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NEW RULE EASES TENANCY-IN-COMMON DEALS

Tenancy-in-common deals and 1031 exchanges are about to get a whole lot easier and cheaper to execute for multiple owners of single properties.

In July the Treasury Department and the Internal Revenue Service provided the 1031 exchange market with guidance on how to use a Delaware Statutory Trust, or DST, an entity created to hold, manage, operate and administer assets. Under so-called Revenue Ruling 2004-86, for purposes of 1031 exchange deals, authorities classify the DST as a trust rather than a business.

The distinction is important. Were the DST to be defined as a business, it would have the same status as a partnership, and interests in partnerships do not qualify for the sorts of “like kind” property swaps used in 1031 exchanges, says Rob Hannah, CEO of Tax Strategies Group, a Chicago-based real estate investment firm. Indeed, the tax code disallows partnership interests because of tax loophole abuses perpetrated in the past.

“[This] will, I think, open up this market and make it easier and cheaper for investors to get in and out of transactions,” said Hannah.

More to the point, Hannah says, the DST can be used to hold a property on behalf of multiple partners. This works especially well for tenancy-in-common, or TIC deals, which involve single properties held by several owners.

TICs are an offshoot of the 1031 exchange market, which allows owners to defer capital gains taxes on property sales if they turn around and buy a property of equal value. The property owner has 45 days to identify a replacement property and 180 days to buy it. Under a TIC arrangement, the owner can complete the 1031 exchange by buying a fractional interest of a different property.

Before the ruling, when a TIC group went through a lender to buy a property, each interest holder had to acquire his or her own interest separately, which meant each had to pay real estate closing fees ranging between $5,000 and $10,000. Now, because the DST owns the property, each TIC participant simply pays a fee, usually about $200, to record the assignment of beneficial interest. The process can take less than a day, versus two to four weeks previously, Hannah says.

The guidance also enables property holders to use grantor trusts, a type of trust commonly used on the West Coast for estate planning. These grantor trusts allow a property holder to shift income from any source, whether rent or investment earnings, to another party taxed at a lower rate, for a period of about 10 years. Previously, there was no clear guidance on how to use such grantor trusts for 1031 exchanges. Ruling 2004-86 deems the assets in a grantor trust as real property and not as a business entity, which means that, like DSTs, grantor trusts can be used in 1031 exchange deals, says Hannah.

But those seeking to use a DST this way must abide by strict covenants. A trustee is appointed to control the property, but can collect and distribute income only for the TIC participants, according to the ruling. The trustee is prohibited from refinancing the property’s debt, renegotiating or issuing new leases, or selling the property. Further, the trustee can make only minor, nonstructural changes and is not allowed to exchange the property, to buy assets other than short-term investments for the trust, or to accept additional contributions of assets, for the period specified by the trust.

Of course, this doesn’t mean someone else can’t do these things. The lease (or, in the case of a multitenant property, several leases) can be assigned to a master lessee, for instance, who is empowered to perform all the daily business functions forbidden the trustee, says Hannah. Imagine — a regulatory ruling that makes life easier for just about everyone.