Fall 2009Star Trek fans understand the attraction of and the trouble with Tribbles. Co-owners in tenancies-in-common (TICs) are learning a similar lesson with TICs. While TICs are attractive ownership and investment structures for real property, the current economic climate has exposed fundamental areas of concern: The benefits of IRC Section 1031 exchanges also attract a broader range of co-owners, and their investment interests often focus on the tax benefits of the exchange, without sufficient consideration being given to the business aspects of the investment. Careful drafting of the investment documents and selection of the right product can address and minimize these concerns. This article discusses the issues of clarity of vision, decision making, and dispute resolution.
Managers and owners of businesses and owners of property understand the need for clarity of vision. Without clarity and unity, decisions about real property — its use and its development — are often delayed or forced, and inaction and political solutions impair value and limit the achievement of expected or maximum returns. This in turn fosters disputes. For example, does the vision include the further development of the property, additional investment of funds for tenant improvements, the requirement for refinancing, or the need for additional funds to refinance loans or carry the property for a time? Are all the investors prepared to make additional contributions? Or are the investors not in a position to contribute the additional funds needed by the TIC? The blending of spirited entrepreneurs with retirees focused on fixed-income asset preservation is not a good mix. The key is to identify the business objectives and needs of the TIC investment and accept only those co-owners who accept and are prepared to meet those criteria.
The requirement for unanimous decision making may work in very small, closely held entities, but it is always a red flag. TICs generally provide for management of the real property because co-owners' activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property, but the TIC criteria, i.e., Rev. Proc. 2002-22, requires that co-owners must participate in certain decisions. For example, co-owners must retain the right to approve leases, the hiring of any manager, the sale or disposition of the property, and the creation or modification of blanket liens. Approval must be unanimous. Other decisions require approval by more than 50 percent of the ownership interests. For 35 investors with varying levels of fractional ownership, these approval requirements may be difficult to achieve. As a result, qualifying a TIC for IRC Section 1031 exchange treatment means that the management structure requires cooperation among the co-owners, who may be geographically dispersed and have differing interests and financial capacity. To address these concerns, TIC owners may enter into limited scope co-ownership agreements that address a number of issues, such as transfer, partition, encumbering interests in the property, and voting, and that provide for rights of first refusal.
Disputes among TIC co-owners may quickly escalate into allegations of misrepresentation, breach of contract, breach of fiduciary duties, and failure to mitigate damages, resulting in refusal to cooperate in the economic operation of the property. From the entity perspective, the co-owner who refuses to take actions that are necessary to the continuing management and economic viability of the project is a critical concern. One recalcitrant co-owner can destroy a TIC. If the differing visions or financial capabilities preclude a solution, the concerns may be insurmountable. But even then, the last venue for resolution should be the courts and litigation. While the courts will provide final resolution, they are unlikely to provide the best economic solution. Some alternatives include drafting the documents to include restrictions that are consistent with what a customary lender requires, as noted above, and to limit contractually the right to contest or seek remedies or enforce individual rights against other co-owners without the consent of secured loan lenders. Mandatory mediation and the requirement to seek expert advice on the best investment solutions are suggested provisions.
TICs continue to be a favorable investment structure and are critical to preserving wealth through 1031 exchanges. But the trouble with TICs is that they are so inviting and favorable from a tax perspective that critical business criteria are often overlooked or minimized. Investors in TICs should carefully consider and evaluate the traditional business considerations and risks associated with the ownership of real property and seek a clear statement of the investment vision, management structure, and dispute resolution process. With TICs, litigation will rarely yield a financially acceptable solution, so look for a TIC that incorporates a process that in the event of disagreement promotes sound business decisions that are in line with your investment objectives and the risks involved.