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Resources 1031 White Papers The Evolution of TICs and Section 1031
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| Wednesday, 23 July 2008 14:32 | |
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The Evolution of TICs and Section 1031
Presented at the Mid-Year Meeting
of the Real Estate Committee
of the Tax Section of the American Bar Association
January 21, 2005
San Diego, California
By
Kevin Thomason
Thompson & Knight LLP
Dallas, Texas
Louis S. Weller
Deloitte Tax LLP
San Francisco, California
Darryl Steinhause
Luce Forward Hamilton & Scripps LLP
San Diego, California
Richard Lipton
Baker & McKenzie LLP
Chicago, Illinois
I. The Explosive Growth of the TIC Industry.
Since 2002, the equity raised to finance tenancy-in-common (TIC) syndications has increased from around $150 million to almost $2 billion, and in 2004 almost $4.3 billion of real estate was purchased utilizing the TIC format.[1] Most participants in the industry agree that a major driver of this growth was the issuance of Rev. Proc. 2002-22, 2002-1 C. B. 733 (the “Rev. Proc.”), which provided important insights into the Service’s position regarding the critical tax issue implicated in TIC syndications—that is, the determination of whether the arrangement will be considered for federal tax purposes to create co-ownership interests in real property, which co-ownership interests may qualify as replacement property in a Section 1031 exchange, or interests in a partnership, which clearly may not so qualify. SeeI. R. C. Section 1031(a)(2)(D).
The focus of this presentation is not so much the developments in the tax law or administrative pronouncements since the issuance of the Rev. Proc.—because there has been almost none of either. No cases have been decided since the issuance of the Rev. Proc. that bear on the critical tax issue described above, and since such issuance only one published ruling, Rev. Rul. 2004-86, 2004-33 I. R. B. 191 (July 20, 2004), and one private letter ruling, PLR 200327003 (July 3, 2003), have been issued regarding such issue.
Rather, the focus of this presentation are the many practical issues that have arisen in the structuring and executing of TIC syndications, where those issues rub up against the ruling guidelines set forth in the Rev. Proc., and how practitioners are addressing the tension caused by such friction.
II. The Relevance of the Rev. Proc.
“The guidelines set forth in this revenue procedure are not intended to be substantive rules and are not to be used for audit purposes.”
--Section 3 of the Rev. Proc.
By its very terms, the Rev. Proc. provides that the ruling guidelines set forth therein are not intended to be substantive rules. Rather, the Rev. Proc. purports merely to set forth certain conditions under which a particular taxpayer may obtain an advance ruling that the proposed joint ownership arrangement qualifies as co-ownership of real property and is not a partnership. Those conditions include the provision of certain information, e. g., the name of the taxpayer, a description of the property, certain representations, and all of the promotional, transactional, lending, lease and management-related documents to be utilized in the transaction.
More importantly, the Rev. Proc. provides that “the Service will not consider a request for a ruling . . . unless the conditions described [in Section 6 of the Rev. Proc.] are satisfied.” It then list 15 conditions, with no particular commentary as to whether some are more important than others and no cross-reference to the support for each condition in the existing case law that has heretofore provided guidance on the issue of “co-ownership versus partnership interest.”
Thus, one must keep in mind that in the great struggle to meet, when structuring a TIC transaction, all of the 15 conditions set forth in the Rev. Proc., the overriding reality continues to be that the ultimate arbiter of whether a particular arrangement qualifies as a co-ownership arrangement, as opposed to a non-qualifying partnership, is the court system, and that the true guidance regarding that issue is found in the relevant cases, not in the Rev. Proc. The above-quoted language from the Rev. Proc. says so itself.
III. Scenes from the Front: The Reality of TIC Deals Versus the Strictures of the Rev. Proc.
Here follows a listing—certainly not an exhaustive one—of various issues that implicate certain of the conditions of the Rev. Proc. The live discussion that accompanies this paper will highlight the real world responses of some of the leading tax practitioners in the TIC world to such issues.
A. Non-Pro Rata Liability.
The Issue: The debt utilized in TIC transactions is usually non-recourse to the borrowers. However, in certain circumstances one or more of the TICs—and/or the sponsor, who may or may not retain an interest in the property—are required to personally guarantee such debt. Moreover, non-recourse lenders almost always require a guaranty related to certain contingent liabilities, i. e., certain “carve- out” liabilities for fraud, misrepresentation and the potential future commission of certain “bad boy” acts such as filing a bankruptcy petition or a partition action.
Two of the Rev. Proc. conditions bear on such arrangements, to wit:
.08 Proportionate Sharing of Profits and Losses. 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. Neither the other co-owners, nor the sponsor, nor the manager may advance funds to a co-owner to meet expenses associated with the co-ownership interest, unless the advance is recourse to the co-owner (and, where the co-owner is a disregarded entity, the owner of the co-owner) and is not for a period exceeding 31 days.
.09 Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.
The Questions:
1. Can there be non-pro rata guaranties of non-contingent liabilities?
2. Can there be non-pro rata guaranties of contingent liabilities, such as non-recourse carve-outs?
B. Multiple Properties.
The Issue—A TIC sponsor may desire to package multiple properties, subject them to one blanket lien, and sell the properties to investors subject to that lien, probably after master leasing all of the properties to a sponsor affiliate. In such a case, each TIC would own the same pro rata interest in each of the properties.
Although not addressed in the 15 conditions, Section 4 of the Rev. Proc., entitled “Guidelines for Submitting Ruling Requests,” has this to say about multiple properties:
Where multiple parcels of property owned by the co-owners are leased to a single tenant pursuant to a single lease agreement and any debt of one or more co-owners is secured by all of the parcels, the Service will generally treat all of the parcels as a single “Property.” In such a case, the Service will generally not consider a ruling request under this revenue procedure unless: (1) each co-owner’s percentage interest in each parcel is identical to that co-owner’s percentage interest in every other parcel, (2) each co-owner’s percentage interests in the parcels cannot be separated and traded independently, and (3) the parcels of property are properly viewed as a single business unit. The Service will generally treat contiguous parcels as comprising a single business unit. Even if the parcels are not contiguous, however, the Service may treat multiple parcels as comprising a single business unit where there is a close connection between the business use of one parcel and the business use of another parcel. For example, an office building and a garage that services the tenants of the office building may be treated as a single business unit even if the office building and the garage are not contiguous.
The Questions:
1. What does it mean that “the Service will generally treat all of the parcels as a single ‘Property’?”
2. What constitutes a “single business unit?”
3. What are the other issues implicated in multiple property TIC transactions?
C. Need for Unanimous Consent of TICs.
The Issue: The following Rev. Proc. conditions present major practical problems in the day-to-day operations of running a commercial real estate project:
.05 Voting. 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. Any sale, lease, or re-lease of a portion or all of the Property, any negotiation or renegotiation of indebtedness secured by a blanket lien, the hiring of any manager, or the negotiation of any management contract (or any extension or renewal of such contract) must be by unanimous approval of the co-owners. For all other actions on behalf of the co-ownership, the co-owners may agree to be bound by the vote of those holding more than 50 percent of the undivided interests in the Property. A co-owner who has consented to an action in conformance with this Section 6.05 may provide the manager or other person a power of attorney to execute a specific document with respect to that action, but may not provide the manager or other person with a global power of attorney.
.12 Management and Brokerage Agreements. 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 a sponsor or a co-owner (or any person related to the sponsor or a co-owner), but who may not be a lessee. . . .
The Questions:
1. Can leases of de minimus portion of a property be exempted from the unanimous consent requirement? What is de minimus?
2. If the TICs have agreed on certain leasing parameters and the form of lease to be utilized, can leases meeting those parameters and done on those forms be excepted from the unanimous consent requirement? What parameters are acceptable? How big of a space?
3. To what extent may the implied consent mechanics approved in PLR 200327003 be utilized for the items requiring unanimous consent? How much notice is needed?
D. Restrictions on Business Activities.
The Issue: At some level of activity, the actions of the co- owners and their agents can rise to the level of the carrying on of a business, which is a primary indicia of a partnership arrangement. Treas. Reg. Sec. 1.761-1(a); Bergford v. Commissioner, 12 F. 3rd 166 (9th Cir. 1993). The following condition speaks to that issue:
.11 No Business Activities. The co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property (customary activities). See Rev. Rul. 75-374, 1975-2 C. B. 261. Activities will be treated as customary activities for this purpose if the activities would not prevent an amount received by an organization described in § 511(a)(2) from qualifying as rent under § 512(b)(3)(A) and the regulations thereunder. In determining the co-owners’ activities, all activities of the co- owners, their agents, and any persons related to the co-owners with respect to the Property will be taken into account, whether or not those activities are performed by the co-owners in their capacities as co-owners. For example, if the sponsor or a lessee is a co-owner, then all of the activities of the sponsor or lessee (or any person related to the sponsor or lessee) with respect to the Property will be taken into account in determining whether the co-owners’ activities are customary activities. However, activities of a co-owner or a related person with respect to the Property (other than in the co- owner’s capacity as a co-owner) will not be taken into account if the co-owner owns an undivided interest in the Property for less than 6 months.
The Questions:
1. What activities are allowed/not allowed? By whom?
2. What structuring solutions can prevent the activities of the sponsor from being attributed to the TICs when the sponsor is (probably through a related entity) a co- owner? When it is not?
3. Grace Period? 18 months? Longer? See PLR 200327003 (July 3, 2003).
E. Personal Liability of Owners of TIC SPEs.
The Issue: In planning for the hard reality that some projects may require capital calls from the co-owners thereof, all TIC agreements provide for mandatory contributions from the TICs under certain circumstances. Since the actual TIC owners are the SPEs described above, such obligations can be easily avoided by the beneficial owners of the TIC interests. In such a case, in order to avoid a default on any indebtedness secured by the property, often the other owners—usually the sponsor—will advance the defaulting TIC’s share of the capital call. Again, absent some personal liability for such advances by the owners of the TIC SPEs, those advances are effectively non-recourse loans to the TIC SPEs. At its outer limits, this can produce a non-pro rata sharing of the liabilities on, and costs of, the property.
The Rev. Proc. has this to say about of cost-sharing:
.08 Proportionate Sharing of Profits and Losses. 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. Neither the other co-owners, nor the sponsor, nor the manager may advance funds to a co-owner to meet expenses associated with the co-ownership interest, unless the advance is recourse to the co-owner (and, where the co-owner is a disregarded entity, the owner of the co-owner) and is not for a period exceeding 31 days.
The Questions:
1. Is there a practical alternative to the usual approach of having the owners of the TIC SPEs be personally liable for such advances by the other TICs, the sponsor or the manager that still allows a “should” opinion? What if the lender demands that such provision be deleted?
2. If the lender requires a non-consolidation opinion, does this provision present insuperable problems for bankruptcy counsel?
F. Restrictions on Alienation.
The Issue: Lenders live in the nightmare world of the “serial bankruptcy”—the fear that when a property becomes ripe for foreclosure each of the 35 TICs will put their SPE into bankruptcy ONE AFTER THE OTHER such that the lender is stayed from foreclosing on the property literally for years. Waivers of the right to file a bankruptcy petition are generally unenforceable, so lenders regularly require independent managers of the TIC SPEs as a roadblock to such filings. The biggest motivator of TICs to avoid making a bankruptcy filing is the insertion in the controlling loan documents or a provision that makes such a filing one of the “bad boy” acts that triggers personal liability (either of the entire debt or that TIC’s pro rata share of the debt) to the owner of the TIC SPE that engages in such an action (or sometimes to the sponsor and/or the other TICs).
Likewise, the filing of an action for partition of the property is one that would severely tie up title to the property. Lenders regularly request that the borrowing TIC SPEs waive their common law rights of partition. That request implicates the following condition of the Rev. Proc.:
.06 Restrictions on Alienation. In general, each co-owner must have the rights to transfer, partition, and encumber the co- owner’s undivided interest in the Property without the agreement or approval of any person. However, restrictions on the right to transfer, partition, or encumber interests in the Property that are required by a lender and that are consistent with customary commercial lending practices are not prohibited. . . .
The Questions:
1. Why not just make the filing of a partition action an event of default, as opposed to having the TICs waive their right of partition? What has been the response of lenders to such a request?
2. What are “customary commercial lending practices?”
G. More Than 35 TICs.
The Issue—In the standard “TICs on title” structure, or even the master lease structure, there may arise situations where the sponsor wants or needs more than 35 investors.
The Rev. Proc. speaks very precisely to this issue, to wit:
.02 Number of Co-Owners. The number of co-owners must be limited to no more than 35 persons. For this purpose, “person” is defined as in § 7701(a)(1), except that a husband and wife are treated as a single person and all persons who acquired interests from a co-owner by inheritance are treated as a single person.
The Questions:
1. Can you have more than 35 persons in a TIC transaction? (Ignore for this discussion transactions done utilizing a Delaware Statutory Trust under Rev. Rul. 2004-86, supra.
2. If so, how many more?
III. Summary.
There are many practical issues that arise in TIC syndications that require solutions that make it impossible to meet all 15 of the conditions in the Rev. Proc. Many of those solutions seem well within the parameters set forth in applicable law for determining whether an arrangement is a co-ownership of real property as opposed to a partnership. Only further guidance or litigation will ultimately determine whether some of the solutions being crafted to deal with these practical issues still protect the co-ownership characterization, notwithstanding the fact that such solutions are outside the Rev. Proc.
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| Last Updated ( Monday, 08 September 2008 21:10 ) |
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