TICs More Common Since '02 IRS Ruling

      A tenancy in common, a form of ownership not often seen until recently, is becoming more prevalent. The impetus behind this increased usage is Revenue Procedure 2002-22, which recognizes a TIC as providing each tenant in common with a direct interest in real property. Such recognition entitles a tenant in common to take advantage of the tax-deferment rights provided by Section 1031 of the Internal Revenue Code.

      Section 1031 allows a property owner to exchange investment property for like-kind assets without paying capital gains tax on the acquired property at the time of the exchange. Instead–in this 1031 Exchange–the tax payment is deferred. Juxtaposed with the benefits of a 1031 Exchange are certain entity requirements of CMBS lenders, namely, the need for single-purpose, single-asset bankruptcy remote entities (SPEs). As a result of Rev. Proc 2002-22, the TIC may now become the ownership vehicle of choice for borrowers of CMBS loans that are trying to complete a 1031 Exchange as part of the same transaction.

      As the TIC structure becomes more commonplace, a lender should be aware of the unique issues that it presents. A tenant in common can request a partition of the property and separate its share from that of the other tenants. While a mortgage remains in full force after the partition, a lender will be faced with managing and interacting with two or more properties and two or more borrowers. In addition, the property partitioned into smaller parcels may not generate the same revenue as the larger parcel and therefore the value of certain pieces might significantly decrease, adversely affecting the borrower’s ability to satisfy the debt service requirements of the loan.

      Even worse, a court might determine that a property partition is not tenable and order a sale of the asset. To prevent such a scenario, a lender will prohibit the tenants in common from exercising any partition rights. The waiver of the right to partition is irrevocable, at least until the loan is satisfied. The borrower’s lawyer will be required to deliver to the lender an opinion that the waiver is enforceable under applicable law. If the waiver is not possible, the lender may add a covenant stating that any attempt by a tenant in common to partition the property will be seen as a loan default, entitling the lender to its remedies, including acceleration of the loan.

      The lender might also require that the partitioning will be seen as an exception to the non-recourse nature of the loan. While such steps do not prohibit the exercise of any partition rights, it does provide disincentive to the borrower to exercise it.

      When making loans to tenants in common, a lender must be aware of the potential for serial bankruptcy filings by the TIC. These filings might result in the imposition of numerous bankruptcy stays, precluding the lender from taking any action to foreclose or restructure the loan. While the bankruptcy of any one of multiple investors is not unique to the TIC structure, the potential for serial filings is greater since each investor has a direct interest in the asset. To hedge against this, a lender, particularly a CMBS lender, will require that each TIC be structured as an SPE.

      It’s possible that this requirement may run afoul of the 1031 Exchange requirements that the purchaser of the replacement property be the same taxpayer as the seller of the relinquished property. However, a single-member limited-liability company structure will apparently satisfy both competing requirements. The SMLLC is organized to hold the interest in the TIC, with the entity or individual taxpayer seeking the tax deferment under the 1031 Exchange as the sole member of the SMLLC. This structure not only satisfies the CMBS lender’s requirement for an SPE entity but also allows the borrower to maintain its tax-deferred status under the 1031 Exchange, because the IRS does not treat the SMLLC as an entity separate from the sole member, preserving the tenant’s direct interest in the asset. One note of caution, however: CMBS lenders will require that the entity be formed under the laws of the State of Delaware.

      A TIC provides a number of tenants with equal interest in the property. That’s good news and bad news. As the number of investors, or tenants in common, expands with respect to any one project, the levels of experience in owning and operating commercial real estate and financial net worth varies, and the potential for disagreement over how to operate the project becomes greater. Although a lender will require liability for all of the borrower’s obligations under the loan for each tenant in common, a lender will also require a centralized management structure controlled by the party most experienced in managing properties of similar type and size. The borrower will be prohibited from amending or terminating this arrangement without the lender’s consent. This allows the lender to deal with only one party.

This article was written with the assistance of Chaviva Schoffman, an associate at Newark, NJ-based law firm of Sills Cummis Radin Tischman Epstein & Gross. Law firm partner Robert Hempstead has specialized in real estate finance, particularly CMBS, for the past 10 years.