A tenancy-in-common (TIC) is often used as part of a 1031 tax-deferred transaction. What’s a 1031 tax-deferred transaction? IRS Code §1031 tax-deferred treatment is a tax tool often used by real estate investors to avoid having to pay capital gain taxes. The basic example of a 1031 tax-deferred transaction is where a real estate investor sells one property to buy another. It’s actually a little more complex, and involves more than just this form of transaction, but the focus here is how a TIC can be used for to apply the 1031 tax-deferred treatment to your real estate investment.
How to Comply
Complying with the rules that make a TIC work for the 1031 tax-deferred treatment is essential. The TIC only works for the tax strategy if certain conditions are met. First, the manager of the TIC must distribute net revenues to the TIC’s owners within three months of receipt of the revenues. Second, management fees cannot depend on the income or profits derived from the property. Third, the management fees cannot have exceeded the fair market value of the manager’s services (have fun figuring that out).
Real estate investors like to use TICs to take advantage of the IRS Code §1031 tax deferred like-kind exchange option. They can replace any fractional interest in a cash flowing property (think sale followed by purchase) in order to defer capital gain taxes. However, if your interest in the real estate is structured as a partnership, this option won’t apply. This is where the TIC comes in because a TIC does not function as a partnership. If formed correctly, a TIC operates as an ownership in real property (although a limited liability company or partnership can be an owner of the TIC). There are 15 conditions dictated by the IRS by which a TIC can qualify (also subject to state law).
The 15 conditions set forth by the IRS include, among others, that:
- There can be no more than 35 investors;
- Every owner must have the right to transfer, partition and encumber their own respective undivided ownership interest in the property without requiring the agreement or approval of any other person; and
- A lender may restrict the right of an owner to transfer, partition or encumber their undivided ownership interest in the property, as long as it is a customary commercial lending practice (i.e. restrictions on the transfer of a controlling interest in the property or the acquisition of additional loans secured by the property).
Of course, these are only the basics. TICs and 1031 tax-deferred transactions are more complex and are not always available. However, if the structure is available, it can prevent you from having to shell so much of your profits out on taxes. If you’d like to know more about how you can utilize IRS Code §1031 tax-deferred treatment or a TIC for your real estate investment, please call Dodson Legal Group at IRS Code 844-4DODSON for a consultation.