Tom Kelly: Tax-deferred exchanges offer a different path for real estate investors

Most real estate investors are familiar with tax-deferred exchanges. This practice allows the seller of an investment property to defer the gain on a sale by purchasing property of equal or greater value if specific timelines are met.

One problem that arises is that the “replacement property” (the property an investor wants to exchange for the existing property) may be far more expensive than the investor can afford, and the net sale on the first property is not enough to acquire the second property.

While property prices have come down on many buildings and properties, the answer for many taxpayers has been the TIC transaction, or tenant-in-common. This strategy allows investors who sell an investment property to buy ownership interests in another property (or properties) instead of buying the whole parcel.

While TICs have been around for years and have been structured by a number of savvy property exchange specialists, they were officially blessed 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 a 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.

TICs have become popular and some big-name sponsors have entered the niche. This activity offers investors diversification in location and property type.

“Investors need to properly research any TIC offering and understand what they are accepting,’’ said Tom Oldfield, a Tacoma-based tax-deferred exchange specialist. “They need to know how the property is going to be managed, and if the costs include a commission – which is typically paid by the seller, not the buyer.’’

Oldfield said that many TIC commercial buildings often are leased to one master tenant who is associated with the TIC sponsor. The master tenant then subleases the building and stands to profit the most when rental rates rise. TIC participants are guaranteed a rate of return but typically none of the additional windfall rents.

A tax-deferred exchange (commonly known as IRS Section 1031 Exchange) is really an arm’s-length sale and purchase. 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 gains 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 by providing the required exchange documentation.

By pooling the proceeds of 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.

No more leaking pipes and chasing down tenants for the rent check? Sounds like an attractive option.