A Statement Of Cash Flows And Its Related Disclosure What Investors Should Know About TIC

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What Investors Should Know About TIC

Lauren is a dentist with $900K in cash to invest in commercial real estate. She has been looking for commercial properties in the Bay Area for the past 2 years. There are some commercial properties for sale in the Bay Area in the $1M – $3M range. And if there are, they are very old and in undesirable parts of the city with long maintenance and financially weak tenants. She wonders who would have the courage to invest in such a property. She cannot afford better and more expensive property. However, she saw several good and affordable shopping centers outside of California with brand name tenants and high incomes. With her busy work schedule and 2 young children, finding time to just look at these properties is a monumental task. Moreover, she does not know whether the area is a good place to invest. She has to find a reliable property manager and then make business decisions like who to rent out an empty lot thousands of miles away. She felt that it must be a good investment solution.

Sunny has been working as an engineer in the Bay Area for over 15 years. Over the years he has contributed to his company’s 401K plan and accumulated over $350K in his IRA rollover account. He noticed that the returns on his IRA funds were underperforming. As he grows older, he worries about the volatility of the stock market. His faith in public corporations was shaken by the recent scandals of backdating stock options and Enron. He now wants to use his IRA money to invest in tangible real estate where he has more comfort and control. He realizes that he can put this money into a self-directed IRA to invest in real estate. While he does more research, he can use the money in the self-directed IRA account as a down payment. But the IRS prohibits any personal guarantee for the loan – reducing its leverage. This personal guarantee is a major restriction as all residential lenders require it. Additionally, a self-directed IRA account without a Social Security number or federal tax ID is not a creditor-identified borrowing entity (A full-length article on how to use a self-directed IRA to invest in real estate will be featured in an upcoming issue.) A solution is

What is TIC?? While TIC simply stands for Tenancy in Common, the term TIC often refers to a type of property that multiple investors buy together. A real estate broker brings together a group of investors like Lorraine and Sunny to buy income-producing properties as an investment club. A real estate broker is called a TIC sponsor. The sponsor is keen to find the best property so he can promote it to investors like Lorraine and Sunny. These assets are often more expensive, e.g. $5M-$10M; Thus, most investors cannot buy individually. Lorraine and Sunny are happy to invest in good properties with strong returns. The TIC sponsor earns a commission and contingent fee from the sale in the form of 10% ownership of the property. So it’s a win-win situation for both TIC sponsors and investors. The TIC sponsor manages the assets, provides quarterly operating income and expense reports, and distributes income to investors.

Investors benefit: The concept of TIC is, “It is better to own a portion of a more valuable, stable, well-performing asset than to own 100% of an inferior asset”.

  • Lorraine is happy because she can invest in a good property with strong income and appreciation potential. The property is in the hands of the TIC sponsor; So, she can focus on her dental business and
  • Sunny is very happy as he owns less than 25% assets and thus, he does not need to provide any personal guarantee for the loan. He meets the IRS requirements and still gets the maximum benefit. A share of his operating income will be deposited into his self-directed IRA account.
  • As the loan amount is quite large to finance the property, e.g. $6-10M, and since the property has excellent features, the interest rate will be lower, e.g. 6% instead of 7%. As a result, investors will get good returns on their investments.

Operating Agreement: This is a document that contains the rules for operating an investment club that all investors must agree to. This will reduce potential disputes between investors. Some key rules may be:

  • Major decisions, viz. Selling the entire property will require unanimous approval among the LLC members.
  • All members own the property as tenants in common and hence the term TIC.
  • Each co-owner has the right of first refusal when other co-owners want to sell their share.

Title under TIC: TIC sponsors often form a limited liability company (LLC) to hold title to the property. An LLC will protect assets from potential liability exposure. For example, if one of the investors is sued, 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 can make some decisions, e.g. Signing new leases on behalf of all investors.

Loan for property: Property is generally a non-recourse loan in which the property is the sole collateral for the loan. In case of default, the borrower cannot go after the investors’ other assets. All investors who own more than 25% of the property are required to submit a loan application. So, Sunny needs to keep his ownership below 25% because his self-directed IRA owns the property.

income tax: All income can be reported on Schedule E by individual investors. For example, if Lorraine owns 25% of the property, she will receive an operating statement from the TIC sponsor with income and expense information. She will report 25% of income, 25% of expenses and 25% of depreciation on her Schedule E. For Sunny, all positive cash flow is deposited into his self-directed IRA account and he defers. some income.

1031 Exchange: An ownership interest may be a 1031 exchange property if the co-ownership is not classified as a partnership for tax purposes. Investors can thus receive a tax deferral on a similar exchange of their fractional ownership interest.

The Happy Ending: TIC sponsors suggest both Sunny and Lorraine to consider investing in a $7.9M, 2-year, 30,900 SF, 12-tenant and 100% NNN leased upscale shopping center with 2 other investors in a fast growing and affluent city. In the suburbs of Atlanta, GA. The property is located opposite a Walmart Supercenter; So, they both know it’s in a prime location. The property currently has $6M of non-recourse debt due 2016 at a below market rate of 5.6% interest. So while the cap rate is respectable at 7.25%, the cash on cash return is more than 10% because the interest rate is so low. After reviewing the property’s prospectus and financial information, they sign a subscription agreement to proceed with the investment.

Disclosure: To ensure compliance with the requirements imposed by IRS Circular 230, we hereby notify you that the US federal tax advice contained in this article is not intended to be used, nor was this article written for, and may not be used. Any taxpayer for the purpose of: (i) avoiding penalties under the Internal Revenue Code, or (ii) advertising, marketing, or recommending to another party any transaction or matter addressed herein. This article does not provide any tax advice for any particular transaction. If you require advice on any particular transaction, please consult a professional tax advisor.

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