terrific options if you have additional net sales proceeds to invest after identifying other property or if you are seeking a passive investment.
Tenants-In-Common 1031 Exchange
Tenants in Common 1031 exchanges allow property owners to defer capital gains when replacing a fractional interest in a cash flowing property. Tenants in Common is a form of direct ownership that is not affected by the IRC §1031(a)(2)(D) exclusion as long as the co-tenants or owners are not treated as partners for income tax purposes. In 1984, Congress excluded interests in partnerships from 1031 consideration by legislating IRC §1031(a)(2)(D). This was a response to taxpayers using IRC §1031 exchange as a strategy to defer gains realized on termination of burnt out tax shelters in the ‘70s and ‘80s.
In 1999 and 2000, after tenants in common interests in real estate were being sold as replacement property for 1031 like-kind exchanges, several taxpayers requested rulings from the IRS that undivided fractional interest (TIC) arrangements would not be treated as partnerships for tax purposes. In 2000, the IRS issued Revenue Procedure 2000-46, 2000-2 C.B. 438, stating their intention to issue public guidance whether a TIC interest in real estate will be treated as a separate business entity for federal income tax purposes.
Revenue Procedure 2002-22
In 2002, the IRS issued Revenue Procedure 2002-22, 2002-14 IRB 733, setting forth guidelines that a TIC co-ownership arrangement will not be treated as an entity separate from its owners. A new market was created with more than 25 sponsors raising an estimated $1 billion in capital in 2003 for tenants in common properties. Co-owners must hold their interests as tenants in common under local law. Property title cannot be held by an entity such as a single member limited liability company. The maximum number of co-owners is limited to 35. A husband and wife are treated as a single entity as are all persons who acquire interest from a co-owner by inheritance.
Each co-owner must share in revenue and expense allocation in proportion to the co-owner’s undivided interest in the property. Debt must be shared amongst co-owners in proportion to their undivided interest. Unanimous approval of the co-owners is required on any blanket lien modification. Given a manager is employed by the co-owners for the purpose of collecting revenue, the manager must disburse to the co-owners their share of net revenue within three months from the date of receipt of those revenues. The appearance of a partnership is forbidden. Co-owners are prohibited from conducting themselves as a partnership or common business entity. Co-owners cannot file partnership tax returns. Their activity must be limited to maintenance and repair of the property.
TIC Target Market
The target market for TIC ownership is taxpayers with a net worth in excess of $1,000,000 who are seeking a monthly cash flow without the headaches of the landlord. Caution should be exercised when evaluating prospective properties. What is the exit strategy? Is the property overvalued? Who are the tenants? There are a variety of types of tenants in common products to choose from, including warehouses, apartments, marinas, office and commercial buildings, marinas, nursing homes, hotels and motels as 1031 replacement property.
Delaware Statutory Trust 1031 Exchange
A 1031 exchange into a Delaware Statutory Trust represents a potential solution that any real estate owner and advisor should consider if confronted with the challenge of selling highly leveraged property. A Delaware Statutory Trust is a beneficial interest in a trust that holds real estate assets managed by professionals. These underlying assets are often single tenant net leased properties or portfolios of net leased properties with leases guaranteed by national credit tenants.
Examples of the types of properties held by a Delaware Statutory Trust are necessity-based retail assets like drug stores, banks, grocery anchored shopping centers, single-tenant office and multi-family assets. These professionally managed trust interests can provide attractive returns and the benefits of real estate ownership, including depreciation pass-through.
Non-Recourse Financing
More significantly, certain Delaware Statutory Trust offer assumable, non-recourse financing, sometimes with leverage in excess of 80 percent. Delaware Statutory Trusts are most often thought of as income producing investments, but a very highly leveraged Delaware Statutory Trust can be used to reduce the investor’s debt level over time, while avoiding the out of pocket tax loss associated with a short sale or simply walking away from the property. The trust accomplishes this by directing all income to paying down the loan, thereby increasing the taxpayer’s equity over the course of the holding period. Then, upon the eventual disposition of the asset, the taxpayer can potentially use another 1031 exchange to invest in an income producing Delaware Statutory Trust in accordance with their enhanced equity position.
In the $2,000,000 property example above, the distressed property owner conveys the property for $1,400,000, pays off the $1,000,000 loan and uses a 1031 exchange with an 80 percent or more assumable non-recourse Delaware Statutory Trust for $1,400,000. The remaining 20 percent portion requires a cash infusion. The 25 percent recaptured depreciation tax is effectively deferred.
Delaware Statutory Trust Qualification
The 1031 Delaware Statutory Trust is not for everyone, given you must be an Accredited Investor as defined in Regulation D of the 1933 Securities Act and later defined by the 2010 Dodd-Frank Act. Individual investors who have a minimum net worth of $1 million (excluding the value of a person’s primary residence) or have an annual income in the last two years of $200,000 if single or $300,000 if married and have a reasonable expectation that this income level will continue in the future are candidates.
Delaware Statutory Trusts or Tenants-In-Common Qualified Intermediary
If you are considering a 1031 exchange utilizing Delaware Statutory Trusts or Tenants-In-Common, Atlas 1031 provides the accommodation services compliant with Internal Revenue Code Section 1031. Click below to begin a consultation or call our office at 1 800 227 1031 to discuss your 1031 exchange.
