Dialing for Dollars with Dead Tics

Dialing For Dollars With Dead TICs

Edward A. Peterson
Winstead PC
Dallas, Texas

I.Introduction

By this time, most of the members of the College have been actively involved in restructures of distressed debt of one kind or another either for lenders, borrowers or equity providers. Why is this topic of interest to this group, which probably possesses more experience in this area of practice than anyone in the country? The restructure of debt secured by real property where title is held not by one individual or one entity but rather by a group of tenants in common is unique, and therefore restructuring the debt or the ownership, or both, presents equally unique issues. This presentation will not explore all the possible issues that can arise in a restructure of a tenant-in-common investor-owned property, but will endeavor to point out the major issues that both the borrower and the lender will confront and to present some practical advice when dealing with such restructures.

II.Summary of Origin of TIC Structures

A.Origin of Tenancies in Common

The concept of tenancy in common first appears to have been recognized by the English courts in the fourteenth century during the reign of EdwardI.[1] The concept of cotenancy evolved from previously accepted forms of concurrent ownership, such as joint tenancies, which require unity of time, title, interest and possession.[2]

By 1470, English common law had developed a near complete set of rules regarding cotenancy relationships.[3] The English courts recognized this form of ownership following a movement by English peasants to pool their money and to acquire better farmland than any one of them could have afforded individually.[4]

Initially, courts favored joint tenancies and would require specific language or intent to create a tenancy in common.[5] Modern common law and statutes have reversed this presumption, and now almost every state has a statute creating a presumption in favor of tenancies in common over joint tenancies.[6]

B.Development and Nature of Tenancies in Common

Tenancies in common are the simplest form of concurrent ownership of real property (hereafter referred to as “property”). A tenancy in common exists when two or more people or entities have the undivided right to possess and use the same parcel of land.[7] Tenants in common may have different estates in the property, such as a fee simple or a life estate, and different percentages of undivided interests in the property.[8] Tenants in common may also acquire their interest in the property at different times.[9]

Tenants in common have a several and distinct estate and, other than the lack of exclusive possession, have the same rights as a tenant in severalty, including the unrestricted right to sell, lease or pledge their interests, absent a contractual agreement to the contrary.[10] Indeed, one tenant in common is not required to obtain the consent of fellow tenants in common before selling or encumbering its property interest and injecting a stranger into the cotenancy relationship.[11] A cotenant may also force the property to be partitioned through judicial action.[12] If the property cannot be fairly divided, the entirety of the property will be sold and the proceeds from the sale will be divided among the cotenants in relation to their proportionate share of ownership.[13] The right to partition is absolute and cannot be defeated by showing that dividing the property would be inconvenient or have an adverse impact on the property’s value or another tenant in common’s financial position.[14]

Each tenant in common has a common law right to fully possess and use the property as if it were the sole owner, subject, however, to the same rights of other tenants in common.[15] This includes the right to earn income from the land.[16] Most states, however, whether through statutory or common law, impose an obligation on a tenant in common occupying the land to account for outside rental income received from the use of the land, less any costs incurred by such tenant in common for maintenance expenses.[17] Statutory and common law rights among tenants in common regarding rental income can also be modified by contract.

C.Modern Tenant in Common Structures

In today’s world, tenancies in common are the most prevalent form of joint ownership of property, due primarily to the presumptions in favor of tenancies in common discussed above. The most common way that tenancies in common are created is through the passing of title to property upon the death of the property owner. Another common example is found in mineral estate ownership. Often, owners of the mineral estate own only a fractional interest in the minerals as a result of partial reservations of mineral estates upon conveyance of their interest in the surface estate.

During the last decade, real estate promoters utilized the tenancy in common concept to expand the pool of equity sources for commercial real estate investments. Appealing to the same motivations that caused English peasants to pool their resources to acquire better farmland, real estate promoters would market to potential investors the chance to own an undivided interest in quality commercial properties, such as an office tower or shopping center. Through contractual agreements among cotenants, promoters would effectively create a structure resembling a partnership and thereby eliminate certain rights of a cotenant, such as the right to full possession, that would otherwise inhibit the commercial leasing of the property.

The modern use of tenancies in common as an investment vehicle for commercial real estate is essentially a repeat of the limited partnership syndications used prior to the passage of the Tax Reform Act of 1986.[18] Real estate promoters offered the timeless appeal of the chance to own higher quality commercial real estate through joint ownership. Also, investors were attracted to favorable tax treatment. An owner of a partnership interest in commercial real estate could shelter earnings by investing in real estate through the purchase of limited partnership interests. During this time period, investors were able to receive certain “tax benefits” due to accelerated depreciation and tax credits in year one of the investment. Given the near 50% marginal tax rate at the time for certain individuals, these tax credits were an integral part of tax avoidance. When the U.S. Congress passed the Tax Reform Act of 1986, which made these tax shelter real estate syndications extinct, the face of real estate investment was changed. The combination of tax free exchanges and the TIC structures in effect were the real estate syndications of the 21st Century.

D.How Did TIC Sponsors Structure Tenant In Common Investments

A promoter (“TIC Sponsor”) of the tenant in common (“TIC”) structured investment would first locate an attractive commercial property. Simultaneously, the promoter would begin locating investors “TIC Investors”), including investors looking to complete a 1031 Exchange (as discussed below), or others simply interested in owning a small interest in income-producing properties. Many TIC Investors were looking for an annuity and believed that owning high quality commercial real estate was a safe investment relative to the risk-adjusted returns offered by corporate bonds or equities. TIC investments also attracted investors who previously owned and managed commercial real estate and, although attracted to the idea of owning property, were no longer willing to be involved in day-to-day management of the property. The characterization and sale of TIC interests in the master lease structure is discussed in IV.C., below.

Once the investor pool was finalized, the promoter would purchase the property with a combination of TIC Investors’ equity and debt from a commercial lender. Title to the property would be taken in the names of all of the TIC Investors.At closing, the TIC Investors would sign either a management agreement with an affiliate of the TIC Sponsor, giving the TIC Sponsor certain managerial duties of the property for a fee, or a master lease of the property to an affiliate of the TIC Sponsor. Under either approach, the TIC Investors delegated management of the property to a third party, often an affiliate of the TIC Sponsor, and waited for the checks to come in every month.

E.Tax Advantages of a TIC Structure

Investment in TIC deals was generally driven by income tax considerations. Section 1031 of the Internal Revenue Code (the “Code”) provides a property owner with the opportunity of deferring a gain from the sale of its property. In order to complete an exchange of property under Section 1031 of the Code (“1031 Exchange”), the owner sells its property and then uses the proceeds from such sale to exchange the property within 180 days of closing. The “exchange” is accomplished by using a qualified intermediary that holds in escrow the proceeds from the relinquished property and then uses those funds to complete the acquisition of the acquired property on behalf of the real estate investor. Through this qualified intermediary, the seller of the property never technically receives the money from the first sale, and therefore the seller has no gain to recognize for tax purposes. Importantly, the real estate investor’s basis in the acquired property is the same as its basis in the relinquished property.

A 1031 Exchange requires that the relinquished property and the purchased property be property held for productive use in a trade or business or for investment, as provided in Section 1031(a)(1) of the Code. Further, Section 1031(a)(2) of the Code specifically provides that: (1)stock in trade or other property held primarily for sale; (2)stocks, bonds or notes; (3)other securities or evidence of indebtedness or interest; (4)interests in partnerships; (5)certificates of trust or beneficial interests; or (6)choses in action do not qualify as property available for a 1031 Exchange.

If a real estate investor uses the sales proceeds to acquire an interest in a “partnership” or a “security,” it will not be allowed to defer its gain under Section 1031 from the sale of the relinquished property.

In 2002, the Internal Revenue Service (the “IRS”) issued Revenue Procedure 2002-22 (the “RevProc”) that set forth how a TIC investment in commercial real estate can avoid being classified as an investment in a “partnership” under Section1031(a)(2) of the Code, and instead be considered an investment in real estate. The RevProc acknowledges that the central characteristic of a TIC structure is that each TIC Investor is deemed to own individually an undivided part of the entire parcel of property. However, in order for the IRS to rule that a tenancy in common is an investment in real estate as opposed to an investment in an interest in a partnership, the tenancy in common must satisfy a 15-part test.[19] These conditions are:[20] (1)actual tenancy in common ownership, as opposed to a partnership or limited liability company; (2)no more than 35 persons as co-owners;[21] (3)no treatment of the co-ownership as an entity; (4)the existence of a co-ownership agreement; (5)the right of co-owners to approve certain “major” decisions, such as hiring a manager, sale or leasing the property, and creation of blanket liens; (6)the right of co-owners to transfer, partition, and encumber their interests without the approval of any person; (7)sharing of proceeds and liability; (8)proportionate share of profits and losses; (9)proportionate share of debt; (10)the ability to issue options relative to purchasing a co-owner’s interest; (11)the activity of the co-owners must be limited to those customarily involving maintenance and repair of the property, and not any business activity of their own; (12)any management agreement or brokerage type agreements must contain certain restrictions of duration and other matters; (13)leasing agreements must be bona fide relative to tax considerations and must reflect the fair value; (14)lenders for the property cannot be affiliated with any cotenant, sponsor, manager or lessee of the property; and (15)payments to the TIC Sponsor are restricted to payments for fees and other interests.

If these 15 criteria are met, the IRS would likely issue a private letter ruling that the TIC investment is a property interest under the Code.

IV.Typical TIC Structures

A.Ownership and Documentation

TIC Sponsors structured the ownership of TIC investments to be compliant with the RevProc and to avoid or dilute many of the concerns that are inherent to investors and lenders in this form of property ownership. Any property acquisition arranged through a TIC Sponsor will typically include the following documentation: (1)organizational documents of each TIC Investor, incorporating liability protections and lender’s required separateness/bankruptcy-remote provisions (typically formed as a single member limited liability company, which is a disregarded entity for tax purposes and allows an investor to preserve 1031 Exchange tax treatment); (2)purchase and sale agreement (acquiring TIC interest in the property); private placement memoranda, subscription agreements and other securities related documentation; (3)TIC agreement (the “TIC Agreement”); (4)management agreement; (5)master lease, if applicable to the structure; and (6)assignment and assumption agreement (i.e., assuming the rights of any agreements that were previously entered including the TIC Agreement, any management agreement, master lease, among others).

B.TIC Agreement

The TIC Agreement is entered into or assumed by each TIC at the time of acquisition of each TIC Investor’s ownership in the property and is similar to a partnership agreement or an operating agreement in that the TIC Agreement controls the rights between the parties who have ownership in the property similar to the way the organizational documents control the operations of a legal entity. The TIC Agreement contains various restrictions and protections that are of particular importance to lenders who are providing financing secured by the property and to the TIC Investors who want to ensure compliance with the requirements set forth in the RevProc. Without such an agreement in place, state law will govern the rights between the parties and there is no way to ensure the protection of the 1031 Exchange tax treatment that motivates the majority of the TIC Investors to participate in this ownership structure. Without an agreement to the contrary, a TIC Investor has the following rights:[22] (1)to use and occupy the entire property without being subject to the exclusion of other TIC Investors, thereby making it extremely difficult, if not impossible, for the other owners and any third party (including a lender) to truly understand and appreciate the rights and obligations they have in relation to the property or collateral; (2)to seek contribution for a prorata share of the operating and maintenance expenses of the property, with a lien attaching to the interest held by a TIC Investor who fails to contribute; (3)to sell an interest in the property without any approval from or notice to the other TIC Investors, creating unnecessary risks associated with a new owner having interests that are not aligned with the other TIC Investors; and (4)to partition the property, which in theory would create individual rights of exclusive ownership and possession of a divided portion of the property (most properties cannot be physically partitioned, so this results in a forced sale through the courts and the division of the net sale proceeds).

In order to address these concerns and the requirements of the RevProc necessary to preserve the deferred tax treatment, a TIC Agreement is drafted to include the following provisions: (1)waiver of the right to partition, the exercise of which will constitute a default and trigger a right of first refusal for the non-defaulting TIC Investors to acquire the interest of the defaulted TIC Investor at fair market value; (2)appointment of a property manager or master lessee to control the operations of the property; (3)obligation for each TIC Investor to comply with the terms of any due-on-sale or other transfer restriction contained in the applicable loan documents prior to selling its interest in the property; (4)a right of first refusal in favor of the other TIC Investors if a TIC Investor is interested in selling its interest; (5)waiver of lien rights so long as any financing remains outstanding, or, at a minimum, the subordination of such lien rights to the rights of any lender; (6)appointment of a managing TIC Investor who will be responsible for making administrative decisions, interacting with third parties and acting as an agent for receipt of appropriate notices on behalf of the other owners (at least for non-material matters); (7)details pertaining to those decisions that require the unanimous consent of the TIC Investors pursuant to the RevProc (i.e., leasing, renewal or appointment of property manager, securing indebtedness secured by a lien, and sale of the property, among others); (8)provisions similar to those found in documentation that govern a separate legal entity including voting, allocation of profits and losses, capital calls, sale of the property, dissolution, or termination, among other rights; and (9)lender-specific requirements, including the grant of third-party beneficiary rights, the obligation to obtain lender’s consent for any modification or amendment to the TIC Agreement, separateness covenants, and the right to cure TIC Investor defaults, among other provisions. This is not intended to be an exhaustive list, but instead emphasizes the protections and mitigants that can be addressed in the TIC Agreement between the TIC Investors who participate in this ownership structure.