If you’re a real estate investor, you likely have three primary goals. You want to make money, you want to reduce time, effort, and resources expended, and you want portfolio diversification for future ventures and endeavors.
Real estate investing and real estate ownership are about putting your hard-earned income to work and creating lasting, durable cash flow. Although many investors may quickly fix and flip or rapidly sell for short-term profit, many want the trustworthiness of passive cash flow.
At NNN Deal Finder, we have helped countless clients find properties at fair market value, leveraging their financing and previous earnings to build reliable wealth for the rest of their lives.
One of the main ways we do this is through the highly effective mechanism of the 1031 Exchange.
Through the 1031 investment vehicle, co-owners, whether commercial real estate investors or non-commercial real estate investors, can own various types of real property at once. Called TIC ownership, this form of 1031 Exchange involves tenant-in-common ownership structures.
TIC property and TIC ownership are just two terms that may apply to numerous forms of fractional interest and fractional ownership. If any of this is unclear or confusing, do not worry.
Firstly, let’s cover the basics of the 1031 Exchange, and then we can get into the specifics of exchanging real property under TIC rules and regulations.
What is a 1031 Exchange?
Generally, the term 1031 Exchange refers to an exchange of assets defined under Section 1031 of the Internal Revenue Code. Some of the top real estate investors in the industry use this crucial vehicle to enjoy various significant advantages.
In short, the 1031 Exchange is an exchange whereby an investment property or multiple properties are exchanged or swapped for one or more other properties. Any property sold is called relinquished property and any property purchased is called replacement property.
Whether accredited investors or first-time real estate investors, any taxpayer can take advantage of the 1031 Exchange. The main advantage of using this exchange is the ability to defer capital gains taxes.
Depending upon the portion of the sale proceeds of the relinquished property put into the replacement property, investors may enjoy a partial or total tax-deferred exchange.
What Kind of Investment Property Qualifies?
Property investors looking to defer taxes on their real estate may be wondering if their property can be exchanged under the rules of Section 1031. Before worrying about tax deferral or seeking tax professionals, taxpayers must ensure their properties are like-kind.
The truth is, there are many kinds of real property. Real property can include renovated and unrenovated properties, massive complexes, lavish beach homes, rental units, vacant land, and everything in between.
Whether you have full and direct ownership over a small apartment building or are doing your due diligence to pay off multiple mortgage payments, your property may qualify as like-kind.
Defining Like-Kind Investment Property in a 1031 Exchange
The term like-kind property encompasses a broad range of properties. For a replacement property and relinquished property to be 1031 Exchange investment properties, they must be similar in nature.
This does not mean 1031 Exchange investment properties have to be similar in quality or grade. One can be an old, rusty building, and the other can be brand new. An apartment can be exchanged with a townhouse.
What matters is that the investment properties are being used for either investment or business purposes. You can certainly sell a property where you conduct business. The properties must, however, be located in the United States. They cannot be a primary residence, frequently used vacation home, or designated personal property.
Again, replacement properties and relinquished properties under a 1031 Exchange must constitute some form of real estate investment or business interest. Any properties bought and sold for any other reason will not qualify.
Understanding a Fair Market Value 1031 Exchange
In a 1031 Exchange, fair market value is a critical consideration. Before you exchange for a replacement, you should be well aware of market fluctuations, comparative analysis data, and buyer/seller trends.
A top-notch 1031 Exchange specialist can help you in all regards.
Because the main advantage of the 1031 Exchange is the deferral of some or all capital gains taxes, you need to understand how these calculations are made.
Important 1031 Exchange Rules and Guidelines
When you roll sale proceeds into a suitable replacement property, the replacement property must be of equal or greater value than the sold property for total deferment.
If the sale price of the new property is less, the portion you don’t reinvest in the new property will be your ‘boot.’ This boot is then subject to capital gains tax.
The 200 Rule
Generally, an exchanger can identify up to three potential investment properties for replacement. If he or she wishes to identify more than three, he or she can do so. However, there is a caveat. The total fair market value of these identified properties cannot exceed 200% of the fair market value of the property relinquished.
This is why it’s critical to have a sound understanding of the market and a keen ability to accurately calculate the various costs, fees, and expenses.
The 95 Rule
Of course, there are exceptions to the so-called 200 Rule. If a taxpayer identifies over three properties that exceed 200% of the sold property’s value, the taxpayer must acquire at least 95% of the value of those identified properties.
Generally, any taxpayer must identify a suitable replacement property within 45 days of finalizing the costs and sealing the deal on a relinquished property. This 45-day period will begin the day the first sold property closes if multiple properties are being relinquished.
Identified properties do not need to be contracted and the investor does not need to acquire any identified properties. That said, the investor cannot acquire unidentified properties either.
Any properties that are identified and acquired must be identified and fully acquired within 180 days. The only real exception is natural disaster declarations.
Types of 1031 Exchanges
Depending upon an investor’s goals and objectives, one may engage in various 1031 Exchanges. These exchanges can offer many advantages and disadvantages. One type of 1031 Exchange may expedite the process if you’re in a bind, while another 1031 Exchange may allow you breathing room to acquire a suitable replacement property.
Depending upon your related fees, costs, and expenses, every 1031 Exchange is different. Some investors want to defer taxes on capital gains for a period and others want to defer them in perpetuity with continued investments.
Let’s cover the four sub-structures of a 1031 Exchange.
Improvement/Construction 1031 Exchange
Finally, this type of 1031 Exchange refers to the use of tax-deferred money to renovate or improve the replacement property. To fully defer taxes on capital gains, all the proceeds from the property relinquished must be used to improve the new property.
In other words, all equity must go toward finished improvements or down payment by the time the 180-day window has closed. The improved property must be “substantially the same property” identified earlier on the 45th day.
Simultaneous 1031 Exchange
As one of the more uncommon types, this 1031 Exchange involves the different parties exchanging at the same time. In this case, the replacement property and relinquished property have to close on the same day.
Locating properties of the same value can be very difficult, especially when factoring in mortgages. This involves a close relationship between the exchangers so that all details are fully fleshed out.
You must also ensure that the channels for payment delivery are sound so that the exchange is made efficiently on the same day.
Fortunately, a qualified intermediary can assist throughout this 1031 Exchange.
Reverse 1031 Exchange
Under this 1031 Echange, the replacement property is acquired through a titleholder before relinquishing the owned property. Owners using this exchange typically get little help from banks. Usually, these exchanges are funded through cash not loans.
Taxpayers have 45 days to identify any property being relinquished and the full 180-day window to relinquish this property and officially purchase the replacement property.
Delayed 1031 Exchange
This is the most popular 1031 Exchange because it gives both the replacement property owner and the relinquished property owner time to sort things out. Once the exchange proceeds are acquired from the property relinquished, the exchanger can begin to search and identify replacement property.
An intermediary can hold the funds while this happens until the deal is closed on the replacement property.
Overall, there are many ways in which taxpayers can enjoy the benefits of the 1031 Exchange. However, what if there are multiple co-owners interested in the same properties? What happens when traditional ownership becomes fractional ownership with several if not dozens of co-owners?
This is where the concept and real-world application of TIC properties and TIC owners become so critical. The 1031 TIC Exchange is a unique and potentially lucrative mechanism.
What is TIC Property?
The term TIC property refers to investment real estate whereby there are tenants in common or tenancy in common. Through a TIC agreement, co-owners of a TIC property or TIC properties create a distinct co-ownership structure.
In a TIC structure, a given property has more than one owner. Therefore, a tenancy-in-common (TIC) agreement is where property co-ownership is shared between two or more co-owners. The co-ownership percentages may vary widely depending upon agreement terms, other co-owners, and investment minimums.
When a co-owner dies, the interest in the TIC common property goes to an identified heir. Tenants-in-common fractional ownership signifies an undivided interest, meaning any co-owner can use the entire property.
However, this common arrangement in property does not have to pertain strictly to TIC investment properties. A tenancy-in-common structure or tenants-in-common structure may be used for alternative investments or they may have nothing to do with profit and investment property.
That said, TIC agreements among two or more owners often do align with TIC interests in real estate investment, especially for a larger property. A TIC structure can be particularly useful for exchanging TIC investment properties under a 1031 TIC Exchange.
Tenants in Common (TIC) Structure Under a 1031 Exchange
Under TIC structure, TIC ownership is based on undivided interest in real property. This simply means that any co-owner can use the full property and not merely parcels. These fractional interests are typically based on percentages shared among two or more owners, or pro-rata.
For example, depending upon the co-ownership structure, one co-owner may enjoy more or not as much control as other investors under the common arrangement. Splits in tenancy-in-common co-ownership may dictate how often and how much co-owners can use a given property.
Under Revenue Procedure 2002-22, there is an implied “safe harbor” whereby TIC co-owners can enjoy 1031 tax-deferred treatment, as long as they adhere to IRS requirements. As a result, many TIC sponsors, brokers, and other parties have begun using 1031 Exchanges to their benefit.
Tenancy-In-Common Ownership Rules Under a 1031 Exchange
For any tenant-in-common agreement to qualify under Section 1031, TIC co-owners must adhere to the following real estate investment rules, regulations, and guidelines. These important aspects of the 1031 Exchange apply particularly to tenants in common.
These requirements help to delineate critical tenants-in-common fractional interests, fractional ownership aspects, and other shared circumstances. Tenants in common should also consult any local law that may pertain to any accredited investor, active investor, or passive investor.
To qualify under a 1031 Exchange, tenants in common must abide by:
- Tenants in Common Limit
There cannot be more than 35 co-owners or tenants in common.
- Unanimous Approval
This is a requisite for all sales, leasing, management procedures, and refinancing efforts. In other cases, only majority approval is required.
- Manager Compensation Terms
If tenancy-in-common co-owners choose to hire a property manager, that manager can only receive compensation from gross rental income, no other sources. Ultimately, tenants in common make the final decisions on all matters.
- Sponsor Compensation Terms
Any sponsor, syndicator, or otherwise who is not on the title may still receive fair compensation. However, this compensation paid by tenants in common cannot be derived from investor returns or profits.
Rather, compensation must be based on property fair market values.
- Co-Owners’ Shared Rights
All tenants in common have the right to transfer their shares, borrow against their shares, and execute a forced sale with appropriately allocated proceeds.
- Co-Owners’ Distribution
Tenants in common are required to appropriately distribute their expenses, income, debts, profits, and cash amounts. This sharing is determined by agreed-upon co-ownership percentages among the tenants in common.
Those who are not tenants in common are prohibited from this sharing.
It is important to note that all tenants in common must be listed on the property title. For a 1031 tax deferral to be legitimate, the tenants in common must also be noted as mortgage borrowers for any mortgages.
As a result, tenants in common can be liable for full or partial amounts stemming from mortgages, debts and losses, and various other damage-related expenses.
Tenants in common should stay abreast of all fees paid, other co-owners’ fractional interests, and various tenant-in-common real estate obligations.
In other words, every tenant in common must act accordingly based on his or her fractional interest and the requirements under Revenue Procedure 2002-2022.
Tenant-in-Common Protection Under a 1031 Exchange
Because each TIC interest may vary based on the tenants-in-common agreement, co-owners are always looking for ways to protect themselves. It doesn’t matter how large or small a fractional interest may be, tenants in common should always attempt to protect their liability.
Limited Liability Under the 1031 Exchange
One vehicle for protecting tenants in common is the Limited Liability Company (LLC). By using an LLC, tenants in common can convert their co-ownership into an entity form. However, this process is often dubious, taking an unknown amount of time and leaving much to be desired.
For better 1031 Exchange protection against liability and IRS audits, tenants in common can make their shares single member limited liability companies (SMLLCs). This is a great option for income tax purposes, as the tenant in common is regarded as directly owning while enjoying liability protection.
In addition to having their legal protections figured out, tenants in common should also know how to calculate their fractional ownership interests. This will help them in determining what may be taxed or the ‘boot’ under a 1031 tax-deferred exchange.
Understanding TIC Ownership Interests
A tenant in common’s fractional interest will vary depending upon countless factors. Under a co-ownership agreement, one must consider aspects such as new and changing tenants, property value fluctuations, real estate types, asset classes, comparative market trends, and more.
For instance, what happens if one or more tenants in common suddenly pass away? What happens when significant, uncontrollable, and unforeseen events completely change the value of properties? Tenants in common need to have a firm understanding of the structure, its interests, and its current and projected state.
DST vs. TIC Structures
As a result, many investors use what is called a Delaware Statutory Trust (DST). By using Delaware Statutory Trusts under 1031 exchanges, investors never own titles and are not obligated to manage or control replacement properties.
Thus, unlike with a TIC structure, there is only one loan and one borrower, the trust. Moreover, any number of investors may get involved in a DST transaction.
With TIC fractional interests, tenants in common must understand their obligations and liabilities. There are many ways ownership percentages are tabulated.
Calculating Tenant-in-Common Interests
Some tenants in common may be actual tenants, living on the properties they co-own. In this case, their ownership percentage may be greater or subject to various obligations. This will vary depending upon the TIC property type as well.
Occupancy rights in a multi-family apartment complex are different than for some large estates. The percentage of ownership may depend upon the area or lot size, how many square feet or units, and so on. The size discrepancies between these aspects of TIC property may dictate the allocation of shares.
This will all likely factor in the purchase price. Investors must remember that to undergo a 1031 tax-deferred exchange, they must abide by local and state regulations. These differ from area to area and may significantly impact TIC structure, co-ownership, and more.
Consult a top 1031 TIC exchange specialist to understand what your ownership interest, expenses, and tax-deferral options may look like.
In Closing: Why Use a 1031 TIC Exchange?
You’re an investor for a reason. You want to create a strong, sustainable income. You want to build and diversify your portfolio. More than anything, you want to look to the future knowing it’s going to be good for you and your loved ones.
Especially for investors involved in triple-net (NNN) commercial real estate, a TIC 1031 Exchange can be lucrative.
Truth be told, the economy is in the dumps. and every investor is looking at his or her bank account wondering what may happen. The future is unpredictable, and the present is changing all the time.
That’s why we need to do the best we can now to ensure everything is well-prepared. Fortunately, TIC investments are a reliable way to bolster your financial health against inflation, uncertainty, and inevitable events.
With TIC triple-net exchanges, you can enjoy healthy capital appreciation, reduced fees and closing costs, higher liquidity, and the freedom and convenience to create the income you want. Don’t hold yourself hostage with bad realty investments and time-consuming, headache-inducing stressors.
At NNN Deal Finder, we have the experience, expertise, and network of consummate professionals to make your investment dreams come true. Give us a call today and let’s start the journey.