| If you are planning to sell investment real estate, you can use the provisions of Section 1031 of regulations to defer your capital gain by investing in “like kind replacement property.” A recent trend, which accounted for $4.1 billion of investment in 2005, is for promoters to encourage real estate investors to buy a fractional interest in larger properties than they could otherwise afford. This article will explain the risk of those 1031-TIC investments, and offer a better alternative.
A few definitions are in order for the novice:
• The IRS is the Internal Revenue Service
• The SEC is the Securities and Exchange Commission
• Section 1031 is the portion of the IRS regulations which explains the specific circumstances by which the payment of capital gain taxes may be deferred by transferring the adjusted basis of property A to property B, if properties A and B are both “like kind” (i.e. both are investment real estate). Additionally, if the real estate which is sold is owned personally, the replacement real estate must be purchased personally and not in partnership.
• A tenancy in common (TIC) is a long established form of real estate ownership, which has its roots in English feudal law, in which two or more people separately own an undivided interest in real estate with no right of survivorship. For example, parties A, B and C each own 1/3 of an unsubdivided piece of land. If A dies, A’s heirs, and not B and C, own A’s interest. B may sell his interest to D, and so forth.
Uninformed buyers may be in for an unwelcome and expensive surprise if the IRS or SEC determines either that the ownership structure of the new property being promoted as a TIC is in fact a partnership, or that the property itself is a security and not real estate. Although the IRS has issued a ruling (Rev. Proc. 2002-22) which specifies the conditions by which an undivided interest in real estate will be defined by the IRS as a TIC, and not a partnership, neither the IRS nor the SEC has issued a clear or recent ruling as to the conditions by which an investment will be considered as real property and not a security. Lawyers presently look to the 1933 Securities Act and the Supreme Court’s 1946 ruling in SEC v Howey for that distinction. The basic test of whether a 1031-TIC investment opportunity is a security involves analysis as to whether others are involved in the investment (such as they are with a Tenancy in Common) and as to whether the profits will come solely from the efforts of others (such as the promoter who is selling the TIC and managing the investment property).
So, if someone (a promoter: i.e., a broker or developer) is encouraging you to reinvest your proceeds from the sale of investment real estate, so that you would be a part owner of a significant investment property, with the intention of deferring your capital gains taxes through the 1031 provisions, and the promoter told you that the investment return you are being quoted is net income after management fees and expenses, there is an excellent chance that the investment could be construed by the IRS or SEC as either a partnership or a security. In either event, you would not be entitled to the provisions of the Section 1031 tax deferral, and upon audit, the capital gain taxes would be due immediately on the initial sale. This could create a real cash flow problem for many investors, who probably rolled the tax deferral into the purchase for the second property.
Is this complicated? You bet! Do lawyers and accountants disagree? Of course! Attorneys and accountants whose bread is buttered by the real estate industry advocate that 1031-TICs are real property, and that real estate brokers (and not securities professionals) are entitled to commissions for selling TIC interests. Attorneys and accountants who represent securities dealers argue the opposite. While it would be helpful if the IRS and SEC would issue a clear ruling, they have not done so.
What should a wise investor do who wants to take advantage of 1031 tax deferrals?
1. Obtain expert tax and legal advice from an accountant and/or attorney before becoming obligated in the transaction. Even under the best of circumstances, there are specific rules and procedures that need to be followed exactly.
2. Don’t buy investment property solely for perceived tax benefits. Ask yourself if the property that you are considering buying would be a good purchase, even if there would be no 1031 tax benefits from doing so. Is it well located in a path of growth, enabling a good exit strategy? Is it in good condition and well managed? Is there a rental market?
3. Avoid investing in a fractional share of a property that is being promoted or managed through the efforts of another, as there is a significant risk that such an investment could be defined by a subsequent tax audit as a partnership or security, thereby disqualifying it from the benefits of Section 1031.
4. When investing in real property, it is best to either be familiar with the property itself or to have great confidence in someone or an organization (the promoter), through whose efforts you have reason to be confident that the investment will be well managed and profitable.
One of the problems for many investors is that there has been a shortage of opportunities for investors to purchase quality replacement properties priced in the range of $250,000 to $1,500,000. The Mountain View Office Park offers individual investors an opporutntity to purchase fee simple property in a Cumberland County, Pennsylvania location with a healthy office market and a large growth upside.
Please call us to learn more about this investment opporutntity that does not have the risks of a 1031-TIC opportunity. You may get initial information by clicking below:
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