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

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

(1) Each of the co-owners must hold title to the Property as a Tenant-in-Common under local law, so title to the Property as a whole may not be held by an entity.19

(2) The number of co-owners must be limited to no more than 35 persons.20

(3) The co-owners may enter into a limited co-ownership agreement that may run with the land.21

(4) The co-owners must retain the right to approve the hiring of any manager, the sale or other disposition of the Property, any leases of a portion or all of the Property, or the creation or modification of a blanket lien.22

(5) Each co-owner must share in all revenues generated by the Property and all costs associated with the Property in proportion to the co-owner's undivided interest in the Property.23

(6) The co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.24

(7) The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually, with an agent, who may be the sponsor or a co-owner (or any person related to the sponsor or a coowner), but who may not be a lessee.25

(8) All leasing arrangements must be bona fide leases for federal tax purposes. Rents paid by a lessee must reflect the fair market value for the use of the Property.26

(9) Generally, "the amount of any payment to the sponsor for the acquisition of the co-ownership interest (and the amount of any fees paid to the sponsor for services) must reflect the fair market value of the acquired co-ownership interest (or the services rendered) and may not depend, in whole or in part, on the income or profits derived by any person from the Property."27

If an application of the conditions of Rev. Proc. 2002-22 determines that an undivided fractional interest in real estate acquired by a taxpayer qualifies as "like-kind" property in exchange for real estate under Section 1031, such taxpayer is thereby qualified for deferral of taxes with respect to the gain upon sale of the relinquished real estate. Most taxpayers defer purchase of the replacement property until after the closing of the sale on the relinquished property (called a "delayed exchange") instead of acquiring the replacement property at the same time as the sale of the relinquished property. Doing so enables the taxpayer to most easily engage in an exchange without requiring additional cash.28 If a taxpayer engages a delayed exchange, in addition to requiring that the replacement property be "like-kind," the taxpayer must identify the replacement property within 45 days after the sale of the relinquished property29 and must close on the sale of the replacement property within 180 days after the sale of the relinquished property.30 Failure to meet one of these deadlines will result in loss of tax deferral and imposition of capital gains tax on the gain and recaptured depreciation from the sale of the relinquished real estate.31

Issuance of Rev. Proc. 2002-22 has resulted in a dramatic increase in the number of sponsored TIC offerings. TIC offerings generally fall under one of two structures:32 the first consists of a sponsor affiliate serving as asset and property manager for the investors; the second consists of a sponsor affiliate entering into a master lease for the real estate that is coterminous with the mortgage on the real estate.33 With both of these structures, the sponsor negotiates a non-recourse conduit mortgage loan for the real estate.34 Since the mortgage loans for TIC properties are later securitized, the loan documents typically require that investors obtain lender approval for transfers of their TIC interests, and hold their TIC interests through a limited liability company that qualifies as a special purpose entity.35 Moreover, the loan documents typically require a principal or the sponsor to execute an environmental guaranty, prohibit investors from terminating the management agreement or master lease with the sponsor affiliate, and prohibit the investors from filing an action for partition.36 Lenders depend upon the experience and reputation of the sponsor in making the loan and want to assure that the sponsor stands by the transaction while the loan is outstanding. Also, because lenders do not want to have to provide notices to each TIC, lenders require that the sponsor serve as agent of the TICs, enabling them to receive loan notices.37 Therefore, lenders typically prohibit the TICs from terminating the management agreement or master lease with the sponsor-entity without the lender's consent, effectively tying the TICs to the sponsor for the term of the loan.38