01/09/2014 11:34 am ET Updated Dec 06, 2017

Workout Strategies for Distressed TIC-Owned Properties -- The Section 721 Roll-Up

Dealing with a distressed real estate investment is always difficult. The difficulty is compounded with tenant-in-common ("TIC") projects, where ownership is often divided among as many as 35 different investors.

Many mortgage loans secured on TIC projects during the real estate boom in the early and mid-2000s have now matured or are near the end of their terms. Few commercial lenders or other investors are willing to consider refinancing TIC projects, even on properties that have significant equity. On projects where the market has sufficiently recovered, owners can sell the property and use the proceeds to pay mortgage debt and any taxable gains that are due. But for owners still seeking to wait out the market, a better strategy may be to refinance existing mortgage debt after restructuring their TIC investments through what is known as a section 721 roll-up.

Nature of a TIC Structure

TIC investments became popular in the early 2000s, after the IRS issued Revenue Procedure 2002-22. Revenue Procedure 2002-22 set forth the requirements for treatment of TIC investments as real property interests eligible for section 1031 exchanges. This allowed investors to sell commercial real estate or other business investments in exchange for a "fractional," TIC interest in replacement real estate. Section 1031 exchanges enabled owners who otherwise would have faced significant tax bills to defer capital gain until sale or disposition of their new TIC investments.

During the early and mid-2000s, sponsors marketed TIC investments for commercial real estate across the United States, including retail, office, and multi-family properties. TIC investments were often highly leveraged and thinly underwritten, and the tightening of commercial credit markets has hit TIC projects particularly hard. For TIC deals, both performing and non-performing, financing has all but disappeared, with few projects meeting current equity and other loan requirements.

Additionally, the very nature of a TIC investment can make it uniquely difficult to restructure or recapitalize. TIC projects face numerous challenges compared to unitary ownership structures:

Highly fractionalized ownership. Under Revenue Procedure 2002-22, properties with up to 35 co-owners are eligible for section 1031 exchanges. Typically, TIC owners acquired their investments through sponsors and brokers and had no prior business or other relationship with one another. TIC owners vary widely with regard to business and investment expertise. Some owners are in fact "accredited investors" with extensive commercial real estate experience. Others are senior citizens and passive investors who were rushed through the process by brokers and advisors only marginally familiar with the projects that they pitched. Because of their varying sophistication levels and the absence of any prior relationship between them, TIC investors often find it difficult to communicate and deal with one another and reach a consensus on how to proceed when faced with a loan default or maturity.

Unanimous approval required. Another requirement of Revenue Procedure 2002-22 for a TIC project to be eligible for a section 1031 exchange is that investors must unanimously agree to decisions regarding the sale, lease and financing of the property. This unanimity requirement can make it near impossible for TIC investors to arrive at a solution to avoid a loan default or foreclosure.

Limited ability to raise funds. TIC agreements typically include capital call provisions in the event money is needed for property expenses or debt service. Enforcement provisions, however, tend to be weak, and many TIC investors are senior citizens with limited financial resources and little or no ability to contribute additional capital if needed.

No point person. TIC investments generally are operated by property management companies rather than their owners. Real estate management companies on TIC investments range from professional and competent to marginal and self-dealing. And even real estate management companies competent in property operation and leasing often have little or no experience in refinancing or restructuring TIC transactions. In many cases, there is no simply no effective point person to guide a workout or restructuring on behalf of the TIC ownership group.

Lender and purchaser discrimination. Many lenders, purchasers, and investors shy away from dealing with TIC projects. The real estate recovery is still in progress, and the inventory of distressed real estate remains fairly deep in most markets. Given a choice, most potential investors will look for deals they can negotiate with a single, easily identifiable person as opposed to 35 co-owners located across the country.

721 Roll-Up Solutions for TIC Projects

The dysfunction inherent in TIC-owned projects means that their owners face a significantly increased risk of loss if any type of financial distress occurs. Even in markets well into the recovery phase, few lenders or equity investors are willing to consider TIC projects unless ownership is restructured into a single entity.

The problem for TIC investors is that transferring ownership to a partnership or other entity can constitute a disposition for tax purposes, which can trigger recognition of the gains they sought to defer when they completed their original section 1031 exchange. A strategy to avoid a disposition for tax purposes is to roll up TIC interests into a limited liability company ("LLC"), limited liability partnership ("LLP") or corporation through an exchange under section 721 of the Internal Revenue Code.

2014-01-09-DSC_0164.JPG"Section 721 roll-ups are complex and involved, but they are often the only workable option for TIC projects that need new capital," explains Jack Rose, Chief Strategist at Breakwater Equity Partners. "Equity and other requirements are too tight in today's credit market for most TIC projects to obtain financing unless they convert to an LLC or LLP."

A major advantage of section 721 roll-ups for TIC investors is the ability to preserve existing tax attributes and allow for continued deferral of gains from previous 1031 exchanges. "Tax considerations are key for most TIC investors," Rose notes. "This is especially true when the property value has not yet recovered enough to catch up to the tax liability deferred from the owners' prior investment."

To complete a 721 roll-up, look to a commercial real estate advisory, restructuring, and investment firm that uses a multidisciplinary approach to analyze and optimize your TIC investment. Through an experienced and careful approach to each unique TIC situation, you may avoid unanticipated taxable gain and create appropriate exit strategies that protect your tax deferral status in your new investment.

*Warning: This information is not intended to constitute legal, financial, or tax advice and should not be used in lieu of any professional's advice.