Examining the five common reasons why real estate owners (1031) exchange into tenant-in-common

The following article discusses some of the reasons why Tenant-in-Common (TIC) and Delaware Statutory Trust (DST) properties have been purchased by 1031 exchange investors over the past few years. In 2002, the IRS issued Revenue Procedure 2002-22 stating that a TIC investment would qualify as "like kind" replacement property for the purposes of a 1031 exchange. In 2004 the IRS issued Revenue Ruling 2004-86 stating that a Delaware Statutory Trust would work for a 1031 exchange as well. Since 2001, roughly $14 billion of investor equity has been invested in TIC and DST properties (Tic Talk Quarterly, 1st Quarter 2009). With a typical Loan to Value (LTV) (the loan amount divided by the purchase price) of approximately 50% that would equal roughly $28 billion of TIC and DST properties that have been purchased by 1031 exchange investors since 2001. With the slow down in the real estate market as a whole affecting the 1031 TIC/DST markets also, we continue to find investors who are in need of replacement property and who find the TIC/DST as a viable investment option. This continued interest is due in large to the following characteristics of TIC and DST properties: 1. Deferral of capital gains tax using IRS Section 1031 exchange. This has been the major catalyst for the increase in the amount of TIC and DST properties purchased by 1031 exchange investors. Upon the sale of investment property, many real estate owners find themselves in one of two situations: paying a very hefty tax bill to Uncle Sam or searching for "like kind" 1031 exchange replacement property. A challenge with successfully completing a 1031 exchange is the time deadlines. TIC and DST properties are prepackaged for investors to potentially meet their 45-day identification deadline and 180-day closing deadline. This prepackaged structure for the 1031 investor's narrow timeframe is the main reason why so many real estate owners have opted to purchase TIC and DST properties. 2. Potentially increased cash flow. Some real estate owners are surprised when they calculate what they are actually receiving on their equity in their rental property. The following illustration uses certain generic assumptions and is a hypothetical example that may be similar or dissimilar to your particular situation. A rough calculation to find out how your property is performing for you is to take your gross rental income and subtract all of your property expenses (don't forget to place a monetary value on your time spent managing the property) this equals your Net Operating Income (NOI). From here, divide your NOI by the current amount of equity in your property, this equals your cash on cash return. By exchanging into a portfolio of TIC and DST properties investors are potentially able to increase their net spendable cash on cash return. 3. Increased diversification. Often times, real estate owners will have a large amount of equity in a single property. This can potentially be disastrous to a real estate owner if the bulk of his net worth is tied up in one property. With TIC and DST properties that owner has the ability to sell his property, do a 1031 exchange, and invest in a portfolio of multiple properties diversified over geographic locations and asset classes thereby reducing his overall risk with multiple levels of diversification. Although diversification does not eliminate the risk of investment loss it is a valuable tool that investors can utilize. An example, which I will use for illustrative purposes, is one of my clients that sold a 40-unit apartment building and exchanged into a portfolio of mostly multifamily TIC and DST properties. He went from having approximately 40 tenants to having a pro rata share in three different properties, in three different states, and over 750 tenants. 4. Renewed depreciation schedule to potentially increase tax efficiency on rental income. Many real estate owners who have built a substantial amount of equity in their property have owned them for longer than 27 1/2 years in the case of residential property and longer than 39 years for commercial. As a result they may no longer have any depreciation write offs to offset their rental income from tax. By exchanging into TIC and DST properties they are potentially able to purchase more property through the use of leverage (which again is using a mortgage to purchase property which does increase the amount of risk for an investor) thereby creating a new depreciation schedule to offset the rental income and increase their tax efficiency. In the case of real estate owners selling raw or unimproved land, which does not allow for any depreciation deductions, this added benefit could be a very nice additional tax advantage. Utilizing depreciation to potentially offset rental income thereby increasing tax efficiency is a complex tax concept and an investor should always check with a CPA regarding their particular situation. 5. Passive ownership. With TIC and DST properties you will not have the wonderful experience of the "3 T's of real estate ownership" which are Tenants, Toilets, and Trash. As a DST investor myself, my typical duties are to receive via direct deposit in my checking account my rental income along with reading the quarterly report that is sent to me showing how my property performed over the past quarter. This article has given an overview of five common reasons why real estate investors have purchased TIC and DST properties. If you would like to discuss these reasons more in depth please feel free to call for an appointment. Dwight Kay is a licensed registered representative with JRW Investments, Inc., Pasadena, Ca.