Real Estate Tenant-In-Common or TIC Offerings
Technically there are two types of Proportional Ownership products referred to as Tenant In Common (TICs), which are structured as a securitized TIC or a Real Estate TIC.
Since the favorable ruling by the IRS in 2004 allowing a Delaware Statutory Trust, under specific restrictions, to be eligible for a 1031 exchange the use of securitized TICs has diminished. Some security professionals have abandoned the TIC structure for the more lucrative business model that the DST format offers. For the sake of this comparison we will focus on the Real Estate TIC and how it compares to a DST.
A tenancy in common investment (better known as a real estate TIC) is an investment in real estate which is co-owned with other investors. Since the taxpayer holds a deed to real estate as a tenant in common, the investment qualifies under the like-kind rules of IRS Section 1031.
This type of an investment can appeal to taxpayers who are tired of managing real estate. TICs can provide a secure investment with a predictable rate of return. Real Estate TICs are often developed by commercial real estate professionals with an emphasis and expertise on the underlying real estate asset. They are marketed by real estate professionals and not security brokers.
A small number of TIC sponsors take the steps necessary to structure their TIC so that the investment is a real estate investment not subject to state security laws. Usually this means that the TIC sponsor will not be responsible for management of the investment and independent management will be employed by the owners.
Real Estate TICs have significant limitations when it comes to leveraging the properties with debt or investing in large complex commercial real estate that require ongoing management where the quality of the return is reliant on a third party. These limitations force Real Estate TIC sponsors to invest in debt-free high-quality Triple Net Leased properties. These limitations tend to produce a simple structure with a high level of safety and security.
The largest draw back to a Real Estate TIC is that each owner must take an active roll in decision making. This can be cumbersome with even a modest number of owners. The need for decisions can be mitigated up front by not taking out debt against the property and engaging in long term Triple Net Leases with investment grade tenants. This structure effectively eliminates the need for decisions in the near and intermediate term. The tenant in common agreement for each property sets forth the structure whereby these decisions are to be made. Some can be structured with drag rights or other provisions to facilitate decision making. Investors should closely review the tenant In common agreement.
Delaware Statutory Trust or DST Investment Offerings
In an effort to create an instrument that would increase the profitability for securitized TIC Sponsors as well as facilitate the placement of debt on properties the securities industry joined with commercial lenders and invested significant resources in developing a complex alternative fractional ownership structure that would overcome what they saw as the weaknesses and limitations of the traditional Real Estate TIC Investment Property offerings. The result was the fractional ownership structure known as the Delaware Statutory Trust or DST.
The Internal Revenue Service issued Revenue Ruling 2004-86 on August 16, 2004. This ruling offered seven significant management limitations that if followed, permitted the use of the fractional ownership structure of the Delaware Statutory Trust or DST to qualify as replacement properties as part of an investor’s 1031 Exchange transaction.
Each co-investor owns an individual beneficial interest in the Delaware Statutory Trust. The DST itself shields the investor from liability with respect to the underlying investment property owned and held inside the DST. These instruments are created and sponsored by securities professionals with expertise and an emphasis on creating a quality security instrument. They are sold by securities brokers with no required training, experience or education in real estate and are governed by the SEC.
As discussed above individual investors in a Real Estate TIC structure must vote on all major property decisions. Without a majority owner and appropriate structure, it can be somewhat dysfunctional to get the individual TIC Investment Property co-investors to agree on major decisions. To address this issue, the individual investors or beneficiaries in a Delaware Statutory Trust are not permitted to vote. In the DST structure partners relinquish the agency and authority to make all decisions regarding the management and wellbeing of the property and investment and vest it in a single trustee – the sponsor. However, for the DST to be 1031 qualified the Trustee must relinquish the right/ability to make major property decisions. This can create an even more difficult situation than the TIC structure.
Financial institutions can loan to a DST entity. Because the loan is made to the Trust there is no need for a lender to separately underwrite each co-investor for purposes of loan qualification since the DST is the borrower and not each individual investor. This structure allows DSTs to hold multiple properties with multiple and varied debt structures. This can provide a false sense of security to investors. Although individual investors are not underwritten by the lender or personally sign on a loan, their investment is used as collateral and is 100% at risk in the event market conditions, fraud or other issues create a default. The debt structure of any DST should be thoroughly evaluated and understood by each individual investor.
The Seven Deadly Sins of a DST
Internal Revenue Ruling 2004-86, which forms the income tax authority for considering a Trust as Real Estate for use with a 1031 Exchange has extensive prohibitions over the powers of the Trustee of the DST. In a 1031 qualified DST structure, the trustee is restricted from many actions that would otherwise be normal in typical ownership structures such as an LLC. The trustee may not renegotiate leases, make capital calls, or even re-finance the property. These IRS imposed restrictions are sometimes referred to as the “seven deadly sins,” and include the following:
- Once the offering is closed, there can be no future equity contribution to the Delaware Statutory Trust or DST by either current or new co-investors or beneficiaries.
- The Trustee of the Delaware Statutory Trust or DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.
- The Trustee cannot reinvest the proceeds from the sale of its investment real estate.
- The Trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
- Any liquid cash held in the Delaware Statutory Trust or DST between distribution dates can only be invested in short-term debt obligations.
- All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis, and
- The Trustee cannot enter into new leases or renegotiate the current leases.
The Springing LLC aka The Nuclear Option
These restrictions are significant. They are put in place to enable favorable consideration by the IRS and may even seem to provide protection for individual investors. However, they place significant limitations on the trustee in the event tenants default or market conditions require deviation from the management plan. In the event any of the above seven restrictions need to be violated, there is a way out. Delaware law permits conversion of the trust to an LLC. This is referred to as a “springing LLC”. This will allow for any or all the prohibited actions to be performed by the trustee without the consent of the members. This is the ultimate safeguard, but it comes with a massive price. This action will disqualify any of the tax-deferral benefits afforded by Section 1031 to the initial investors. The springing LLC clause is required in most DSTs because it gives the lender additional comfort that the trustee can perform necessary actions in the best interest of the bank even though activating this clause will have detrimental tax consequences to all 1031 investors in the fund. The alternative to having a Springing LLC clause is not pretty and typically does not provide the Trustee the tools necessary to react to even slight deviations in the anticipated investment course. This could result in a catastrophic failure of the Trust during a market correction.
For more information on 1031 strategies, please contact us.