Why Section 1031 Proceeds Can't Be Invested in a Real Estate Fund and How a TIC Can Be Used Instead
A violinist’s control over a musical performance depends on their role. A solo violinist performing an unaccompanied Bach Sonata or Partita must make every decision about bowings, tempo, phrasing, and interpretation. In contrast, an orchestra violinist contributes only one part to a vast collective. The violinist’s sound is inseparable from those of other violinists in the section, with the musical interpretation decided by the conductor and the bowings determined by the section leader.
A violinist in a string quartet lies between a soloist and an orchestra violinist. In a quartet, each violinist performs their own part and is completely responsible for how it sounds. They have significant control over bowings, tempo, phrasing, and interpretation, but these decisions also must be coordinated with others in the group.
Real estate ownership structures can be likened to the violinist's roles. Someone can be an active real estate investor who buys directly as a sole owner and have complete control over their investment. However, that comes with the responsibility of making all operational decisions, which can be challenging for someone who isn't a real estate expert. Also, it requires a significant amount of time to operate a successful property.
In contrast, a real estate investor can invest passively in a real estate fund, where they have little to no control over operations but also no responsibility for making operational decisions. With real estate funds, investors leave decision-making to experienced real estate professionals, whom they must trust to act in their best interest.
This article discusses these distinctions, how these structures are viewed under Section 1031 of the Internal Revenue Code (Code), and why Section 1031 investors can’t defer taxes when investing in a real estate fund. The article also discusses tenant-in-common (TIC) structures as an option for sponsors who want to accommodate Section 1031 investors.
What is Section 1031?
Section 1031 exchanges have been around since 1921. At first, a Section 1031 exchange required a literal swap of the two properties. For a direct swap, tax deferral makes sense because it’s often difficult to determine the “sale prices.” And, unlike a cash sale and reinvestment, a sale doesn’t result in a cash payout that an investor can use to pay taxes.
However, over the years, Section 1031 exchanges have evolved to become more flexible. Now, most people don't literally swap real estate. Instead, they sell one property and use the cash they receive to buy another property. For more than 30 years, there has been a safe harbor for real estate investors who use a “qualified intermediary” to hold the property sale proceeds until the investors buy a new property.
The Section 1031 safe harbor (which most investors use) requires compliance with a strict process and time deadlines. But there is no limit on the amount of gain that can be deferred. A key requirement is that the relinquished (sold) property and the replacement (purchased) property be “like-kind.”
For real estate, “like-kind” has been interpreted broadly. An investor can exchange farmland for an apartment building, raw land for a warehouse, or an office tower for a shopping center as long as the relinquished and replacement property are both held for investment or for use in a trade or business.
Interests in a Real Estate Fund Aren’t Real Estate Under Section 1031
While real estate funds own real estate, when an investor buys units in a real estate fund, they aren't buying real estate. Instead, they are purchasing an interest in a partnership or limited liability company (collectively referred to as LLCs), which holds title to the real estate. And LLC interests aren’t like-kind with real estate.
Using our violinist example, the soloist directly makes every decision about the musical performance and, in a sense, "owns" the musical decisions for the performance, like someone who directly owns real estate. In an orchestra, it’s the conductor who “owns” the musical decisions, much like an LLC that owns real estate. Like the orchestra violinist, a real estate investor’s ownership in the music is indirect.
While this article is focused on real estate funds, the passive nature of a real estate fund isn’t the reason why the LLC isn't considered real estate. Therefore, real estate investors can't avoid the problem with investing Section 1031 funds, even if they actively manage the partnership or LLC.
Another thing to consider is that investors always have the option not to do a Section 1031 exchange with some or all of the proceeds of a real estate sale. They will likely have to pay taxes on part or all of the proceeds.
However, as much as everyone hates paying taxes, sometimes, an investor’s tax or investment situation is such that it is in their interest to pay taxes on some or all of their sale proceeds. For example, they may be in a lower tax bracket than usual in a particular year or have experienced significant capital losses, making it an advantageous time to “harvest” some capital gains. Or a real estate fund might offer them geographic and asset diversification that they cannot obtain from a direct investment in real estate. Or their investment portfolio would be better served by reducing their real estate exposure.
TICs as an Alternative for Sponsors Who Want Section 1031 Investors
TICs can be an alternative for sponsors who want Section 1031 investors. With a TIC, multiple parties own interests in real estate but do not have a partnership, limited liability company, or corporation. In a TIC, each investor receives a deeded fractional interest in real property. Since each directly owns an interest in the real estate, a TIC qualifies as like-kind property.
Governance can be a challenge for TICs. The musical parallel is the string quartet. Each violinist plays an independent part and owns it outright, yet the piece cannot succeed unless the players agree on tempo and phrasing. They are independent, but they must function together.
Fundamental characteristics of TIC ownership include:
Each owner has an undivided fractional interest in the real estate, meaning they have equal rights to access and use the property.
The property can’t be sold without everyone agreeing.
Individual owners can convey their TIC interest.
When one owner dies, the owner's interest passes into the owner's estate, rather than to the other owners via a right of survivorship.
Drawbacks of TICs
TICs must be structured in a specific way to qualify for a Section 1031 exchange. Among the requirements are that 100% of the TIC investors must agree on key decisions, such as selling, financing, leasing, and hiring a property manager. Like a string quartet, each performer must agree on major decisions, such as tempo, or the performance will fall apart.
Because of these limitations, many mortgage lenders won’t loan money for real estate owned by a TIC or severely limit the number of TIC investors they allow (typically to no more than three).
When a real estate fund is involved, it will hold one of the TIC interests, leaving room for only one or two Section 1031 investors. Since it's complicated and increases costs to put together a TIC, it usually only makes sense to have TICs alongside a real estate fund when each TIC investor invests a large amount of money in the deal.
Some sponsors claim they offer Section 1031-qualified TICs but then have the TIC investors authorize the sponsor to make decisions on their behalf via an irrevocable power of attorney. However, a TIC that's structured like an orchestra, where musicians "delegate" decision-making authority to a single conductor, won't qualify for a Section 1031 exchange.
If TIC investors delegate their decision-making responsibility to the sponsor, the TIC doesn't qualify for a Section 1031 exchange. Investors who put Section 1031 money into a TIC that's structured to delegate major decisions to the sponsor risk having their Section 1031 exchange disallowed and having to pay not only taxes but also penalties and interest.
Sponsors should be aware that, although TIC interests qualify as real estate for tax purposes, they usually are considered securities under federal securities laws. Sponsors must therefore navigate securities law compliance, adding complexity and expense to the structure.
Conclusion
Section 1031 exchange proceeds must be invested in direct property ownership, not in a real estate fund structured as a partnership. Returning to the violinist analogy, Section 1031 exchanges can involve soloists and quartets, but not orchestras.
Although a TIC structure is a possible alternative, due to a combination of tax law and mortgage lender requirements, TICs are an alternative only under limited circumstances. Further, because TICs require careful structuring to comply with both tax and securities laws, a sponsor shouldn’t consider this structure without involving an attorney who is experienced in working with TICs.
© 2025 by Elizabeth A. Whitman
Any references to clients and their legal situations have been modified to protect client confidentiality.
DISCLAIMER: The content of this blog is for informational purposes only and does not provide legal advice to any person. No one should take any action regarding the information in this blog without first seeking the advice of an attorney. Neither reading this blog nor communication with Whitman Legal Solutions, LLC or Elizabeth A. Whitman creates an attorney-client relationship. No attorney-client relationship will exist with Whitman Legal Solutions, LLC or any attorney affiliated with it unless a written contract is signed by all parties.