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Tenant in Common Programs
Published: September 1, 2007
Author: Edward J. Lawton
Providing assistance to real estate sponsors with their tenant in common ("TIC") programs has become an important part of Axley Brynelson, LLP's real estate and securities law practices. This includes assisting the sponsor with the design and structure of the TIC program, the preparation of the private placement memoranda for the offering of TIC interests, and providing on-going advice with respect to real estate, tax, corporate, and securities regulation issues as they periodically arise. This article provides a brief overview of the legal issues that frequently arise in organizing a TIC program and in marketing TIC interests. There is also a brief discussion of an emerging issue in the industry.
Introduction
A TIC program includes the acquisition and eventual private placement of interests in income producing real estate. The phrase tenant in common refers to a form of real property ownership in which 2 or more individuals own an undivided fractional interest in real property. Unlike partnership interests TIC interests may be used as replacement property in tax deferred exchanges of real property under Section 1031 of the Internal Revenue Code ("§ 1031"). Typically TIC sponsors identify and place the replacement property under contract, make arrangements for property management, and arrange for the placement of the interests with investors either in need of replacement property or otherwise eligible for a § 1031 transaction.
Operating Issues
Sponsors either acquire the replacement property before selling TIC interests or pool various exchangers' proceeds before acquiring the replacement property. The later method can sometimes allow an individual seller or lender to delay closing with serious tax consequences to time sensitive exchangers. The TICs enter into a property management agreement or master lease agreement with an affiliate of the sponsor. The property manager receives a property management fee and an asset management fee. Generally, removal of the property manager must be approved by both the TICs and the lender. The master lease structure provides greater investor protection as the TIC sponsor becomes a master tenant. However, under this arrangement, the TICs also have less control over the property. Also, the master tenant will generally agree to pay fixed rent to the TICs while subleasing the property. The master tenant retains any rent payments received from tenants in excess of the fixed rent paid to the TICs.
Securities Issues
TIC interests are widely considered securities within the legal profession and an SEC No-Action Letter indicates that the SEC staff agrees with this view at least with respect to the triple net lease structure in which the sponsor becomes a master tenant. [1] Approximately 90 percent of TIC transactions are structured as securities, presumably private placements under Regulation D exemptions which allow the sponsor to avoid the expensive and time consuming securities registration process. [2] The Rule 506 safe harbor under Regulation D is commonly used because it allows an unlimited amount of capital to be raised. The other exemptions under Regulation D cap the amount that may be raised at levels below the price of most institutional grade real estate. Some TIC interests are marketed as real estate rather than securities. The sponsors of these projects believe their TIC interests avoid classification as securities by ceding significant property management authority to the TICs rather than a sponsor or an affiliate of the sponsor. There have been no administrative or judicial rulings on non-security structures. TIC interests structured as securities must be sold by registered broker-dealers and cannot be sold by real estate brokers unless they are also registered broker-dealers under federal securities regulations. The National Association of Securities Dealers ("NASD") prohibits broker-dealers from directly or indirectly compensating a real estate broker, unless such broker is also a broker-dealer, for participating in the transfer of TIC interests structured as securities. [3] To add further complexity, because TIC interests are considered real estate interests in most jurisdictions, state real estate licensing rules may apply as well. In a June 2006 No-Action Letter the SEC indicated that broker-dealers and licensed real estate brokers may work together to market TIC interests if broker-dealers register real estate brokers as "associated persons" of broker-dealers engaged in marketing TIC interests. [4] In the No-Action Letter, the SEC stated that it would not seek enforcement against the real estate brokerage firms that employed the real estate brokers under this arrangement.
Tax Issues
The popularity of TIC offerings, compared to offerings of interests in special purpose entities such as limited liability companies ("LLC"), stems from § 1031 which allows tax deferred exchanges of like kind property in productive use in a trade or business or for investment. Section 1031 provides that tax deferred status is not available for securities; this would appear to be problematic since most TIC interests are offered as securities. However, Revenue Procedure 2002-22 clarified the requirements for obtaining a private letter ruling classifying a TIC interest as an interest in real estate for tax purposes so that an exchange may receive tax deferred treatment. It is important to note that Rev. Proc 2002-22 only provides the essential elements of a request for a private letter ruling and did not create an absolute safe harbor though it may be increasingly treated as such within the industry. Because obtaining a private letter ruling involves a substantial time horizon some sponsors may obtain an attorney opinion letter based in part on the elements set out in Rev. Proc. 2002-22. Rev. Proc. 2002-22 provides that the IRS will ordinarily not consider ruling requests where, among other factors, the number of co-owners exceeds 35 persons (a person may include a partnership or corporation); profit, loss, and or debt are shared unequally; co-owners give up substantial control over the property, or where there are restrictions on the alienability of the TIC interest. With respect to the taxation of the income TICs receive, because the TICs hold direct investments in real estate and not a business entity, the income generated from the property passes through to the investing entity which may be an individual, a partnership, LLC, or corporation. There is no double taxation.
Liability Issues
TIC interests are direct investments in real estate. Sponsors do not provide a limited liability entity to shield the investors as part of the TIC structure. With regard to debt financing investors face little risk as TIC sponsors uniformly use nonrecourse debt. Other liability risks can typically be managed with insurance arranged by the sponsor and or the property manager. Furthermore, most exchangers will be limited liability entities.
Delaware Statutory Trust Structure
A DST is a flexible entity created under Delaware statutory law. IRS Revenue Ruling 2004-86 permits the use of a DST in a § 1031 tax deferred exchange private placement program if its strictures are complied with. In this structure, the DST owns 100 percent of the fee interest in the real estate. Interests in the DST are transferred to the investors, in exchange for the proceeds from the sale of their respective properties. The use of a DST provides benefits to program sponsors, investors, and lenders. With a DST structure investors no longer need to set up single member LLCs in order to shield themselves from liability. Each investor simply owns a beneficial interest in the DST which is a bankruptcy remote entity thereby shielding the investor from personal liability. Furthermore, decision making is streamlined as the rights of individual DST beneficiaries are limited. As a result dissenting beneficiaries are unable to delay major decisions. Instead, the program sponsor may stay on as the DST trustee and manage the property. If the property is sold, an investor may transfer its beneficial interest in a tax deferred exchange. Finally the number of investors is not limited to 35 as the IRS has ruled is the maximum number for TICs. For lenders, the DST structure provides substantial simplification. Rather than making loans to each investor a lender need only evaluate a single borrower, the DST. The DST's bankruptcy remote status prevents creditors of individual investors from reaching the DST's property in the event an investor becomes bankrupt. The lender also need only look to the program sponsors for so-called "bad-boy" carve outs as the individual investors have no governance rights. Rather, they only have rights to receive distributions. Furthermore, the fact that the program sponsor may stay on for more than a year as the property manager and trustee increases the lender's confidence that the sponsor will operate the property for the long term. The drawbacks to a DST structure stem from restrictions required by the enabling IRS Revenue Ruling. These restrictions limit the powers of the trustee so that the beneficiaries may be construed to have acquired a direct interest in real estate for purposes of federal tax law. They include prohibitions on: contributions to the DST by investors; renegotiation of the loan terms; reinvestment of proceeds by the trustee from the sale of the real estate; capital expenditures by the trustee beyond normal maintenance and repairs; and the renegotiation of current leases or the creation of new leases. Because of these restrictions, a master tenant structure must be employed where the master tenant, typically an affiliate of the sponsor, assumes operational responsibility for the property.
Conclusion
Any business with significant amounts of capital deployed in real estate assets could consider a TIC offering when assessing mechanisms to release that capital. TIC sponsors have routinely executed sale-lease-back transactions with respect to hospitality, senior living, health care, and golf course properties. Real estate based businesses may be able to obtain more favorable lease terms and a higher price for the assets sold to third party investors.
[1] Triple Net Leasing,LLC, SEC No-Action Letter, 2000 WL 1221859 (August 23, 2000).
[2] Mark Levine, The Boom and TICs: Will They Continue? (2006), http://www.naiop.org/foundation/levine_tic.pdf.
[3] NASD NTM 05-18 (March 2005); NASD Rule 2420.
[4] Welton Street Investments, LLC, SEC No-Action Letter, 2006 WL 1896896 (June 27, 2006).
Edward J. Lawton is an associate at Axley Brynelson, LLP and a member of its Business Practice Group. He can be contacted at 608.283.6717 or elawton@axley.com. For additional information please contact Jonathan L. Schuster at 608.283.6769 or jschuster@axley.com, or Gregory C. Collins at 608.283.6749 or gcollins@axley.com.
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