I recommend purchasing midsize rentals. Buying them usually requires a little more money than investing in single-family homes. If additional capital is needed, consider forming a small group of active investors. |
There are various entities available to group or gather investors. Some of the more familiar ones are limited partnerships, corporations, general partnerships, and real estate investment trusts. A relatively unknown form of ownership to effectively gather active investors is the tenants-in-common (TIC) form of ownership. It’s an easy, low-cost method of funding real estate investments while maintaining tax benefits.
OWNERSHIP FEATURES THAT PROVIDE FLEXIBILITY
Tenants-in-common is a form of ownership that may involve two or more people, and it does not require a marital relationship. With a tenants-in-common ownership:
1. There can be two or more co-owners, but their ownership interests need not be equal. For example, if three people are co-owners, one could have a share of 25 percent, another 30 percent, and the third 45 percent.
2. There is no automatic right of survivorship. Unlike joint tenancy, a share in the property held by one owner does not automatically pass to the other owners at death. When a tenants-in-common
owner dies, that owner’s interest is transferred to his or her heirs and not to the other tenants-in-common, unless there’s an agreement giving title to the co-owners.
3. Interest held by tenants-in-common may be sold separately by individual owners. In many cases, when tenants-in-common first acquire the property, they agree to give the other co-owners a “first right of refusal” to buy out one another.
WAYS TO SAVE WITH A TENANTS-IN-COMMON OWNERSHIP
Here are seven advantages of the tenants-in-common ownership over other entities:
1. Low set-up costs: Compared to other forms of ownership, tenants-in-common has one of the lowest set-up costs. You don’t need an attorney to prepare offering circulars or registration with governmental agencies. In fact, all that is required is to have the names of the owners recorded when the transaction closes. A formal document is not necessary, though we would recommend one. Accounting fees for preparing partnership, trusts, and corporation returns are eliminated as well as state and federal income taxes.
2. Low down payment: In some public offerings, restrictions are imposed on the use of leverage. Using the tenants-in-common form of ownership, there are none. This is an important investment strategy in purchasing and selling midsize apartment complexes. The lower the down payment, the more leverage, and the more property you can control.
3. Active voice in management: An important investment goal is to reduce taxes. The tenants-in-common form of ownership does this by allowing an active voice in management. Tenants-in-common owners, with the help of qualified consultants, are extremely effective in making the right decisions. The old adage “two heads are better than one” hits the bull’s-eye, especially when these heads are concentrating on be-coming wealthy.
4. Ease of transferability: Unlike a certification of ownership in a partnership, the tenants-in-common ownership has a greater degree of transferability. Each owner’s name is on the deed and is recorded. An owner’s interest can be sold, hypothecated, willed, or transferred without the consent of the other co-owners, and each owner has complete control of his or her interest. In evaluating collateral, lenders generally give more credence to an interest in a recorded tenants-in-common interest than in a limited partnership.
5. Economy of scale: Because investment dollars are being accumulated by a group, there are more dollars available to purchase larger properties. Many individual investors don’t have the opportunity to use the economies of scale unless they form a group. How does this concept apply to apartment complexes? If one unit were vacant in a four-unit complex, what would the vacancy factor be? If you said 25 percent, you are correct. On the other hand, if one unit were vacant in a 40-unit complex, what would that vacancy factor be? Right, 2.5 percent.
Just think about it! When the carpet layer is called, to whom do you think the better square-foot price will be given, the owner of the 40-unit building or the four-unit building? The same applies to all vendors.
6. No mortgage or qualifying restrictions: Unlike most public limited partnerships, tenants-in-common ownership doesn’t have any restrictions for financing or investor qualifications. Financing can be structured to give the greatest flexibility to each individual owner either at the time of purchase or sale. The group is formed based on the needs and desires of its members not on standards imposed by governmental agencies. Individual owners don’t need a minimum or maximum net worth to invest. They’re not required to have someone attest to their capability of making their own investment decisions. Nor are they forced to have experts make these decisions for them.
7. Tax advantages: Using the tenants-in-common form of ownership, gives you the opportunity to become an active investor. As such, you can qualify for the $25,000 per year write-off against your salary, dividends, interest, and other income. This form of ownership provides the flexibility needed to implement the tax-saving strategies discussed earlier. Other forms of ownership satisfying only passive investor requirements do not have these capabilities.
8. Neither a real estate nor a securities license is required to form a private tenants-in-common group to invest in real estate. If you do not manage or control the group, it doesn’t have to be registered or qualified with any governmental
TAX IMPACT OF TENANTS-IN-COMMON OWNERSHIP
Deferred income on recognition of taxable gain when selling rental property (the Internal Revenue code section 1031) mandates that the tenant-in-common co-ownership must meet these four requirements:
1. To form a tenants-in-common group, each of the co-owners must hold interest as tenants-in-common. No one can previously have held interest in property in any other legal entity (for example partnership).
2. The allocation of income and expenses as well as liability for blanket and encumbrance shall be in accordance with the co-owners percentage interest and ownership interest.
3. All of the co-owners of the entity must have the right to vote on all issues of the ownership. An owner, sponsor, or manager may advance funds to cover payments due from another co-owner. This debt is recourse and must be paid within 31 days.
4. There is an exit requirement that each co-owner retains a right to transfer, petition, or encumber their ownership interest.
NEW GUIDELINES FOR TENANTS-IN-COMMON INTEREST
Procedure 2022-22 provides guidelines in the use of fractional interest in the replacement properties in the 1031 exchange. The key criteria are:
1. The number of tenants-in-common cannot exceed 35.
2. The sponsor of interest may own the property or an interest there for only 6 months before 100 percent of the interest can be sold.
3. Any decision has a material impact on the property owners must be approved unanimously by the owners.
4. The management agreement must be renewed annually and must provide for market rate compensation.
There are definite advantages to group ownership. Probably the most prevalent is economy of scale. The tenants-in-common form of ownership provides a simple, low-cost way for investors to form groups, while maintaining many tax benefits.
Depending on your preference, the tenants-in-common group can be formed as a security or a nonsecurity. If classified as a security, no public advertising is permitted unless it is registered as a public offering. Conducting nonsecurity transactions is relatively easy and inexpensive.
If a co-ownership group is being formed as a nonsecurity, don’t jeopardize your position by acting as a promoter or general partner. By doing so, you’ll be indemnifying its members against all losses.
ABOUT THE AUTHOR: Eugene E. Vollucci, is the Director of The Center for Real Estate Studies, a real estate research center He is author of four best selling books and many articles on rental income investing, apartment investing, real estate and taxation. To purchase any of our reports and to learn more about the Center for Real Estate Studies, please visit us at http://www.calstatecompanies.com
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