On June 21, 1893, at the World’s Columbian Exposition in Chicago, more than 2,000 people gathered for the opening of the world’s largest Ferris Wheel. After George Washington Gale Ferris, Jr., designer of the wheel, and other dignitaries gave speeches, and the fifty-piece Iowa State Band played patriotic tunes, the wheel was started for the first time, belying the background story.

The Chicago Herald,[1] however, described a humorous back story that was less well-planned. It seems that someone had decided that the Iowa State Band should perform while riding to the top of the Ferris Wheel. Some of the band members refused to get onto the wheel, so they performed from the ground. Of the musicians who did ride the wheel many stopped playing as the wheel carried them high in the air. Perhaps they stopped because they found it difficult to perform while moving. But, some of the band members may have suffered from acrophobia.

Regardless of the reason, it would be very difficult for musicians to stay together with some on the ground and others in the air. Adding playing while moving slowly upward must have done nothing to improve the ensemble. And with performers dropping out as the wheel climbed into the sky, the performance likely was disastrous.

The bottom line is that the band’s performance was not well-planned, and obvious flaws were ignored. Fortunately, the band was able to recover sufficiently to give a laudable performance after the musicians were safely at the top of the wheel.

Tenant-in-Common Exit Strategy Challenges

During the 2000’s, many real estate investors diversified their Section 1031 exchange funds by investing in tenant-in-common real estate securities. In recent years, some tenant-in-common (TIC) real estate investors have found themselves caught in a similarly ill-planned situation.

Since the majority of TIC investments were financed using CMBS[2] loans. These loans frequently had an eight- to ten-year term followed by a balloon payment. As those loans have reached maturity, TIC investors have had to decide whether to refinance or sell their properties.

Due to IRS requirements, TIC investors face unique challenges as their mortgage loans mature. First, all of the TIC investors must agree on a decision to refinance or to sell a TIC property. It is an understatement to say that it is difficult to find an exit strategy that works for up to 35 unrelated individuals with differing financial situations.

Just bringing TIC investors together to discuss an exit strategy can be challenging. Many TIC investments were sold through the broker-dealers to investors who do not know each other. Broker-dealers were paid for selling securities and have no financial incentive to try to herd a TIC group years later. And with the passage of time, the broker-dealers and securities sponsors may no longer be in business.

Even where the sponsor continues to be available, they 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 beyond the originally anticipated hold period.

If the TIC investors can get together, they may have different long-term goals, tax situations, and liquidity needs. Also, because most TIC investors have a low tax basis in their TIC investments, the TIC group needs the guidance of an experienced TIC attorney to help meet competing goals and needs and minimize the adverse tax consequences of their decision.

External Challenges

Mortgage document requirements can make both refinance and sale of TIC properties challenging. Many CMBS loans require defeasance (i.e. purchase of real estate securities to replace the cash flow from the mortgage) if a loan is prepaid more than a few months before maturity. This makes timing tight for both refinance and sale for TIC groups.

Changes in mortgage lender requirements in the 2010’s add an additional obstacle. Concerned about the cumbersome decision-making process required by the IRS, most mortgage lenders will no longer finance real estate owned by a large TIC group. As a result, TIC groups desiring to refinance may need to change their ownership structure.

Sales of TIC-held real estate provide unique challenges. The sheer volume of paperwork required from up to 35 investors can overwhelm all but the most experienced title companies and attorneys.

Refinancing a TIC Property

Nevertheless, TIC investors who decide to retain and refinance their TIC investments may be able to continue to defer their capital gains taxes. To do so, they usually will need to change their ownership structure into one of the following:

• Delaware Statutory Trust (DST). Many mortgage lenders will loan money to a DST and a properly structured DST will meet IRS requirements for a fixed investment trust holding real estate so that the investors should continue to experience deferral of capital gains tax. Investors moving into this structure should not experience tax liability by reason of moving into the DST. They also should be able to defer capital gains tax upon sale of the property by the DST. However, due to very strict IRS requirements, this structure will require a sponsor who is willing and able to serve as DST manager and usually also as master tenant.
• Limited Liability Company (LLC). All mortgage lenders will loan money to a LLC, provided it meets certain requirements. TIC investors moving to an LLC should not experience capital gains tax liability at the time of the refinance. However, they probably will incur capital gains tax liability upon selling the property.

Selling a TIC Property

TIC Investors who decide to sell the property also may have options that can enable them to continue to defer their capital gains.

• Section 1031 Exchange Individual TIC investors can do a Section 1031 exchange into other real estate. But finding a properly-sized replacement property can be a challenge.
•  UPREIT. TIC investors selling their property to a REIT might be able to defer taxes via an UPREIT. With an UPREIT the TIC investors transfer the property to the REIT in exchange for REIT units. There should not be any taxes due as a result of the transfer to the UPREIT. But the investors likely will incur capital gains tax liability upon sale of their REIT units.

Planning for the Ferris Wheel Ride

The Iowa State Band’s unfortunate Ferris Wheel ride experience could have been better with careful planning. Likewise, careful planning can make the difference between a smooth TIC exit strategy and a disastrous one.

Not all of the options discussed here will work for every TIC group. Individual TIC investors will vary in their liquidity needs, tax concerns, and risk tolerance.

However, planning ahead and with the help of an experienced TIC attorney, a TIC group can find the option which best meetings the needs of TIC group and the individual TIC investors, alike.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.