1031 Exchange TIC: Your Key to Diversifying Your Real Estate Portfolio Passively!

What Is a 1031 Exchange?

Before we can look at a 1031 exchange TIC, it’s first worth doing a recap on what a “regular” 1031 exchange is.

The 1031 exchange is a particular provision in the IRS tax code that allows investors to exchange one like-kind property for another. If you execute a 1031 exchange, you can sell one property and buy another, all while deferring capital gains taxes (or a capital loss).

Executing a 1031 exchange is a little cumbersome, but in the world of the IRS, it’s still straightforward enough. Essentially, you’ll need to use a qualified intermediary to hold the proceeds of the sale and use that money to purchase the new investment. You must close on the new property within 180 days of selling the old one (and there are a few other essential deadlines to meet).

An Example

The best way to illustrate a 1031 exchange is to use a couple of examples.

Suppose Bob has an investment home worth $300,000 that he bought for $100,000. He hears about this excellent investment opportunity – a farm – outside of town, worth $500,000. Bob finds a qualified intermediary to hold the $300,000 from the sale. He then puts in an offer for the farm and gets a loan for $200k, plus the $300k from the intermediary to buy it.

Bob does not have to pay any capital gains taxes at the time of sale. However, the farm he purchased has a cost basis of $100,000 since that was the initial value of the first property used in the exchange. When Bob goes to sell the farm for $1 million 20 years from now, he’ll pay capital gains tax on $900,000 or he can repeat the lucrative 1031 exchange process to purchase another property.

Why Do a 1031 Exchange?

1031 exchanges are popular because they enable investors to defer paying taxes “indefinitely,” potentially. You can keep rolling over one investment into another without reducing your purchasing power by the capital gains tax at each step.

Practically, this means that you can usually increase your monthly real estate rent revenue faster.

Consider two investors, each buying three properties where the monthly rent equals 0.3% of the property value. The first investor doesn’t do 1031 exchanges. They buy a home for $100k, sell it at $300k, and take a 15% capital gains hit. Now, they can only purchase a property for $270k. They buy a home for $270k, which also appreciates 3x for a value of $810k. They take that $810k and buy a home for a final rental income of $2,430 a month.

The second investor does 1031 exchanges. They can buy the home for $100k, sell it at $300k, and then buy the next house with 3x appreciation to $900k. When the 1031 exchange investor buys the last place, their rental income would be $2,700.

This example is a toy one, of course, but it shows how deferring capital gains by 1031 exchanges can make accessing bigger, better deals much more feasible!

What Is a 1031 Exchange TIC?

Now that a 1031 exchange should feel more intuitive, we can come back to the original question of what a 1031 exchange TIC is and, perhaps more importantly, how it can diversify your portfolio.

“TIC” is an acronym for “tenancy in common.” Under this ownership structure, multiple people can own commercial real estate property. Each person holds a fractional share of it (for example, investor A might own 50%, and investor B might own the other 50%).

Like any other asset, shares in a TIC-owned property are always sellable. Investor A can sell their shares to Investor C, who can then sell their interest in the property to Investor D, and so forth.

A 1031 exchange TIC is when an investor exchanges one of their existing investments for ownership in a tenancy in common property. In 2002, the IRS defined the requirements necessary for one of these exchanges to take place.

Ruling 2002-22: Requirements for a 1031 Exchange TIC

There are six total requirements that any 1031 exchange TIC must meet:

· There must be no more than 35 co-owners.

· Unanimous approval is necessary for specific actions, like selling, refinancing, and leasing; the majority can approve other activities.

· Managers must receive compensation based on gross rental income, and owners must be able to make all the final decisions.

· Each co-owner must retain the right to borrow or transfer their share.

· Co-owners must share all income, expenses, etc., based on their titled ownership percentage.

· The sponsor or syndicator of a deal may receive reasonable compensation based on the FMV of the property.

If TIC investments meet these criteria, it’s eligible for a 1031 exchange! 

Investing Tax-Deferred Money in Real Estate Syndications

The eligibility criteria above meant that investors could (sometimes) invest tax-deferred money into real estate syndications. A subsequent ruling, 2004-86, recognized that sellers could exchange investment property for a beneficial interest in a specific type of trust, called a Delaware Statutory Trust (or DST, for short).

Some sponsors now organize this trust type, acquire a property under it, and become the manager. Then, prospective investors can do a 1031 exchange to own a share of the trust. The above ruling essentially meant that people could use a 1031 exchange to swap direct ownership of a property and ownership of an entity that owns a property.

Now, a TIC 1031 exchange is much less common. Instead, syndications create Delaware Statutory Trusts to hold onto the properties. Individual investors can then 1031 exchange in and out of these investments when they start and end.

This concept becomes remarkably powerful when you want to roll over funds from one TIC/DST to another. Instead of taking significant capital gains hit when the syndication sells the building, you can roll the proceeds over to the next investment, tax-deferred.