Lorain is a Dentist with $900K in cash to invest in commercial real estate. She has been looking for a commercial property in the Bay Area for the last 2 years. There are few commercial properties in the $1M – $3M range for sale in the Bay Area. And if there are, they tend to be very old and in an undesirable part of town with a lot of deferred maintenance and financially-weak tenants. She wonders who would have the courage to invest in such a property. She cannot afford the better and more expensive properties. However, she noticed many good and affordable shopping centers outside of California with brand name tenants and high income. With her busy work schedule and 2 young children, taking time off just to see these properties is a significant task. Moreover, she would not know whether the area is a good place to invest. She would have to find a reliable property manager and then make business decisions like whom to lease the vacant space to, thousands of miles away. She thought there must be a better investment solution.
Sunny has been working as an Engineer in the Bay Area for more than 15 years. Over the years he contributed to his company’s 401K plan and has accumulated over $350K in his IRA rollover account. He notices the return on his IRA funds is underperforming. As he grows older, he is concerned about the volatility of the stock market. The recent scandals about backdating stock options and Enron shook his confidence in public corporations. He now wants to use his IRA money to invest in tangible real estate where he has more comfort and control. He learns that he could put this money in a self-directed IRA to invest in real estate. As he researches more, he can use money from self-directed IRA account as a down payment. But the IRS precludes any personal guarantee for the loan – minimizing his leverage. This personal guarantee is a major restriction because all residential lenders require it. In additional, a self-directed IRA account without a social security number or Federal tax ID is not a borrowing entity that lenders recognize (A full-length article about how to use self-directed IRA to invest in real estate will be featured in a coming issue.) There is a solution.
What is TIC? While TIC simply stands for Tenant In Common, the term TIC often means a type of property in which several investors purchase together. A real estate broker gathers a group of investors like Lorain and Sunny together as an investment club to purchase an income-producing property. The real estate broker is called a TIC sponsor. The sponsor is motivated to look for the best property so he may promote it to investors like Lorain and Sunny. This property is often more expensive, e.g. $5M-$10M; thus, most investors cannot purchase individually. Lorain and Sunny are happy to invest in a good property with strong income. The TIC sponsor earns a commission from the sale and a contingent fee in the form of a 10% ownership of the property. So it’s a win-win situation for both TIC sponsor and investors. The TIC sponsor manages the property, provides a quarterly operating income & expense report, and distributes income to investors.
Benefits to investors: The concept behind TIC is “it’s better to own a part of a more valuable, stable, well-located property than to own 100% of a lousy property”.
- Lorain is pleased because she can invest in a good property with strong income and strong potential for appreciation. The property is in good hands with the TIC sponsor; so, she can focus on her dental business and
- Sunny is very happy because he owns less than 25% of the property, and thus, he does not have to provide any personal guarantee for the loan. He meets the IRS requirement and can still maximize leverage. His share of operating income will be deposited to his self-directed IRA account.
- Since the loan amount to finance the property is substantially larger, e.g. $6-10M, and the property has superior characteristics, the interest rate will be lower, e.g. 6% instead of 7%. As a result, the investors will receive a better return from their investment.
Operating Agreement: this is a document with rules to govern the investment club that all investors have to agree to. This will minimize potential disputes among investors. Some of the key rules may be:
- Major decisions, e.g. to sell the entire property will require unanimous approval among LLC members.
- All members own the property as Tenant in Common and hence the term TIC.
- Each co-owner has the right of first refusal when any other co-owners want to sell their share.
Title under TIC: the TIC sponsor often forms a Limited Liability Company (LLC) to take title to the property. An LLC will shield the property from potential liabilities exposure. For example, if one of the investors is sued, the creditors cannot go after the property. This is because the investor has an equitable interest in the property but does not legally own it. The LLC is the legal owner of the property. The TIC sponsor is the manager of the LLC so he can make certain decisions, e.g. sign the new lease on behalf of all investors.
Loan for the property: the property normally has a non-recourse loan in which the property is the only collateral for the loan. The lender cannot go after other assets of the investors in case of default. The lender will require all investors who own more than 25% of the property to fill out loan application. So, Sunny needs to keep his ownership at less than 25% because his self-directed IRA is the owner of the property.
Income Tax: All the income may be reported by individual investors on the Schedule E. For example if Lorain owns 25% of the property, she will receive an Operating Statement with income and expense information from the TIC sponsor. She will report 25% of the income, 25% of the expenses, and 25% of the depreciation from the property on her schedule E. For Sunny, all the positive cash flow is deposited to his self-directed IRA account, and he defers some income.
1031 Exchange: The ownership interest can be 1031 exchange property if the co-ownership is not classified as a partnership for tax purposes. Thus the investors may get tax deferral on a like-kind exchange of their fractional ownership interest.
The Happy Ending: The TIC sponsor suggests both Sunny and Lorain to consider investing with 2 other investors in a $7.9M, 2-year old, 30,900 SF, 12-tenant, and 100% NNN leased upscale shopping center in Lawrenceville, a fast growing and prosperous city in the suburb of Atlanta, GA. The property is located in front of a Walmart Supercenter; so, they both know it’s in a prime location. The property currently has a $6M non-recourse loan at below market rate of 5.6% interest through 2016. So while the cap rate is respectable at 7.25%, the cash on cash return is over 10% because the interest rate is so low. After reviewing the brochure and financial information of the property, they sign the subscription agreement to move forward with the investment.
DISCLOSURE: To ensure compliance with requirements imposed by IRS Circular 230, we hereby inform you that the U.S. Federal tax advice contained in this article is not intended to be used nor has this article been written to be used, and it cannot be used, by any taxpayer for the purpose: (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. No tax advice is being given by this article for any specific transaction. If you desire advice about any particular transaction, then please consult a professional tax advisor.
