A "TIC"ING TIME BOMB: RULE 506 MEETS SECTION 1031

Fordham Journal of Corporate & Financial Law, 2007 by Whitman, Elizabeth Ayres

I. INTRODUCTION

In 2002, the Internal Revenue Service issued Rev. Proc. 2002-22, clarifying when acquisition of a tenant-in-common interest in real estate qualifies as replacement real estate under section 1031. The result was creation of a new type of security, known as a tenants-in-common or "TIC," sold primarily through lower-tier securities broker-dealers under the private placement exemption safe harbor contained in Rule 506 of Regulation D.1 The TIC industry has grown exponentially in the four years since adoption of Rev. Proc. 2002-22.2 Inherent in the TIC structure, however, is a tension between strict timing requirements under federal tax law and the prohibition on general solicitation in connection with the sale of privately placed securities under federal securities laws. Recently, this has resulted in a slowdown of TIC sales and an increase of inventory despite increased demand. This article discusses this tension and possible resolutions under current securities law and regulations, as well as through possible new regulatory action.

II. THE TENANT-IN-COMMON STRUCTURE

With a current federal capital gains tax rate of fifteen percent for capital gains3 and twenty-five percent for recaptured depreciation on the sale of real estate,4 not to mention state tax obligations on those items, a taxpayer selling investment real estate can face a significant tax burden. Internal Revenue Code Section 1031, adopted more than 50 years ago,5 provides that "[n]o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."6 Under section 1031, a taxpayer may defer capital gains tax not only on appreciation but also on recaptured depreciation for investment property, including investment real estate.7

For purposes of section 1031, all real estate is considered like-kind. Therefore, a taxpayer selling an apartment building could exchange it for an office building, shopping mall, or any other type of investment real estate.8 However, other types of investments, such as stocks, bonds, partnership interests, or personal property, are not considered like- kind with real estate for purposes of section 1031. Therefore, a person selling investment real estate may not defer taxation of gains by reinvesting in a real estate investment trust ("REIT"), real estate limited partnership, or in an ongoing business, such as a nursing home that happens to own real estate, even though there are real estate aspects to these new investments.

The traditional Section 1031 exchange involves a taxpayer selling one piece of investment real estate and reinvesting the proceeds into another piece of investment real estate of equal or greater value.9 Although this provides tax deferral of gains on the sale of the relinquished property, it does not always meet the taxpayer's needs. As the baby boomers age, they may want to sell their self-managed apartment buildings but not want to reinvest the proceeds into other real estate that they must manage.10 These investors may want to invest in a higher quality real estate asset" that is more amenable to professional management and which they hope will be less dependent on a particular tenant's occupancy for income. Such investors may want to defer taxation of their gains while also attempting to increase the security of their investment by diversifying through investment in multiple properties in different markets throughout the United States. Purchase of a fractional, undivided interest in high quality real estate, known as a "Tenant-in-Common" interest under state law, can meet the needs of such investors.12

TICs are not a new form of real estate syndication.13 Until recently, however, there was concern that sponsored TIC offerings-in which a sponsor either leases back the real estate or continued to manage it after a sale to investors-could create a partnership between the investors and the sponsor which would not qualify for like kind exchange with real estate under Section 1031.14 Although there were a few small TIC offerings, mostly in Southern California, in the 1990s it was not until 2002 when the IRS issued Revenue Procedure 2002-2215 that the TIC industry began to grow.16 Rev. Proc. 2002-22, which describes "the conditions under which the Internal Revenue Service will consider a request for a ruling that an undivided fractional interest in rental real property ... is not an interest in a business entity,"17 applies in determining whether an undivided fractional interest in real estate acquired by a taxpayer qualifies as "like-kind" property in exchange for real estate under Section 1031. In addition to acquiring "like-kind" property, a taxpayer must also satisfy certain timing and deposit requirements to qualify for deferral of taxes under section 1031.18

Rev. Proc 2002-22 sets forth fifteen conditions to be satisfied, including the following: