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Bitten by a 1031 TIC?
If you own real estate as a Tenant in Common with a group of strangers; you got there with the help of a stock broker; and you are now watching the property suffer financial difficulties ... you are not alone. Read on.

If you own real estate as a tenant in common (TIC) with a group of strangers; you got there with the help of a stock broker; and you are now watching the property suffer financial difficulties ... you are not alone. Read on.

The Internal Revenue Service allows real estate investors to defer federal capital gains taxes when the equity from the sale of one commercial property is exchanged into a new commercial property. These exchanges under Section 1031 of the Internal Revenue Code have been around since the 1920’s. They make good sense to many people who hold real estate that has appreciated in value. 

In a traditional Sec. 1031 exchange, the investor would deal with a real estate broker, who would locate a buyer for the property held and also arrange for a new property; frequently taking a standard real estate commission on each transaction. Most often, it was a one property for one property exchange.

In 2002, the IRS issued a new interpretation under this section, allowing sellers of appreciated properties to join with others as tenants in common in a larger property.

Within 3 years of this IRS ruling, an industry of real estate and securities “professionals” grew to sell billions of dollars of tenants in common interests to real estate investors nationwide. Real estate firms that didn’t exist at the beginning of 2000 became the largest sponsors of real estate projects for TIC investors.

The sponsors were in largely the driver’s seat, buying the properties (and collecting a commission) and reselling it to the group of investors (and collecting a commission), and frequently managing the property thereafter, collecting fees for this as well.

The sponsors also managed the investment, i.e., they arranged for the financing, arranged for the lawyers and CPA’s, arranged for the preparation of the offering memorandum and the marketing materials, collected and paid out the investors’ funds and communicated with everyone on an ongoing basis. Naturally they took fees for this also.

The TIC structure was considered to be a plus for the investors, many of whom had previously managed their own properties. In addition to the tax deferral, investors were promised the benefits of owning commercial property (including continued appreciation), and monthly cash flow without any management responsibilities.

Most projects promised monthly or quarterly disbursements. In addition to the debt service, operating costs, and management fees, and whatever else it cost to operate the property, investors were promised a cash yield on their investment.

Professional management, continual cash flow, tax deferral and future appreciation; for real estate investors who had previously dealt with tenants and tradesman, it was too good to be true. And it was.

The first sign of trouble is usually a notice from the sponsor that your distribution will be cut or will stop completely. The reasons are always external…a bad real estate market; lots or empty space in the neighborhood; trouble with tenants; increased costs; repairs. Most importantly, the sponsor will tell you that the problem was unforeseen. They couldn’t have known about it before they sold the property to you.

By 2004, most of the TIC investments that were sold were sold by stockbrokers, rather than real estate brokers. An interest in real estate, held as a tenant in common with others, is considered by regulators to be a security, and can only be sold by licensed securities brokers, acting through registered brokerage firms.

It was the job of the brokerage firms to sift through the many sponsors and projects and recommended a suitable investment for each customer who wanted and needed a Section 1031 exchange.

In 2005, the FINRA, the regulatory body that oversees stockbrokers, issued a notice which said that it was not appropriate for the brokerage firms to recommend a TIC transaction simply relying upon representations made by the sponsor in an offering document. Every brokerage firm was required to make a reasonable investigation to ensure that the offering document does not contain false or misleading information. The investigation to include, at a minimum, background checks on the sponsor’s principals, a review of agreements and an inspection of the property.

So, if the broker who sold the TIC to you was required to conduct an investigation beforehand the question of whether or not the problems infecting your TIC were actually unforeseen, is right out there.

Here is what we see:

Bad people

The number one reason that a TIC real estate project will fail is that the people behind the deal are just no good. It would be bad enough if they were just bad real estate people; if they didn’t know how to structure a transaction or manage the property. But I’m talking about bad people; people who are out to screw the investors.

In one case the sponsor had a prior conviction for fraud. He had pled guilty to running a ponzi scheme - using investors money, not profits, to make distributions. He served time in jail. He got out, went to work at a mortgage company, and ten years later struck out on his own, seeking investors money for as many as 25 real estate projects. His prior conviction was never disclosed.

Recently it has come to light that he has been up to his old tricks, skimming operating revenues and paying himself fat consulting fees. A fair amount of investors’ money has not been accounted for, and investigators are calling his real estate company a ponzi scheme, because investors got paid a “return” even though the projects lost money.

Another sponsor, while head of a prior company had been sued by an investor and was accused of failing to make mortgage, tax and maintenance payments. His response: close the door on that company and set up a new, squeaky clean one. The recent problem: he used investors money to make tenant improvements, even though the offering materials clearly stated that this was the sponsor’s responsibility.

A third sponsor touted that he had been involved in $80 million of successful projects at a former company. He failed to disclose that $60 million of investors’ money had been lost, and that a class action alleging fraud had been settled for a substantial amount.

All of this prior litigation was a matter of public record. There is no excuse for the brokers not discovering it, and directing their clients’ money elsewhere.

Bad projects

The sales literature always makes a property look good, that’s why they call it sales literature. But the due diligence investigation is supposed to separate the true facts from the fluff.

One project was touted as being 80% rented to a AAA tenant; all that was needed was lease up the rest. Unfortunately, the downtown area of the city where this building was located had a high vacancy rate for a long time, a fact that the brokers failed to identify or disclose. Two years later, 20% of the building is still empty, and the cash flow the investors were promised is not going to happen.

Another sponsor likes to buy and resell apartment buildings near large universities that are suitable for student housing. Investors in one building were told that it had a 95% rental rate going back a number of years. They weren’t told that a new apartment building and a new dormitory were already under construction when this building was being offered to them. Result two years later: 70% occupancy and a reduction of rents across the board as the market attempts to absorb 1300 new beds at a time when university enrollment has been stagnant. Long term outlook: the university is planning 3 more dormitories; a plan announced 4 years before this apartment building was sold to the investors.

Bad structure

Sometimes you can make a bad deal out of a good building. In order to entice investors, some sponsors will resort to a guaranteed return or will make distributions in excess of actual profits. In the best case, this depletes reserves. In the worst case, it can cause deferred maintenance and leave a long term encumbrance on the project.

In one case, the sponsor was loaning these distributions to the project, at 14% interest, without disclosing the loan, or the interest, nor highlighting the fact that the project was low on cash reserves.

In another case, the sponsor took his fees out up front, not just the fees he disclosed, but an additional $4,000,000 in profits, by selling the building for that much more than he had paid for it, less than 90 days earlier. What is remarkable is that the building’s appraisal did not include that $4,000,000. So ask your self, why would a broker recommend that his customers invest in a building that was being sold for $4,000,000 over the appraised value?

The punch line in each of these cases is that the brokerage firms who sold these TIC’s to investors held themselves out as experts in 1031 exchanges. They were supposed to know real estate. The truth is they didn’t; and in most cases never actually conducted any type of investigation or due diligence examination, at all. The brokers failed to do their job, and the investors took the losses.

The bottom line is that there really is no excuse for a broker to recommend a TIC transaction to a customer where the sponsor is a crook, where the vacancy rate in the neighborhood has been historically high, or where competing projects are already under construction, especially if these facts are not disclosed in the offering memorandum.

We are currently bringing claims on behalf of investors against the brokerage firms that sold these projects, and others, where material facts were not disclosed, and where the project did not turn out as represented.

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