Evaluating tenant-in-common interests in real estate.

ONE OF THE MOST COMMON CONCERNS U.S. INVESTORS AND their professional advisors face when structuring tax-deferred exchange transactions is the difficulty in locating, identifying and acquiring like-kind replacement properties within the unforgiving tax-deferred exchange deadlines. Because many investors wait until the closing of their property sale to start the search for properties, the tax-deferred exchange deadlines already are imminent. Investors are under the gun, and are forced to rush the search for suitable properties and shorten the due-diligence period.

Section 1031 of the Internal Revenue Code places strict time constrictions and rules on designating like-kind replacement properties. Investors typically designate no more than three replacement properties--given the difficulty making a proper identification under the rules--and because of the time limit, they typically evaluate only local or regional properties of the same asset class. Though this manner of identification could meet investors' goals, replacement properties chosen in haste are likely to have the same problems or conditions that originally motivated the investor to sell the relinquished property--inflated sales prices, poor cash flow or intensive property management requirements, for example. Often, investors ultimately face a tough choice: purchasing less-than-ideal properties to complete the tax-deferred exchange or letting the exchange fail and continuing the search for replacement properties that make sense outside 180-calendar-day deadline.

The second practical problem that arises with designating like-kind replacement properties relates to investors' ability to negotiate and close on properties they identify within the 180-calendar-day exchange period. Even where the identification process has been relatively simple--where the investors have no trouble finding properties that make economic sense within the 45-calendar-day identification period--there is no guarantee that the investors will be able to close on the properties in the time remaining.

Real estate transactions fail to close for many reasons: problems discovered during the property inspection, defects in structure, tenant issues, environmental problems and difficult third parties, to name just a few. Though these problems are difficult to redress in the context of a normal real estate closing, they can prove disastrous in the tight time frame of a tax-deferred exchange. Investors who fail to take specific steps to remediate risks to closing their identified properties could find themselves in a position where they are unable to close on the property within 180 days and unable to identify any other properties because the 45-day identification period has passed. Their tax-deferred exchange transaction then would be doomed to fail.

To avoid this scenario, investors must reorient themselves to think of identifying replacement properties as a strategic process. Rather than submitting their identification based on a preliminary assessment of potential properties, investors should identify only properties for which they have considered whether they can conduct due diligence in a timely manner, whether the property makes economic sense and whether the transaction has any inherent risks that might prevent closing within the deadline.

These considerations mean investors should start doing due diligence on potential properties very early in the exchange period. Accordingly, investor would have the additional benefit of being able to begin trying to acquire one or more replacement properties during the first 45 days, allowing them to revoke the identification and re-identify additional properties if a contingency were to occur.

LACK OF SUITABLE PROPERTIES LEADS TO TIC INTERESTS

Pursuing a tax-deferred exchange and using a strategic process for identifying replacement property does make one large assumption: that properties meeting investors' particular needs are, in fact, available. However, it is not uncommon for properties on the market to pose a risk to investors in one capacity or another, or to simply not be economically feasible.

In response to this lack of suitable replacement properties, for tax-deferred exchanges and real estate investors in general, an industry has sprung up to develop and offer syndicated property interests as alternative investment vehicles. These fractional ownership arrangements have names such as co-ownership in real estate, or CORE--or more commonly, tenant-in-common, or TIC--interests. Investors should carefully consider and evaluate the merits of these opportunities instead of rushing into an acquisition that does not ultimately make economic sense.

TIC interests in real estate were introduced when real estate entrepreneurs who understood the advantages of owning syndicated property interests in the form of triple-net-leased properties recognized that the size of the properties and the liquidity required to get into triple-net-leased property precluded most investors from participating. So they set out to develop a way to make these interests more marketable. These entrepreneurs began individually arranging financing for and purchasing large properties with triple-net leases to large, credit-worthy tenants and dividing the properties into smaller deeded units, referred to as tenant-in-common interests. These smaller deeded interests are then available for direct purchase to investors through private placement offerings and, since the issuance of revenue procedure 2002-22 in 2002, have been expressly declared valid as like-kind replacement properties for investors in tax-deferred exchange transactions.

TIC properties--because of how they are packaged, distributed and sold--can provide an alternative to investors struggling with tax-deferred exchange timing requirements. Simply stated, TIC interests allow investors to acquire, together with other investors, a percentage or fractional interest of a larger, institutional-quality property that is potentially more stable, secure and profitable than what they otherwise could have acquired alone within the exchange deadlines.

The interests are, in essence, prepackaged investment properties; the purchase/sale agreement and financing already is negotiated and set in place. In addition, investors can acquire TIC ownership interests in a number of different properties to improve diversification and investment portfolio quality. TIC interests also allow investors to purchase an interest or value in the exact amount necessary to satisfy tax-deferred exchange requirements.

Investors can work with professionals in the syndicated TIC investment arena to ascertain which opportunities are suitable for them. Syndicators, or TIC sponsors, are responsible for locating, evaluating, financing and acquiring TIC properties. Once arrangements to acquire or actual acquisition of the property occurs, the property is ready to take to market. From that point, TIC brokers market the TIC interests in the same manner as other regulated securities. TIC brokers, who typically work with numerous TIC sponsors, can help investors evaluate various investment options and offer advice as to whether a TIC ownership interest is right for a given portfolio.

TIC STRUCTURES TYPICALLY COMPLY WITH FEDERAL REGULATIONS

Putting together a syndicated TIC offering begins with a sponsor, usually a large real estate investment company, using their commercial contacts across the United States to identify properties likely to have good cash-flow potential and that are priced under market value. After identifying a property, the TIC sponsor's acquisition team begins the due diligence process, verifying the representations and projections and justifying the initial assessment of the property's value. When the acquisition team is satisfied that the project is a good acquisition, the sponsor then purchases the property, arranging the purchase/sale agreement and the financing of the property through an institutional lender.

The syndication of the property into TIC investments begins at this point. The sponsor announces the property's availability to a network of brokers who, in turn, analyze the investment to determine whether it's appropriate for their clients. TIC investments that could be characterized as a security under the Securities Act of 1933 and the Securities Exchange Act of 1934 come to market as what are called Regulation D offerings. This procedure allows an exemption to the registration requirements of the Securities Act of 1933, but also means that only people who meet the accredited investors standard as defined by securities regulations are eligible to invest.

When a prospective investor expresses interest in buying into a particular TIC property, either as a direct purchase or as part of a 1031 tax-deferred exchange, the broker sits down with the investor and his real estate professionals and goes through the private placement memorandum, or PPM, which contains all the information rendered from the sponsor's due diligence process and all disclosures related to the property. The broker and investor decide whether the investment is suitable and, if so, the broker calculates the percentage of the property the investor's purchase money or equity will buy. The investor then acquires that percentage of the property and debt, as outlined in the sponsor's offering.