By Paul White, Professional Investment Advisors
As a real estate professional and financial advisor, you pride yourself in providing unique solutions for your clients. One of the most powerful tax saving tools you can use with your clientele is a 1031 Exchange. One day, you receive a phone call from a client asking for your help in finding a replacement property to complete their 1031 Exchange. The client has sold property and has placed the proceeds with a qualified intermediary. Their tax advisor estimates taxes to be in excess of 30 percent due to the Federal and State Capital Gains Taxes, as well as a 25 percent Federal Depreciation Recapture.
Your client is in one of the fastest growing demographics in the nation, aging baby boomers, that prefer passive to active ownership seeking to rid themselves of property management and the 3 T’s: Tenants, Toilets and Trouble. This appears to be the ideal set of circumstances for a 1031 Exchange — except one small detail — the amount of your client’s exchange equity is only $500,000.
Knowing that this amount of equity may limit your client’s choices, you begin to search for a suitable replacement property. Your client wants the usual, predictable income with minimal maintenance. You assume that the best solution would be a single credit worthy tenant, double or triple net lease property. Continuing your search you find properties in this price range involve tenants with low or no credit, less than desirable lease terms, and difficult, if any, financing arrangements. Not the ideal solution. One other important detail, the 45 days for property identification is running out, putting pressure on both you and your client to make a serious decision, fast. You don’t want your client to settle for less than predictable property, because this exchange represents a substantial portion of their retirement assets. If you and your client settle for mediocre replacement property, it could fall short of your client’s expectations.
You hear about a new type of property ownership, Tenant-In-Common (TIC) replacement property. You’ve heard rumors about TICs, but unsure about the specifics, you contact a friend who mentioned doing exchanges using TICs. When you do some research, you discover that Tenant-In-Common is one of the oldest types of real estate ownership dating back to England in the 1600s when commoners were permitted to own land. Historically, because land was so expensive, several Serf farmers got together to purchase a single farm and thus, the TIC was born. After more research, you find out that in 1994, two partners in a large real estate company, Tony Thompson and Bill Passco, sought to secure investments from 1031 Exchangers to purchase large Institutional Grade A properties with Grade A tenants in order to professionally manage the properties for their investor clients. As the story goes, they hired Darrel Steinhouse, Esq., in San Diego to prepare all the necessary legal documents. Hence, the modern day TIC was reborn.
And to comfort your client’s concerns about whether these TIC exchanges conform to IRS rules, you learn that these TIC programs come with tax opinions from qualified tax attorneys which are based upon a recent IRS revenue ruling in March 2002, stating that Tenant-In-Common ownership was considered valid “Like Kind” 1031 Exchangeable replacement property. You ask yourself, it sounds too good to be true and why isn’t everyone buying a TIC? Discovering a recent study that exhibits 1031 Exchange proceeds invested into TIC properties it was only a mere $166 million in 2001, grew exponentially to over $5.4 billion in equity purchasing approximately $20 billion in TIC properties in 2006.
Wondering why are TICs so popular and why you haven’t heard more about them in the past, you are informed that 1031/TIC Exchanges allow investors with smaller amounts of equity to join together, enabling exchangers to upgrade and purchase larger, presumably safer, investment properties than they could on their own. You further learn that there are a plethora of different types of TIC properties available including; retail, office, senior housing, apartments, collegiate living and industrial located across broad geographical areas.
You do more research and discover, if a TIC property has any debt, it has a very unusual structure unlike a normal conventional mortgage. TIC debt, if any, is a non-recourse mortgage of which the investor is not personally liable under most circumstances. You become aware that included in the TIC program is professional property and asset management, which relieves your client of these responsibilities. In addition, you uncover an additional layer of safety for your clients, most multi-tenant retail and office TIC properties have credit worthy anchor tenants such as Fortune 1000 companies, U.S. Government and state/local municipalities with unlimited taxing authority to pay rent. You learn that TIC properties come in a variety of different asset classes: single- or multi-tenant retail and office, assisted living, multifamily apartments and townhouses, self-storage, industrial, etc. The properties are located in various states to add geographic diversity to your client’s investment. As a professional financial advisor, you remember studying Markowitz’s Modern Day Portfolio Theory which won him the Nobel Prize: “diversify a client’s assets to reduce risk and increase the probability of increased income and asset appreciation.” After gathering all this vital information, you think that TICs may be a great diversified investment for your client by lowering risk and increasing annual yield as compared to their original property.
You also find out that TICs pay an average annual yield of approximately 7 percent paid in monthly installments. Historically, you find out that TICs have achieved an average of about 18 percent annual internal rate of return (i.e. 7 percent annual yield and 11 percent annual appreciation). You think to yourself, not a bad return for my clients in the bare stock market cycle with low return rates. Then you learn that real estate companies that offer TICs are commonly known as Sponsors and some guarantee investor income as well as mortgage payment, if any, through a Master Lease arrangement. Eureka, more intrinsic “safety” for my clients. You read that Sponsors structure most TIC properties with a reserve fund to pay for any capital improvements and maintain investor income should a shortfall occur. I really like that feature of TICs for my clients.
One more question that you ask on behalf of your clients, how do they sell their TIC interest? You find out that your clients have not purchased shares of stock or a limited partnership but own an undivided fractional deeded interest in the TIC, which they may sell or borrow against at any time. When you do additional research on TICs, you discover that TIC properties sell in an extremely short period of time compared to other types of real estate. In fact, many of the most desirable properties, sell out in one day!
By this time you wonder to yourself, why isn’t everyone buying TICs for 1031 Exchange replacement property? And you discover, they probably are!
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Paul White, president of Professional Investment Advisors, has specialized in 1031 Exchanges for over 30 years and is one of the select few Certified Exchange Specialists (CES®) in the U.S.