What Real Estate Investors Need to Know About Tenancy in Common (TIC) Investments

The 1031 exchange is an invaluable tool for real estate investors aiming to defer taxes on their capital gains from the sale of a property, enabling funds and individual investors to invest otherwise taxable gains into a like-kind replacement property.

However, finding these properties and performing a 1031 exchange is not always straightforward. Investors may have partners who don’t want to invest in a new entity. Or they might want to invest into a similar property but defer the daily management of that asset to someone else.

In these situations, a tenancy in common can be an attractive solution. Under a tenancy in common (TIC), investors directly own a share of a real estate asset, such as an apartment building or commercial property. This approach has several advantages, which we outline below. But real estate funds and investors must consider several factors before investing in a tenancy in common.

What is a Tenancy In Common?

A tenancy in common is essentially an arrangement where two or more parties share direct ownership in real property or raw land. Each investor owns a portion of the asset directly—not through an LLC, partnership or corporation, where the investor would own the entity that owns the real estate.

The ownership percentages in the property don’t have to be equal. Each investor shares proportionately in the income, losses and tax benefits of the property, reporting these on their individual tax returns. Each investor is a titled owner of the property.

Tenancies in common can occur in several situations, but the most common is as part of a 1031 exchange. A 1031 exchange allows real estate investors to defer capital gains taxes due upon the sale of real estate by replacing the property they sell with a similar property. At a high level, to perform a 1031 exchange, investors must acquire a like-kind property within a certain period of time after the sale of their original property closes.

Learn More: Deferring a Tax Hit with a Sec. 1031 Exchange

Tenancy in Common 1031 Exchange Examples

Below are two hypothetical examples of how real estate investors typically invest in tenancy in common arrangements through the 1031 exchange process.

Let’s first consider Jack, a successful real estate investor who is preparing for retirement. Over several years, Jack has built up a portfolio of small apartment buildings that he has actively managed himself. In that time, the value of his properties has increased significantly.

Ahead of his retirement, Jack wants to sell these properties and perform a 1031 exchange into an asset managed by someone else, deferring the tax he owes on the sale of his apartment buildings. However, under the rules of the 1031 exchange, Jack is unable to invest directly into a real estate investment fund. Instead, he must purchase a replacement property that qualifies as a like-kind exchange.

Instead, Jack finds a real estate fund that is raising funds to buy a much larger apartment building than those he has managed. Instead of investing in the fund itself, Jack purchases 10% of the apartment building, while the fund purchases the other 90% using a tenancy in common arrangement. This allows Jack to achieve his goals: deferring his taxes while investing in a like-kind property that will be actively managed by someone else.

TICs can also be beneficial for parties who invest together. Let’s consider another hypothetical example: this time with two friends, Sarah and Mary. Sarah and Mary both want to invest in real estate but lack the funds to do so on their own. Instead, they join forces, buying their first investment property together.

Sarah and Mary structure their ownership of the property as a TIC. When it comes time to sell the property, Sarah wants to perform a 1031 exchange. But Mary would rather realize her profits, pay the taxes and move on. A tenancy in common allows both Sarah and Mary to do what they want in this regard. If the real estate had been held in an LLC, the LLC would have had to acquire the replacement property—meaning either Sarah or Mary would be forced to compromise.

IRS Regulations for Tenancies In Common

Tenancies in common are subject to a wide range of IRS rules. These are described in IRS Revenue Procedure 2002 – 22, which essentially outlines a safe harbor for tenancies in common. Below is a summarized version of some of the most important restrictions contained in this guidance:

• Each owner must hold title to the property.
• There can be no more than 35 co-owners of the property.
• The tenancy in common cannot be structured as an entity. It should not file a tax return or conduct business under a common name.
• Owners may enter into an ownership agreement, although this is limited and cannot contain provisions concerning allocation. Instead, income and expenses should be shared proportionately between owners.
• Payments to sponsors must reflect the fair market value of the ownership interest and may not be related to the income or profits produced by the asset.

A complete list of IRS regulations related to tenancies In common can be found in IRS Revenue Procedure 2002 – 22. Real estate investors should ensure they understand these before investing in a TIC investment.

Key Considerations Before Investing in a Tenancy In Common

The tax regulations that govern tenancies in common aren’t the only factors real estate investors must consider. Other variables are important too. One of the first is the amount of tax this strategy allows investors to defer. Investing in a TIC is a relatively complex real estate transaction. If it only provides marginal tax savings, it’s likely the juice isn’t worth the squeeze.

Investors should also consider their objectives. TIC investments, in many instances, involve investors giving up control over how the asset is operated. Think back to Jack, our hypothetical real estate investor who’s ready to retire and invest in less management-intensive assets. A tenancy in common investment might be a great fit for him. But if investors want control, they need to carefully consider whether a tenancy in common is right for them.

TIC investments are relatively illiquid. While investors can sell their interest in a tenancy in common, there is no established secondary market. Because all fees are paid to the sponsor up front rather than on a performance basis, investors in a TIC assume significant risk. Major decisions, such as the decision to sell the asset, require unanimous approval from all investors.

Using a TIC to Sell a Property

With the right approach, real estate funds can also use the tenancy in common structure to sell assets and give investors more control over their next steps.

If a fund currently holds an asset in an LLC, it can dissolve the LLC, liquidate the property and distribute this into a TIC interest. When the property is sold, investors are free to do as they like with their proceeds. In other words, they’re not bound by their shared ownership of the LLC.

Funds that adopt this approach must be careful and seek guidance from real estate tax professionals. For this to be considered a legitimate transaction and not a “drop and swap.” sufficient time must have passed between the transition to a TIC structure and the sale of the property. In most instances, the property should be owned as a tenancy in common for at least two years before the property is sold to avoid IRS scrutiny.

James Moore: Experienced Real Estate CPAs

Investing in a tenancy in common deal can be a great solution for many real estate funds and investors. But there’s no question it’s a complex strategy. It’s vital that investors understand how the model works and are aware of some of the key drawbacks of this ownership structure before they invest in any TIC deals.

James Moore’s team of real estate CPAs and advisors works closely with a variety of real estate investors and operators, from established funds to developers and individual investors. Our professionals bring sophisticated expertise to complex real estate matters, helping clients take a tax-efficient approach to managing their real estate investments.

To learn more about James Moore’s real estate accounting services, contact us today.

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