Tenant-in-common (TIC) 1031 exchanges, private placement deals heavily hyped to financial advisors during the real estate boom, are drawing action by state and federal regulators.

These deals have been promoted as a turnkey way for an investor to defer taxes on the sale of an investment property via a "1031 exchange." Typically arranged through a sponsor, "TICs" let investors purchase fractional interests in a property-often office or retail buildings, taking advantage of this tax-friendly IRS rule.

Under Internal Revenue Code Section 1031, an investor can defer a taxable gain on the sale of a business or investment property by exchanging it for another of "like-kind."

"There have been troubling allegations of fraud in connection with the activities of the promoters of those tenancies in common offerings," says Denise Voigt Crawford, president of the North American Securities Administrators Association and Texas securities commissioner. "It's very important for investment advisors to make sure there is full disclosure about any such offerings and that investors realize these types of investments are highly illiquid. This means the investor has to be able to assume the risk of that investment for an indefinite period of time.

"If an investment advisor does not have the kind of background necessary to make good recommendations as a fiduciary, the investment advisor needs to seek out expertise."

Fueling regulatory concern: allegations of fraud, FINRA arbitration complaints and consumer lawsuits. In addition, there have been bankruptcy filings involving at least two multi-million-dollar national TIC sponsors-retirement home operator Sunwest Management Inc., of Salem, Ore., and DBSI Inc., of Boise, Idaho.

The Oregon Department of Consumer and Business Services on January 25 issued a cease-and-desist order against Sunwest owner Jon M. Harder of Salem for numerous securities violations. The state claims Harder misstated information or omitted facts when soliciting investors and violated Oregon securities laws by not registering the securities or investments and using unlicensed salespeople. The Securities and Exchange Commission also charged Sunwest Management with securities fraud and sought an emergency court order to freeze its assets. The SEC case was pending in U.S. District Court in Eugene, Ore.

Harder's Portland, Ore.-based attorney, Stephen F. English, says that although Harder can no longer have an ownership interest in a company that raises money from investors, he still can be in the senior living facilities business. And in the SEC case, his client is not admitting intentional fraud. But he has agreed not to oppose a claim that he was reckless in his representations to prospective investors concerning one of its senior living facilities. 

Court action was pending against DBSI Inc.

Marilyn Chastain, bureau chief of the Idaho securities bureau, says her state district court case in Boise was pending action on DBSI Inc.'s Chapter 11 bankruptcy case in Wilmington, Del. Her department had alleged that defendants associated with DBSI Inc. misrepresented that their real estate investments were essentially guaranteed; misrepresented terms of the loans on the property; failed to inform investors that their investments were widely considered to be a security-not a real estate transaction; and failed to inform investors that the investment required ongoing new sales and could collapse if sales ceased.

DBSI denied the charges and said it would vigorously defend against them.

Most commonly, Chastain says, TIC interests are sold as part of the (Securities Act of 1933) Regulation D private placement offerings. "We don't have a problem with them selling them this way," she says. "The company we named [DBSI] was not selling it through securities channels, but purely as real estate transactions. The people were buying not only a TIC interest in the property, but they also were hiring DBSI or one of their affiliates to manage the property. Investors didn't really have any management responsibility."

Meanwhile, with the nation's real estate collapse, interest in tenant-in-common 1031 exchanges has waned, and some sponsors have closed or consolidated. Tenant-in-common deals peaked in 2006, when $3.659 billion in equity was raised, according to OMNI Real Estate Services, Salt Lake City. As of January 22, available equity in these deals stood at just $174.7 million.

"For a 1031 exchange to make sense, you have to have land selling and [capital] gains deferred," says Renee Brown, president of the board of directors of the 700-member Indianapolis-based Real Estate Investment Securities Association (REISA). "Properties no longer sold. It was a figment of pricing and a credit market freeze-up."

REISA, formerly the "Tenant-in-Common Association," expects to double its membership of 700 by year-end, according to Brown. That's because real estate funds, limited liability companies and publicly registered non-traded REITs are picking up steam in an undervalued real estate market.

When tenant-in-common 1031 exchanges peaked, the rallying cry was, "Swap 'til you drop," chuckles Andrew Rosenberg, a Coral Springs, Fla., attorney and CFP. Rosenberg, who still handles TIC deals, notes this referred to the fact that investors could swap investment properties until they dropped dead. When a property owner died, IRS rules stepped up the "basis," or original value of the property plus any improvements, to the market value on the date of the owner's death. Unfortunately, that "step-up" basis rule died for the 2010 tax year.

Assume a property, purchased ten years earlier for $2 million, had no improvements and was valued, upon an owner's death, at $5 million.

In 2009, heirs would owe no capital gains tax if they sold it the day after the owner's death.

In 2010, under the same scenario, a non-spousal heir would have $1.7 million in taxable capital gains. That's because that same property would owe capital gains tax based on the dead property owner's original $2 million purchase price, plus another $1.3 million. A spouse could add $4.3 million to the original purchase price.

You add those amounts to the deceased's original purchase price, and subtract them from the $5 million value upon the property's sale to get the taxable capital gain.

"Eventually it's going to all get repealed and changed," Rosenberg says. "Who knows what's going to happen?" In light of today's tax uncertainty and low real estate values, accepting a 15% capital gains tax now may not be such a bad deal.

Some important lessons were learned in an era of plunging real estate values.

Rosenberg says he always told clients that they had the option to cash out and pay taxes, but a lot didn't want to pay taxes under any circumstances. "You can only do so much," he says. "It's their money as to how they want to invest it. I'm just happy I tried to diversify holdings for clients. Typically I didn't put a client into one particular property. I put them into several properties."
Rosenberg says the real estate collapse caused TICs, along with most real estate, to incur losses when buildings were sold, and there are cash flow problems as building tenants fail to renew leases.

With the unforeseen national credit downturn, though, there is one thing for which Rosenberg is grateful. He specifically sought properties that had financing with fixed rates for terms as long as possible.

So despite a national credit freeze that prevented several investment companies from refinancing properties, "Thank goodness!" he says. "We haven't had any financing issues."

Darryl Steinhause, a partner with the law firm Luce Forward, San Diego, believes tenant-in-common private placement deals could stage a comeback when the real estate market rebounds. Steinhause created the TIC legal structure. His law firm is behind a January 14, 2009, no-action letter from the SEC that he says concludes tenant-in-common 1031 exchange deals are securities.
Real estate brokers have been trying to obtain an exemption, so that they can sell tenant-in-common interests as if they were real estate, he notes. Despite several proposals, the SEC had not issued a response as of this writing.

"There's nothing wrong with the tenant-in-common structure per se," Steinhause maintains. "It helps many individuals roll over built-in gains."

The problems arise if you don't have good management or the economics to back up leases.