The real estate agent brought the elderly couple an unsolicited offer for the small store they’ve owned for nearly three decades.
They were torn by the decision. They didn’t really want to sell the store, loved the monthly income from the place but wanted to travel more and get out from behind the maintenance and bookkeeping. In addition, they had an opportunity to buy a big piece of an apartment complex with members of their bridge club, an attractive spot very similar to the community where they now lived.
The couple did not want to sell the store and pay a huge capital gain. So, they decided to sell the place and roll the funds into the apartment complex and take advantage of the latest wrinkle in the tax-deferred exchange arena called TICs, or tenant-in-common investments. This strategy allows investors who sell an investment property to buy ownership interests in another property (or properties) instead of buying an entire “like-kind” property to qualify for an exchange and defer capital gains taxes on the sale.
While TICs have been around for years and have been structured by a number of savvy property-exchange specialists, they were officially blessed last year when the Internal Revenue Service issued a set of 15 guidelines laying out the ground rules for successful TIC deals. Interest increased immediately, especially from investors who had no easy way of locating other investors who wanted – or could only afford – a piece of another property.
Here’s how TICs usually work: A “sponsor” such as real estate investor or broker, will identify and arrange to purchase an apartment building, shopping center or office building. The sponsor will then make available a TIC purchase opportunity to other investors through friends and other brokers. These potential buyers can either buy a TIC interest outright or transfer the proceeds of a previous property sale in order to qualify as an exchange, which allows them to defer capital gains – just like the aforementioned couple who sold the store.
As TICs become more common, investors can choose from a variety of investment options offering diversification by location and property type.
“TICs produce another option for the exchange process,” said Richard Morse of Washington Exchange Services Inc. “For investors who want to stay in the larger scheme of things, it’s definitely something to consider. It’s especially great for property owners who simply don’t have the money to make big-time repairs.
“Most of my customers exchange residential property – one home for another home or a home for a duplex. It’s just the investment strategy that seems most comfortable for them. They feel they simply know homes better and are closer to them. Everybody’s different…”
A tax-deferred exchange (commonly known as IRS Section 1031 Exchange) is really, in Morse’s words, “legally sanctioned fiction.” The transaction will proceed just as a “sale” for you, your real estate agent and parties associated with the deal. However, provided you closely follow the exchange rules, the IRS will “sanction” the transaction and allow you to characterize it as an exchange rather than as a sale. Thus, you are permitted to defer paying the capital gain tax.
An exchange occurs when you trade real property that is other than your home or second residence for other “like kind” real property that you have held for trade, business, or investment purposes. The like-kind definition is very broad. You can dispose of and acquire any interest in real property other than a home or a second residence. For example, you can trade raw land for income property, a rental house for a multiplex, or a rental house for a retail property.
Section 1031 specifically requires that an exchange take place. That means that one property must be exchanged for another property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax deferred transaction from a sale and purchase. The exchange is created by using an intermediary (or exchange facilitator) and the required exchange documentation.
By pooling the proceeds of these investors, TICs combine the tax and estate planning benefits available to investors through 1031 exchanges with the potential advantages of owning a share of an institutional-quality investment property. Investors receive their monthly distributions (after expenses), while giving up the maintenance and administration chores associated with managing property.
And, not everybody loves managing property – especially when they are retired and want to travel.
Tom Kelly’s new book “How a Second Home Can Be Your Best Investment” (McGraw-Hill, $16.95) was co-written with John Tuccillo, former chief economist for the National Association of Realtors and is now available in local bookstores. He can be reached at email@example.com.
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