Leaving a String Quartet or Tenant-in-Common Real Estate Investment
The Cleveland Quartet, founded in 1968, was among the top string quartets in the world until it disbanded in 1995.
Originally in residence at Cleveland Institute of Music, the four musicians moved together as a quartet to State University of University of New York at Buffalo and then to Eastman School of Music. During the quartet’s history, some musicians left the quartet and were replaced.
But in 1995, the quartet decided to disband. Years of international travel had taken their toll, and the musicians wanted to pursue other interests, including teaching and orchestral work.
The Cleveland Quartet musicians had the luxury of selecting the time when they wanted to disband. They also likely didn’t have to think about tax consequences when they disbanded.
However, for individuals who jointly invest in real estate, the situation is different. Mortgage maturity dates dictate when investors must decide whether to remain in or leave the investment. And, any decision can have significant tax consequences for the owners.
Tenant-in-Common Real Estate Ownership
Tenant-in-common (TIC) real estate investments can be compared to string quartets. TICs exist when multiple parties own real estate jointly and do not have a partnership, limited liability company, or corporation. Fundamental characteristics of TIC ownership include:
Each owner has an undivided fractional interest in the real estate, meaning that they have equal rights to access and use the real estate.
The property can’t be sold without everyone agreeing.
Individual owners can convey their TIC interest.
When one owner dies, that owner’s interest goes into the owner’s estate, rather than to the other owners via right of survivorship.
During the 2000’s, many real estate investors diversified their Section 1031 exchange funds by investing in TICs. The majority of those were financed using CMBS loans, which had an eight- to ten-year term followed by a balloon payment. As those loans reached maturity in the 2010’s, TIC investors have had to decide whether to refinance or sell their properties, sometimes within tight time frames dictated by their existing mortgage loan documents and faced serious tax consequences if they could not agree.
Although most loans from those 2000-era TICs have long since matured, TICs existed before the 2000’s and continue to be created and to exist today. Brothers and sisters who jointly inherit a parcel of land from their parents likely hold the real estate as tenants-in-common. Friends or business partners who jointly buy real estate may also own the real estate in a TIC. And some real estate securities sponsors continue to offer TIC securities for Section 1031 exchange.
No matter how the TIC was formed, the owners share common tax concerns. For Section 1031-qualified TICs, unanimous consent for major decisions, such as sale or refinance of the real estate, is mandatory. From a practical matter, TICs generally will require unanimous consent, since each TIC owner will need to sign the deed or mortgage conveying or placing a mortgage lien on the property.
As a result, TIC investors whose mortgage loans come due face stresses and challenges not experienced by other real estate investors.
Most mortgage lenders, noting the cumbersome decision-making process, will no longer finance real estate owned by a TIC, making it even more difficult to refinance the property. Therefore, TIC owners desiring to refinance will likely need to change their ownership structure.
Sale of TIC-held real estate provides unique challenges to both the title company and attorney representing the TIC owners because of the number of individuals who must provide documentation and sign closing documents.
Different TIC owners may have different tax situations, financial needs, and investment goals.
Decision-making can be challenging if the TIC owners disagree on the best course of action.
TIC real estate investments created by real estate securities sponsors may face additional challenges, since the TIC owners have no connection with each other except through the TIC investment:
The TIC sponsors and broker-dealers who sold the TIC investments may not be in business, so they can’t help coordinate the process.
The TIC sponsor may not be able or willing to continue to shepherd the TIC group after a refinance, particularly where the TIC group is unable or unwilling to compensate the sponsor for its continued involvement.
Many TIC investors have a low (or zero) tax basis in their TIC investments, making it critical that they have an experienced and creative TIC attorney work with them to minimize adverse tax consequences.
Despite these practical challenges, unless the TIC owners have sufficient funds to make a balloon payment upon mortgage maturity, the options for TIC owners are the same as for any real estate investor: refinance, sell, or do a 1031 exchange.
Each option has potential tax consequences for the TIC owners. Often, TIC owners are facing capital gain taxes because the real estate will have increased in value. Plus, if the TIC owners have taken depreciation deductions during their ownership, the owners also may face tax on recaptured depreciation.
Option 1: Refinance and Retain
String quartets affiliated with an educational institution which no longer supports their needs can remain together and move together to a new institution, as the Cleveland Quartet did twice. TIC investors who retain their investment and refinance it may have options that let them defer capital gains or recaptured depreciation:
Delaware Statutory Trust ownership structure or similar structure under another similar state law, such as that in Maryland (DST). The DST must comply with IRS requirements for a fixed investment trust holding real estate. Investors moving into this structure should not experience tax liability when they move into the DST, and they should be able to defer capital gains tax when the DST sells the property. However, due to IRS requirements, this structure needs someone not affiliated with the owners to act as DST manager and frequently needs a master tenant. That can be impractical when the TIC structure wasn’t formally put together by a real estate securities sponsor.
Limited Liability Company (LLC) ownership structure. LLC ownership will be accepted by mortgage lenders. TIC investors moving to an LLC shouldn’t experience capital gains tax liability at the time of the refinance (assuming they do not take cash out). However, since LLCs usually are taxed as partnerships, the owners probably will owe capital gains taxes when they sell the property and dissolve the partnership.
Option 2: Sell (or Exchange)
When the Cleveland Quartet disbanded, its members went on to different musical careers;, one as Concertmaster of the Cleveland Orchestra, another as Director of Chamber Music at a music conservatory, and another as a college professor.
TIC investors who sell real estate frequently have to pay taxes on their gain and recaptured depreciation. But TIC Investors who sell the property also may have options that let them defer those taxes while moving on independently to a different real estate investment:
UPREIT. TIC investors selling their property to a REIT might be able to defer taxes via a mechanism called an UPREIT, whereby the TIC investors transfer the property to the REIT in exchange for REIT units. However, those investors’ property will incur capital gains tax liability upon sale of their REIT units.
Section 1031 Exchange out of their TIC property into a new real estate investment.
Which Option is Best?
Different Cleveland Quartet members had different career options after the quartet disbanded. And not all of these options will be available to every TIC investor or group facing mortgage loan maturity.
The quartet members likely had different career goals as they left the quartet. Likewise, individual TIC investors and the TIC groups, themselves, vary in their liquidity needs, tax concerns, and risk tolerance. By seeking counsel from a creative attorney experienced with TICs, a TIC group evaluate which of these and other options best meet the needs and temperament of the members of the particular TIC group and the individual TIC investors in the group.
© 2016, 2019 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality
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