You’ve done well investing in real estate, and are looking to grow your portfolio. Your broker just called and gave you the “hot-tip” of the week: That sparkling Class A office building at Main and Main, the one you have coveted since investor-infancy, will be coming to market in three months.
Now your firm has done well, but not go-it-alone on this diamond well. So what do you do?
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Your lawyer buddy (well, he graduated from law school but technically is now your bartender) had a few ideas about how you could put together such a deal. Some of the ideas rang a bell, but one rang just a little louder.
“Tenants in common,” your bud said. You knew it was some sort of co-ownership of property, but before you could extract any information on the magical phrase, the barkeep was off kibitzing with 13 rowdy conventioneers in the middle of running up a mountain-sized liquor tab.
All you were left with was an empty bottle of beer and a head full of questions.
What is a tenancy in common (TIC)? What are its characteristics? Its advantages and disadvantages? If there are multiple owners, who gets the profits, pays the property expenses, makes the decisions? If I decide my co-owners are delusional, can I sell my part? If I do, can I do a §1031 exchange? And, well, how do I finance my part of the deal?
Okay, let’s see if we can find some answers. I’ll tell you though, because the laws governing TICs vary from state to state, before you make any decision on your Class A office dream, it’d be a good idea to meet with your attorney and tax advisor.
Let’s get started.
What is Co-Tenancy?
First of all, in order to understand tenancy in common, you must first understand co-tenancy. What exactly is co-tenancy? When two or more people own a property, they have a co-tenancy, and are each a co-tenant. Co-tenancy can occur in both residential and commercial arenas, and the two most common forms of co-tenancy are tenancy in common (with the owners referred to as tenants in common, TICs) and joint tenancy with right of survivorship.
Subject to modifications by agreement, co-owners each have a right of access to the entire property, a share of the income generated by the property (including proceeds from a sale), and a duty to share in expenses related to the property. Co-owners may not have to share in the costs of improvements, but if one owner makes improvements at his cost, and the improvements increase the asset’s value at sale, this owner may be able recover his contribution.
Lastly, a party considering co-tenancy will be happy to note that co-owners owe each other a duty of fair dealing.
What is Tenancy in Common and What is a Tenant in Common (TIC)?
As noted above, tenancy in common is a type of co-tenancy, and a tenant in common is each co-owner holding an interest in a single tenancy in common. So, what are the primary characteristics of a tenancy in common? The primary characteristics of a tenancy in common are:
- Each tenant in common holds a separate and undivided interest in the property
- Tenants in common may, but are not required to, hold different percentages of ownership in the property
- There are no rights of survivorship among the co-owners, and
- Each TIC may transfer or encumber their property interest without the consent of the other TICs (though this right may be modified by agreement of the co-owners)
Let’s walk through these TIC characteristics one by one and then cover some other common questions and issues regarding tenancy in common.
Each Co-Owner Has an Undivided Interest in Property
If property is held as a tenancy in common (the structure of ownership is made when the property is acquired), each owner owns a separate and undivided interest in the property, meaning not only that they have the right to access, possess and use all of the property, but also that they may sell their individual ownership interest.
TICs Can Have Different Ownership Percentages
Tenants in common may have different shares of ownership in the whole, typically based on their contribution to the property’s acquisition. For example, if you, your bartender, and one of the conventioneers acquired the Class A building under a TIC structure, you could have a 60% share, the auctioneer a 30% share, and your bartender a 10% share. These ownership shares then determine how you distribute the costs and benefits of the property, such as common area expenses and sale proceeds. The deeds under which TIC acquires their interest will show their ownership percentage.
What Happens When I Die? (Survivorship)
If you’re a dog, you go to this big farm where it’s always sunny and the water bowls are always full…
If you’re a tenant in common, there is no right of survivorship. This means that if a TIC dies, its interest passes to that co-owner’s heirs by will or inheritance laws. Of course, if the co-owner desired, it could provide in its will that upon her death her ownership interest would pass to the other TIC owners.
Does Every Co-Owner Get to Use the Entire Property?
Yes, unless they agree not to.
As noted above, as holders of an undivided interest in the property, each TIC has the right to access, possess and use any portion of the property. Access to all is typical where friends or family acquire property together and where parties purchase an interest in property for passive investment purposes.
However, TICs may also agree to use only assigned portions of the property, e.g., a floor of an office building, residential unit, retail space, storage unit, etc. For example, a TIC can be formed to acquire an industrial park, with each co-owner using only a specific building within the park. Co-owners can also then agree that each has the exclusive right to income generated from the use of their assigned space.
As an aside, a timeshare is an assigned-use TIC structure, but instead of an owner’s use being limited to a certain space, it is limited to a certain time.
The assignment of use and income rights are set forth in a TIC agreement, which, as discussed below, spells out the rights and obligations of the co-owners.
Can I Sell My TIC Interest?
Yes. A TIC has an undivided interest in the property. They may sell, transfer or encumber their interest (e.g., borrow funds secured by their interest) without the approval of the other owners.
However, because such an unfettered right could drastically increase the risk of ownership to the non-selling parties, TIC agreements typically limit co-owners’ rights of transfer. The agreement may, among other limitations, grant owners a right of first refusal on any sale and the right to vet and approve potential buyers. If at first blush this seems unreasonable, remember that a buyer will step into the shoes of the selling co-owner, and all of their rights and obligations.
Imagine if you bought a duplex with your quiet, mild-mannered, and dutifully bill-paying former college roommate, with each of you residing in one of the units. Now imagine your ideal co-owner decided to move to Peru and sell his interest in the duplex to a family of chain-smoking, saxophone and bagpipe players who believe timely loan payments are more of a suggestion than a duty.
Think it might have been a good idea to have a TIC agreement giving you the right to approve buyers?
Now imagine you bought that Class A office space, financed in part with a $20M loan to the three of you, and your bartender wanted to sell his interest to a party with a history of serious financial instability and litigation…
So, yes, tenants in common may sell their interests, but co-tenants may contractually limit this right.
When is a TIC Created?
A TIC is created when owners take title to a property, with the deed indicating each owner’s percentage interest. While it is wise to create a TIC agreement prior to the tenancy in common structure, it is not required. If no TIC agreement exists at the time title is vested, the characteristics of the TIC will be established by state statutes and common law, e.g., each TIC has the right to possess the entire property, each may transfer their interest without consent of other TICs, and each will share the total property income and expenses according to the ownership percentages indicated on their deeds.
Note though, not all of the co-owners must exist at the outset. They can be created at different times. For example, where the owner of an apartment building sells TIC interests to individuals, assigning them use rights as to single units, there could be years between the first TIC owner and the last.
Lastly, a TIC can be created by operation of law when a joint tenancy with right of survivorship (discussed below) is severed.
Is a TIC Different From a Joint Tenancy?
Joint tenancy, or joint tenancy with right of survivorship, is typically used when property is owned by husband and wife, parent and child, or any other group that wants each individual ownership interest to pass to the other in the event of death. This “right of survivorship” allows the deceased owner’s interest to be transferred automatically to the survivor without going through probate. TICs on the other hand have no right of survivorship.
Additionally, while tenants in common can have unequal interests in the property, joint tenants must have equal shares. Because the tenants have equal shares, if there is a partition by sale of the property, the proceeds must be divided equally regardless of the parties’ contributions to the property’s purchase.
Lastly, while tenants in common can transfer their interests, if a joint tenant sells or mortgages their interest without the consent of the other, the joint tenancy is converted into a TIC.
Who Manages a TIC?
The management of a TIC is determined in the TIC agreement. Often TICs with few co-owners and relatively simple management needs are managed by the co-owners themselves, while the management of more complex TICs are handled by separate management companies. Either way, the role and duties of management are set forth in the TIC agreement. And who creates the TIC agreement? Whoever creates the tenancy in common, whether that is a single party or multiple co-owners.
What is in a TIC Agreement?
The purpose of TIC agreements is to (i) clearly spell out the rights and duties of all parties, (ii) to anticipate potential issues with the property and its co-ownership, and (iii) to give definite procedures for how conflicts will be resolved. Where a deal is particularly complex, and the risks high, a well-crafted TIC agreement can, and should be, lengthy and detailed. Any costs saved by drafting a simple or one-size-fits-all agreement will be lost ten-fold if the agreement doesn’t provide clear answers when inevitable disagreements between co-owners arise.
Generally a TIC agreement will give direction on the following items:
Assignment of Usage: Describe what portion of the property each co-owner has the exclusive right to use, as well as areas available for all owners’ use.
Determination of Ownership Share: Describe the method by which a co-owner’s share of ownership is determined, e.g., by space, value, contribution, etc.
Permitted Uses: Identify permissible uses for each assigned space, and any limitations on such uses, e.g., noise, number of tenants, pets, etc.
Property Management: Detail how all aspects of the property will be managed (e.g., common expense accounting, maintenance, repairs), whether the co-owners perform particular tasks themselves, or a third-party manager handles all items.
As further discussed below, TIC interests qualify for IRS Code §1031 tax-deferred treatment if they meet certain conditions. As to the management of a property, these conditions require that (i) the manager disburses to the co-owners their shares of net revenues within three months from the date of receipt of those revenues, (ii) management fees do not depend on income or profits derived from the property, and (iii) management fees do not exceed the fair market value of the manager’s services.
Maintenance: Describe each owner’s duty to maintain its space, and how common space will be maintained.
Expenses: Describe how all property costs will be allocated among owners. Typical shared costs include real property taxes, maintenance and repair of shared areas, shared utilities and insurance.
Because a TIC doesn’t divide ownership of a property, each co-owner will not receive a separate real estate tax bill for their ownership interest. Rather, the taxing authority will issue a single bill for the entire property, holding each co-owner responsible for the entire amount.
Additionally, the agreement should describe how tax deductions should be allocated among the owners, e.g., mortgage interest on a collective loan, property tax, etc.
While the method of claiming a mortgage interest deduction doesn’t need to be a part of a TIC agreement, it is an interesting process. On residential property, where a co-owner’s loan is secured by a mortgage on its property interest alone, the process is simple: it receives a 1098 form from its lender, and claims this full deduction amount. Where there is a group loan among the co-owners secured by a mortgage on the total property, a few extra steps are required: (i) the lender sends the 1098 to the first borrower listed on the loan, (ii) this first-named borrower identifies on its Schedule A only the interest allocated to him under the TIC agreement, (iii) the remaining owners identify (A) their respective allocations on their Schedule A’s as a home mortgage interest not reported on form 1098, and (B) the first-named borrower on their return.
Financing: Describe how acquisition is funded. All owners may be parties to a single note secured by all of their interests, or each co-owner may obtain their own financing secured by their fractional interest. All financial obligations should be spelled out, such as requisite initial deposits, reserve accounts, calculation of loan payments and potential adjustments to payments.
Sale or Transfer of Interest: Outline the rights of tenants in common to transfer their interests, and any conditions on these rights. For example, transfers may be subject to the other owners’ right of first refusal or approval of potential buyers. Note that an outright prohibition on an owner’s right to transfer may be unenforceable as an unlawful restriction on the alienation of property, or may prevent a TIC from enjoying §1031 treatment.
Additionally, TIC agreements may want to consider what rights potential lenders may demand of new co-owners. For example, a borrower may be required to collaterally assign its transfer rights to its lender.
Decision-Making: Detail how decisions affecting the property are made. This can include agreeing upon which decisions will require a majority (e.g., day-to-day operations), super-majority (e.g., repairs or improvements over a certain dollar amount) or unanimous approval of the co-owners (e.g., change to assigned uses or spaces).
Default and Dispute Resolution Provisions: Define what constitutes a default under the TIC agreement, what remedies available to the non-defaulting owners, and a dispute resolution procedure to resolve defaults (e.g., informal negotiation, mediation, arbitration and litigation).
Financing of TIC Property
As briefly mentioned above, typically financing for TIC property is accomplished either (i) by the group of owners holding one or more loans secured by the group’s total property interest, or (ii) each co-owner having their own loan secured only by their property interest.
In the case of a group loan, the payment amounts due from each owner must be agreed to among the owners. One method is to take the amount a TIC paid for their ownership interest, and subtract the amount they put down, resulting in the amount of the group loan attributable to that owner. Then divide this amount by the total group loan amount to determine the percentage of loan payments that owner is responsible for.
One of the primary risks of a group financing is that when one co-owner doesn’t meet their payment obligations, and there are insufficient funds among the other owners to make the total payment, the lender may foreclose against the entire property. To mitigate against this risk, owners (i) vet the financial strength and history of their co-owners, (ii) ensure that the TIC agreement gives them this same vetting right for any potential new co-owners, and (iii) require co-owners to contribute to reserve funds.
In the case of individual loans, because the loan is secured only by the individual owner’s interest, their default does not directly obligate the other TICs. If an owner defaults, the lender may foreclose only on the owner’s share, and not the property. Where this occurs, the lender may sell the foreclosed interest, subject to any limitations the TIC has on transfers (e.g., a right of first refusal).
One other financing structure, sometimes referred to as “wrap-around” financing, occurs where, before the TIC structure is created, the original property owner (often the developer of a project) carries a single loan secured by the entire property, and makes all the payments on this loan. As new co-owners purchase TIC interests in the property, the original owner makes them individual loans. The new co-owners make their loan payments to the original owner, and who then pays its lender.
What is Lending Like Now for TICs? And What is a Section 721 Exchange?
Following the IRS’s issuance of Procedure 2002-22, clarifying that properly created TIC interests were eligible for § 1031 exchanges, investors flocked to TIC deals. Assembled and marketed by “syndicators” or “sponsors,” investors bought fractional interests in TIC-owned CRE assets.
When the recession hit, banking regulations tightened, and banks’ distressed property holdings increased, loans to TIC deals slowed. Put simply, where a financial institution had the choice between dealing with a single party or with a TIC of up to 35 co-owners, the choice was easy. Because the current banking environment remains disenchanted with the multi-party ownership structure, current investors in TIC projects may have trouble finding new capital or refinancing for the loans secured during the boom.
Accordingly, for TIC co-owners an obvious solution to attract new funds is to become more attractive: simplify the multi-party ownership. Tenants in common may do this by “rolling up” their interests into a single, new LLC through an IRS § 721 exchange.
Like a § 1031 exchange, § 721 exchanges, if structured properly, can enjoy a deferral of capital gains tax. Historically, Section 721 has been used by REITs when buying from parties wishing to avoid such gains tax. The process starts with the property owner exchanging its real estate for ownership units in the acquiring REIT’s operating partnership (OP Units). The operating partnership (also referred to as an umbrella partnership) is an entity separate from the REIT, which holds the REIT’s assets. The OP Units may then be transferred, on a tax-deferred basis, to shares in the REIT. Under this process, the real estate owner converts its real property interest into a private or public security.
In the case of a TIC, a Section 721 exchange starts with the tenants in common contributing their TIC interests into a new LLC, or “rolling up” their interests. Following these contributions, the LLC becomes the sole owner of the real estate, and each tenant in common an equity owner in the LLC. This simplified ownership structure makes attracting financing easier. While this exchange can enjoy tax-deferred treatment, tax counsel should be used to carefully structure the refinancing and avoid unanticipated taxable income to the former TICs.
Does a Tenancy in Common Qualify For a §1031 Like-Kind Exchange?
TIC property interests can be exchanged in an IRS Code §1031 tax deferred like-kind exchange. This allows property owners to defer capital gains when replacing a fractional interest in a cash flowing property. A partnership interest, however, cannot enjoy this treatment. Accordingly, a TIC owner intending to use its interest for such tax deferred treatment must be careful that the TIC is structured and operates as an ownership in real property, and not a partnership. To give guidance on what the IRS considers a TIC, it issued IRS Procedure 2002-22, detailing 15 conditions a tenancy in common must meet to qualify for §1031 treatment.
IRS Procedure 2002-22 conditions include, among others, that (i) there be no more than 35 investors, (ii) each co-owner has the right to transfer, partition, and encumber their own undivided interest in the property without the agreement or approval of any person, and (iii) restrictions on the right to transfer, partition, or encumber that are required by a lender and that are consistent with customary commercial lending practices are permitted.
How Many Tenants in Common are Allowed?
Unless the co-owners want to be eligible for §1031 tax deferred treatment, there can be anywhere between two and infinity minus one tenants in common. While there are no limits on how many TICs can have an interest in a single property, if §1031 eligibility is sought, there can’t be more than 35 co-owners.
What are the Major Advantages of Tenancy in Common (TICs)?
One of the primary benefits of TICs to buyers is highlighted in the example of you, your bartender and the conventioneer wanting to buy a Class A office property. While none of you could have acquired the building on your own, a TIC allows you to pool resources and maximize your buying power.
On the flip side, TICs can benefit sellers by giving them greater flexibility in the marketing of their property. They can sell the whole or pieces as the market demands. Often when selling portions of a property, the total income from these sales is greater than if the property had been sold to a single party. In this case, the whole is not greater than the sum of its parts…
What are the Major Disadvantages of a Tenancy in Common (TICs)?
As with any co-ownership, a tenant in common accepts the risk that its co-owners will not meet their obligations. Bartender doesn’t pay his share of the property taxes? You get to. Doesn’t make his share of the group loan payment and didn’t fund his reserve account? Get that checkbook out.
Additionally, because of the complexities of financing group loans and potential risks to a lender of multiple, and possibly changing, borrowers, TICs may face higher lending costs. Further, over the years, financial institutions’ desire to fund TICs has ebbed and flowed. If these complex ownership structures are out of favor with lenders when a TIC needs to refinance, they may face an uphill battle. There may be methods to simplify an ownership structure to facilitate refinancing or sale (e.g., a 721 Exchange where a commercial property is performing well), but the risk of financing availability and cost should be considered.
Additionally, TIC ownership can also expose a co-owner to actions by another owner’s creditors. For example, assume your bartender owes $100,000 to VISA relating to an impromptu trip to Nepal. VISA looks to his interest in the Class A office property. Now, they can only make claim against your bartender’s fractional interest, and not your, or the conventioneer’s, TIC interest. But, they may be able to force a sale of the entire building to satisfy the bartender’s personal debt. While you and the conventioneer could recover your fractional share of the proceeds from such a sale, you would still lose your dream property.
What’s the Difference Between a TIC and an LLC or Partnership Structure?
Limited liability companies and partnerships are business entities in which one or more parties share ownership. LLCs may generally be comprised of one or more owners (members), while partnerships must have at least two partners. State laws govern both the rules of both entities.
The primary difference between an LLC and partnership is one of personal responsibility for entity obligations. LLC members are shielded from entity obligations. Partners are not. Partners in a general partnership are jointly and severally personally liable for all partnership obligations, and partners in a limited partnership are liable up to their investment in the partnership.
A TIC owner is responsible for the share of TIC obligations as described in the TIC agreement. Personal liability is then a question of each co-owner’s entity structure. For example, if a party forms a single-purpose LLC to hold the TIC interest, then the personal liability of the LLC owner will be limited to the value of the LLC’s TIC interest.
An LLC and partnership share a common taxation structure in that business income is taxed once at the member/partner level. On the other hand, corporations are taxed at the corporate level and then again at the shareholder level.
A TIC is not a taxable entity. Each co-owner is taxed on their own income.
Where an LLC or partnership purchases a property, the individual members do not own a share in the property, but rather a share in the entity. In contrast, tenants in common each own a separate ownership directly in the property. Because of this difference, parties may want to consider how easily they may divest themselves of their LLC interest vs. a TIC interest. Generally the answer to this question will depend on the terms of the TIC agreement and LLC formation documents.
Further, as discussed above, the tax-deferred treatment available under IRS § 1031 is permitted with TIC ownership interests, but not partnerships. So if a party is seeking to purchase property for a like-kind transfer, they may enjoy 1031 treatment if purchasing a TIC ownership, but not a partnership or LLC interest.
How Can a TIC be Terminated? (Partition or…)
If you’ve had enough of your bartender’s shenanigans, you can terminate the TIC through a court-ordered partition. Partitions come in three flavors: in kind, by allotment, or by sale. A partition in kind is an actual division of the property among co-owners, and is only available when local subdivision laws permit. A partition by allotment grants ownership to a single owner (or group of owners), who then compensates the ousted co-owners for their loss of ownership. And a partition by sale is exactly what it sounds like: the court forces the sale of the property, and divides profits among the co-owners. Partition by sale is generally the last resort of courts, and only awarded when a partition in kind is not available.
It should be noted, however, that tenants in common may waive their right to partition under their TIC agreement. A total waiver may be an unenforceable restraint on the alienation of property, but a court may recognize limited waivers, such as where partition rights are waived for a period of time or under certain conditions.
So what was the “or…” method of terminating a TIC? Adverse possession. Property acquired by adverse possession terminates a TIC. And now you know.
If that Class A office building comes on the market, and you just can’t go it alone, a TIC may be the answer. If your bartender and the conventioneer have passed your vetting with flying colors, then pooling your resources under this ownership structure could make your office dream come true.
Of course, because this article is for informational purposes only (and not to give legal advice), and given the complexities we’ve touched on, and the risks associated with TICs, please consult your lawyer and tax advisor if you have any specific co-tenancy questions.
What did we miss? Have you ever held a TIC ownership interest? Do you know any bartenders who moonlight as real estate investors? Let us know in the comments below!