Many types of investment vehicles exist today, each one offering structures and benefits that make them of interest to investors. For those who want to buy a property with a friend or relative, they can enter a tenancy in common (TIC) arrangement, which allows for the shared ownership of a real estate asset.
More than shared ownership, TICs offer another perk that makes them attractive to many investors: deferral of capital gains taxes. Through a 1031 Exchange, a TIC allows a taxpayer to defer any capital gains they may have incurred to a later time. In other words, you can keep your capital gains and reinvest it now.
Thanks to these benefits, TICs remain a popular method of investment and property ownership. There is some level of complexity and regulations that come with this type of investment. As such, it’s important for would-be investors to get an in-depth understanding of this legal arrangement before committing to it. Realized 1031 has shared our most comprehensive guide for TICs. Keep reading to gain a deeper understanding of this investment approach, so you can be more knowledgeable in your future ventures.
What Is a Tenancy in Common (TIC) Legal Arrangement?
A TIC is a legal structure where two or more parties share ownership of a real estate asset. At first glance, this arrangement may seem more like a way for investors to pool resources together to buy a property they can’t afford on their own. However, TICs are more than just a way to buy property.
The first benefit of TICs is the undivided fractional interest. Each owner, no matter the size of their contribution, has a right to own every part of the property — hence, the “tenancy in common” phrasing. No single owner is allowed to restrict others in specific portions.
The other major advantage of TICs is capital gains deferrals. This benefit happens when an investor swaps their previous property for a TIC asset through a 1031 exchange. Thanks to this process, the taxpayer can delay tax payments. This deferral can go on indefinitely since TICs are considered real property interests, making them eligible for another 1031 exchange. However, it's important to follow strict IRS guidelines to ensure eligibility for tax deferral.
Brief History of TICs
Unlike the newer investment approaches like the Opportunity Zones program, TICs have been around for nearly a century. This legal structure was established in the Law Property Act of 1925. Initially, TICs allowed the co-ownership of a property and eased the buying and transferring of the asset. Then, the IRS established new guidelines in the early 2000s that made TICs eligible for a 1031 Exchange. This change brought about the possibility of using TICs to defer capital gains taxes.
Check out our more in-depth discussion about the history of TICs here.
Tenants in Common
“Tenancy in common” and “tenants in common” are two distinct phrases commonly used in this area of discussion. There are differences that we want to clarify for added accuracy. Tenancy in common is the legal structure that establishes the framework for property ownership, defining the rights, responsibilities, and relationships among co-owners. Tenants in common, on the other hand, are the individuals who hold undivided fractional interests in the property.
How TICs Work
TICs create an arrangement where several parties — usually individuals — can share the ownership of a real estate asset. The contract outlines each co-owners percentage of ownership.
There are limits to what qualifies as a TIC, especially in the realm of capital gains tax deferral. Here are some specific rules required by the IRS. Failure to stay in compliance with these regulations could prompt the IRS to strip away the tax deferral benefits of the TIC.
- No More Than 35 Members: TICs can’t have more 35 co-owners. This limit is a bit arbitrary, and the IRS hasn’t publicized the reason for it. However, this number means that TICs can grow if they started with just two members. The limit may also allow for more practicality as the complexity of management is directly proportional to the number of people involved.
- TICs Must Have the Proper Structure: TICs must qualify for the requirements of a real estate investment. That way, the TIC can be eligible for a 1031 Exchange and not become a partnership or corporate interest.
- Income Distribution: Only the co-owners can receive income from the property, whether from rental payments or appreciation. Sponsors cannot receive compensation from asset income.
- Decision on Major Operations: Co-owners must be unanimous when it comes to approving major changes to the property, such as renovations or sales.
- Selling and Transferring Shares: Since TICs don’t carry rights of survivorship, all co-owners have the right to sell, transfer, or mortgage their shares independently. If one owner passes, their heirs inherit the shares instead of being distributed to the other owners.
These are some of the key IRS qualifications. It's critical to work with legal and tax professionals who specialize in real estate and TIC arrangements to structure the ownership and agreements in a way that adheres to these guidelines and avoids unwanted tax consequences.
Responsibilities of TIC Co-owners
The TIC itself is not the only entity beholden to certain requirements. Here are a few responsibilities investors must follow.
Financial Contributions
Each co-owner must contribute to the property’s operational and management expenses. These include mortgage payments, property insurance, and costs for repair and maintenance. While the specifics of the contribution will depend on the TIC agreement, the rates are usually in proportion to each co-owner’s share in the TIC.
Property Management
Co-owners are collectively responsible for maintaining the property in good condition. This includes routine maintenance, necessary repairs, and compliance with local building codes and regulations. In most cases, the investors will usually hire a third-party property management team, and the co-owners will be responsible for their fees.
Adherence to the TIC Agreement or Contract
Given that you’re entering a contract, you’re expected to follow the terms outlined in the TIC agreement. The most important ones to keep in mind have to do with working with the other co-owners, such as dispute resolution mechanisms and decision-making procedures.
Compliance With Legal Requirements
This responsibility is especially important if you’re not working with a sponsor, which usually handles the compliance aspect of things. Co-owners must ensure that the property complies with all applicable laws, regulations, and zoning requirements. Otherwise, the IRS could step in and strip away the tax deferral benefits of the TIC.
These are some of the key responsibilities for co-owners in a TIC. Additional responsibilities need to be understood before entering into this legal structure. Working with legal and tax professionals is often necessary to ensure the TIC arrangement is properly understood and structured.
Rights of Survivorship
We mentioned above that TICs don’t carry rights of survivorship. This principle ensures that the surviving co-owners inherit the shares of another co-owner upon the latter’s death. However, TICs allow full transferability of assets to heirs and do not operate under the rights of survivorship.
This characteristic is important to note because it can affect estate planning and inheritance strategies. One advantage is how the lack of rights for survivorship ensures that ownership interest passes to the right heirs. However, the remaining co-owners may find it difficult to cooperate with the beneficiary, causing difficulty with management and payments. As such, it’s important to mull over the risks and rewards of TICs based on this principle, so you can be more proactive with your decisions.
Working With Sponsors
TICs are open to anyone, and co-owners can be close friends or colleagues. However, the other end of the spectrum involves sponsors. These are the companies — usually private equity firms — that market and operate larger TIC properties.
A sponsor is the one that identifies properties suitable for a TIC arrangement. With their capital, the sponsor purchases the property and resells it to the TIC group. The sponsor will handle almost every step of the transaction to earn a fee, which is usually around 5-7% of the TIC property’s value. After establishing the TIC, the sponsor will also take care of the property’s daily operations and maintenance, usually through a hired property management company.
At first, the sponsor will be the owner of the property since it is the entity that purchased the asset. You will get your fractional undivided interest through a separate deed once you join the TIC and the sale is already closed.
As an investor, you’re not required to work with a sponsor like you would with a Delaware Statutory Trust (DST). However, many investors do prefer having sponsors, especially if they prefer a more passive role in the investment. As such, it’s important to have an idea of how involved you’ll be with the TIC. That way, you’ll know which of the two management models you prefer.
Documents To Remember
If you decide to work with a sponsor, there are several critical documents that you must scrutinize before entering a TIC contract. The first is the private placement memorandum or PPM. This document serves as the official investment offering, containing comprehensive information about the TIC investment opportunity, including details about the property, the investment structure, and the associated risks.
On the sponsor’s end, the PPM serves as a level of protection against legal liabilities. You’re expected to learn all material information and risks through the PPM, providing a sort of guarantee for sponsors that they’ve fully disclosed everything about the property.
The PPM is just the first step before you enter a TIC. What comes next is the subscription letter. This one serves as the official legally binding document detailing the transfer of funds from you to the TIC property. Once you sign the subscription letter, you are now legally bound to provide the funding documented on the letter.
The third critical document in a TIC transaction is the TIC agreement, which usually comes with the subscription letter. This is distinct from the PPM, which is also sometimes called TIC offering agreement. The TIC agreement serves as the official document for each specific investor, outlining their percentage of ownership, expenses, management practices, etc.
Tenants in Common 1031: Step-by-Step Process
A 1031 Exchange is the “like-kind” swap that allows investors to defer capital gains taxes indefinitely. There are several ways to perform a 1031 Exchange, the most basic of which is finding a similar property and using the proceeds to buy it. However, this approach is quite difficult, especially with the 180-day deadline imposed by the IRS.
Thankfully, there are other eligible methods that allow investors to enjoy the benefits of a 1031 Exchange. One of these approaches is the TIC arrangement. How does the TIC 1031 process go about? Here’s the step-by-step guide.
1. Partnering With a Qualified Intermediary
The qualified intermediary (QI) serves as the facilitator of the 1031 Exchange, ensuring that the entire transaction follows the rules set by the IRS. The QI will also be the entity holding the proceeds of the sale in escrow before it’s deposited to the TIC investment. It’s critical to find a QI that has a proven track record and membership with organizations like the Federation of Exchange Accommodators (FEA).
2. Relinquishing the Current Property
The next step is to list and sell the property you currently own. You may need to work with a real estate agent — though it’s not required — to expedite the process and ensure an easier transaction. After the sale, the proceeds go to your QI.
3. Identifying the TIC Property
As soon as the sale closes for your original property, the IRS’s 180-day timeframe begins. The first 45 days are dedicated to identifying potential replacement properties. Then, you must submit the identification in writing to your QI as prescribed by the IRS. One thing you have to ensure is the type of property you’re aiming to exchange. It should satisfy the like-kind requirement and have a TIC structure already set up.
4. Review the TIC Property
Before entering a TIC, you must review the property and determine if it meets your investment criteria. It’s also critical to examine the PPM and TIC Agreement thoroughly to ensure that everything is in order. If necessary, you should consult with legal and financial advisors to confirm that the agreement aligns with your interests.
5. Finalize the Purchase
If you deem the TIC suitable for your investment needs, you can proceed to closing the exchange. Sign the necessary documents and notify your QI to transfer the proceeds into the TIC. The entire transaction should happen within the 180-day timeframe to maintain the tax deferral benefit of the 1031 Exchange.
Who Can Join a TIC?
Anyone can join a TIC, especially if they form one for the sake of shared property ownership and not capital gains tax deferral. The latter usually involves sponsors, which put minimums on the amount an investor can set. This practice can limit the types of investors who can enter a TIC agreement.
Friends, family, and colleagues can enter a traditional TIC as long as they agree to the terms of ownership and management of the property. Even a couple, such as a husband and wife, can enter a TIC as individual co-owners. The two can separately transfer or assign heirs to their shares, meaning if one of them dies, the interests won’t automatically go to the surviving individual. These conditions will change in a joint tenancy, which is actually the more popular option for couples. We will discuss joint tenancies later below.
Another common question about TICs is if children can be named tenants in common. In a practical sense, you can’t name a minor as a tenant-in-common while you’re still alive. These people aren’t legally allowed to own property in most cases, and they won’t be able to handle various aspects of management on their own. However, you can include older children in a TIC as long as they agree to the stipulations of the TIC agreement.
Younger children can be named heirs of your TIC shares, no matter their age. Since you have full control over your shares, you’re free to divide them however you desire. Upon your demise, your heirs will receive their inheritance per your wishes. This benefit has made TICs another popular approach in estate planning, allowing investors to easily pass down their assets to their heirs.
Advantages of TICs
TICs offer plenty of benefits that make them appealing to many types of investors. Here are a few that you can leverage.
Flexible Ownership
One of the primary benefits of a TIC is the flexibility it offers in terms of ownership interests. Co-owners can hold unequal shares in the property, allowing them to invest according to their financial capacity. Plus, the autonomy to manage, sell, or transfer ownership adds to the individual control. You can make decisions about your shares without having to ask for the consent of the other co-owners. Such a benefit is not available in other types of co-ownership arrangements, like DSTs.
Tax Advantages
TICs are a popular alternative investment approach because of the tax deferral advantages. Given how this legal structure qualifies for a 1031 Exchange, an investor won’t have to find a suitable property — one that not only satisfies the like-kind requirement but is also similar or greater in value to the relinquished asset. Instead, the investor can simply find broker-dealers who can point them to TIC properties. The investor won’t have to match values since they can invest however much they want as long as they follow the sponsor’s minimums.
This process can continue indefinitely since TIC shares are eligible for 1031 Exchanges. As long as you reinvest the proceeds to another suitable TIC, you continue deferring taxes.
Estate Planning
As we mentioned above, TICs are popular in estate planning because of how easy it is to transfer shares. The owners can ensure that their interest in the property is passed on according to their wishes. Plus, transferring the assets won’t require the probate process. Heirs won’t have to wait a long time or pay legal fees, easing the burden on their end.
Access to Institutional-Grade Investments
One major benefit of TICs is how they allow co-owners to acquire properties that most individual investors can’t reach on their own. Pooling resources together helps them purchase institutional-grade properties, which may provide higher returns due to the demand.
Diversification
Investors can diversify their real estate portfolio by holding interests in multiple TIC properties. This practice allows you to spread risk and potentially increase returns by investing in different types of properties or locations.
Shared Responsibility Over the Property
In the TIC, all co-owners share responsibility for various aspects of running the property, including mortgage payments, insurance, and property taxes. Dividing the costs helps make the overhead more affordable for co-owners. As for maintenance and daily management, the co-owners or the sponsor typically hire third-party property managers. If not, the responsibilities can be equally distributed for each owner through the TIC agreement. This practice creates a collaborative approach that leads to efficiency in property management.
More Systematic Dispute Resolution
Getting up to 35 people to unanimously agree on matters like repairs or remodeling can be quite challenging. Thankfully, unlike other types of co-owner arrangements, TICs include dispute-resolution mechanisms. These procedures allow for better resolution between disagreements, preventing conflicts from escalating.
Disadvantages of TICs
There are risks and challenges associated with TICs, but that’s true in every type of investment. What’s important is having an understanding of these possibilities, so you can take more proactive steps.
Problems With Heirs
The most common concern about TICs is the unpredictability of heirs. Given the lack of rights of survivorship, a co-owner can confer their shares on anyone. This practice can become a problem for other co-owners. If they’re lucky, the heir could be someone who is enthusiastic about the current management practices of the TIC and joins the fold without any issues.
There is a chance that the heir could be someone whom other co-owners won’t like, creating hostility among everyone. This issue could make it more difficult to make unanimous votes on important decisions, possibly escalating into a partition. A partition is the process of splitting the property among co-owners, and it’s an expensive legal process.
Exposure to Personal Liability
Given how investors become direct owners of a property in a TIC, they are more exposed to personal liability. In other words, you could be held personally liable for debts and obligations related to property. If you co-own a rental property that goes into debt, your personal assets may be used to satisfy the obligations.
Thankfully, you can invest in a TIC through a limited liability company or LLC. This practice helps separate your personal finances from your investment assets. In some cases, the income generated by the LLC may be taxed at a lower rate.
Shoulder Tax Liability of Uncooperative Co-owners
Most municipalities count TICs as a single taxable entity, regardless of the number of owners. As such, you will receive one single tax bill rather than separate invoices. Every co-owner will have to contribute their share to pay the income taxes. All could go well until one or several co-owners stop paying their portion. Whatever the reason for this disengagement, the rest of the active co-owners will need to shoulder the tax payments before the deadlines set by the IRS.
Complexity in Decision Making
TIC arrangements often require co-owners to make collective decisions regarding the property. Given the differing goals each investor may have, it may be difficult to achieve unanimous decisions in various areas of management, like property maintenance, improvements, and sales. These disagreements have the potential to escalate into conflicts. While a well-drafted TIC agreement can help manage these disputes, it’s still possible for the disputes to escalate and require legal intervention.
Difficulty Selling Shares
Aside from naming heirs to inherit your shares upon your death, you can sell the interest to other willing investors. This practice proves more difficult in TICs, however. Not a lot of people may want to own a partial interest in a property co-owned by strangers. In some TIC agreements, the approval of the co-owners may be required before anyone can sell their shares. These two disadvantages may lead to delays in potential sales, creating a challenging exit for investors.
TICs vs DSTs
TICs and DSTs are two approaches used in 1031 Exchanges for those who don’t want to go through the process of finding a like-kind property the traditional way. These structures have one unifying characteristic — they allow multiple investors to own a fraction of interest in a property after pooling their resources to buy the asset.
Compared to a TIC, a DST is a more structured yet passive investment vehicle. You don’t have direct ownership of the property. Instead, you have a beneficial interest in the trust. It’s the DST — the legal entity — that owns the property. Thanks to this structure, the investors can defer taxes, enjoy a truly passive role, and reduce personal liability since DSTs have non-recourse debt. With the latter, the investors are not personally liable for the loan and other liabilities.
Knowing the pros and cons of each can help you assess the best option. Here’s a definitive comparison.
1. Control and Management
Property owners who want to be less involved may prefer DSTs. However, this structure removes any kind of direct control over management and operations. A TIC may be the ideal option if you still want to participate in decision-making.
2. Tax Deferral
Both DST and TIC offer tax deferrals. The major difference is how long you can defer taxes. Technically, both offer indefinite deferrals as long as you can find another DST or TIC where you can reinvest the proceeds of a sale. However, DSTs typically have holding periods that last between five to 10 years. On the other hand, you can sell the TIC whenever you want and with approval from co-owners. TICs are more liquid in this regard. However, the holding period of DSTs may be more appealing for investors who prefer a longer-term investment horizon and are less concerned with immediate liquidity.
3. Minimum Investments
A DST sponsor typically requires a minimum of $100,000 and sometimes even lower for cash payments. This value makes DSTs more approachable for small-time investors. TICs have a more variable minimum investment. Those who opt to create a TIC on their own will need to invest as much as they can, together with other co-owners, to purchase the TIC property. If investors chose to work with sponsors, then they’d need to have the minimum investment amount set by the latter.
4. Complexity
DSTs are generally more straightforward with fewer legal complexities. TICs, on the other hand, are more complicated. The added operational and legal challenges may make some investors hesitate. The most obvious complication would be difficulty in making decisions. DST sponsors are in charge of major property changes while TICs will need the unanimous vote of co-owners before they can enact any renovation, repair, or sale of the property.
5. Transferability
Both DSTs and TICs allow investors to name beneficiaries of their shares. One major difference is that while DSTs generally allow investors to transfer their interests during their lifetime, this may be subject to certain restrictions and approval by the trustee or sponsor. TICs are not restricted as much thanks to the lack of rights of survivorship.
Other Types of Tenancy
Apart from TICs, there are two other types of tenancies that investors can explore to better understand their options. Joint tenancies and tenancy by entirety (TBEs) have distinct characteristics that may make them suitable options for specific investment goals.
Joint Tenancy
A joint tenancy is an arrangement where two investors each own 50% interest in the property. This is the default property ownership model for married couples and usually comes with rights of survivorship. If one spouse dies, the surviving owner immediately inherits the deceased one’s share. Rights of survivorship is not a guarantee in some states, such as California. In this case, the share may pass to named heirs if indicated in the will.
Can investors enter a joint tenancy with a partner who isn’t their spouse? Yes. Like TICs, anyone can enter a joint tenancy. Many friends, business partners, and family members may take advantage of this arrangement thanks to the benefits similar to that of TICs.
For those who want tax deferrals, the joint tenancy 1031 process works similarly to TICs. Sponsors are typically unnecessary in joint tenancies since these entities are usually associated with more complex investment structures, like a TIC. Joint tenancies are simple enough to enter. Instead of TIC agreements, the co-owners simply need to draft and sign the deed with witnesses to establish the tenancy.
Given the lack of sponsors, the investors are solely responsible for managing the joint tenancy property. They handle property taxes, insurance, maintenance, and other areas or processes related to owning a property.
Tenancy by Entirety (TBE)
Compared to the other types of joint property ownership, a TBE is perhaps the most ironclad. While a joint tenancy recognizes two owners, a TBE regards all owners as one single entity. As such, the states that do allow this arrangement reserve TBEs for married couples only. No investors, business partners, or family members may enter a TBE.
In a TBE, the married couple theoretically owns 100% interest in the property. As such, the mutual and equal ownership entails unanimous agreements over decisions such as renovations and sales. One spouse cannot sell the property without the full consent of the other.
Another major difference between a joint tenancy and TBE is the extent of the rights of survivorship. While this right can be waived in a joint tenancy if there are named heirs, a TBE structure mandates that the entirety of the asset passes to the surviving owner if one of them dies. There is no legal ground for anyone to challenge ownership rights, and the property won’t need to undergo probate.
The TBE dissolves once one owner dies or if the couple files for divorce. After the dissolution, the surviving owner (or, in the case of a divorce, the individual who gets the asset) can do whatever they please with the property. Upon the surviving spouse’s death, the property will then need to go under probate before it can be claimed by the named heirs.
Only half of the states recognize TBEs. The rest simply use joint tenancy arrangements for married couples. Check out the full list of states in our in-depth article for TBEs.
The Future of TICs
As more and more people look for alternative ways to invest, TICs likely will become more popular. The rising costs of properties make it harder for many individuals to buy a single asset. Enter TICs, which provide a more affordable entry point for sole investors or aspiring homeowners. Through this arrangement, people can co-own a property without having to buy an entire building or unit on their own.
There’s also the matter of demographic shifts, which preludes changing investor preferences. Many Gen Z and millennial investors seem to be attracted to flexibility and community. TICs are appealing to these demographics because this structure offers both. Co-owning properties relieves some financial burden, and it incentivizes cooperation between the owners and the wider community.
The future of TICs may change based on updates in legal and regulatory frameworks. In some states or jurisdictions, new laws may come up to better define various aspects of TICs, such as dispute resolution and ownership. These regulations may standardize TICs and add clarity to confused investors, but at the same time, could undermine some existing TICs. As such, it’s important to consult with financial advisors or investment experts to have a better idea of the possibilities in your location.
Wrapping Up: Understanding Tenancy in Common
Tenancy in common arrangements primarily serve as a way for many individuals to have direct ownership of real estate property. Through the TIC, anyone can own a percentage of the asset and enjoy full control over their shares. These characteristics give TICs major advantages, such as easier estate planning and access to institutional-grade assets. However, perhaps the biggest appeal of TICs is its eligibility for a 1031 Exchange. By working with a sponsor, an investor can put their proceeds into a TIC and enjoy an indefinite tax deferral.
TICs, given their benefits, do have certain risks and challenges. It’s important to be aware of these possibilities to ensure that you’re making informed decisions before committing. Working with experts like us at Realized 1031 can help you gain a better understanding of this arrangement and increase your potential for success. Contact us today, and let’s talk.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.investopedia.com/terms/t/tenancy_in_common.asp
https://www.ubt.com/learning-center/blogs/tenancy-common-interest-can-ease-distribution-real-estate
https://www.lawteacher.net/lectures/land-law/co-ownership/joint-tenancy-v-tenancy-in-common/
https://www.nolo.com/legal-encyclopedia/what-is-private-placement-memorandum.html
