I turned to my friend Bob Stearns -- a font of good information on narrowly defined topics such as baseball or real estate -- and I asked him to fill me in on this phenomenon of tenants-in-common partnerships.
In simple terms, this financial tool allows someone to sell their real estate holdings and end, once and for all, the responsibilities and hassles of being a landlord.
Otherwise, what makes many people hang on to aging properties is the tax liability that comes with a typical sale. A 1031 exchange takes advantage of the tax code that allows those "vast holdings" to be turned into a comparable investment and defers what otherwise would have been owed in taxes.
A typical 1031 exchange is complicated and impractical for most people because of time constraints. The new property has to be located and closed on within a short time after selling the existing property.
Tenants-in-common partnerships create more timing flexibility and create an environment in which deals can fall into place. Essentially, they are partnerships of as many as 35 investors who buy a property as partners. They are actually on the title -- not just owners of limited partner shares, such as the rip-offs that plagued the early '80s.
Today, there are about 70 so-called "sponsors" -- companies that have chosen property, assembled investors, managed the property and recommended a sale at an opportune time. The concept has been around since the mid-1900s but caught fire in 2002, when the IRS finalized regulations controlling this financial instrument.
David Waal of Presidio Exchange Advisors in Walnut Creek has been in the industry since its beginnings and offered some advice in regard to the efficacy of the sponsors. He contends that there are only about 13 of the roughly 70 that do a credible job.
The partnerships can be structured in ways that favor the sponsors at the expense of the investors.
Other, more subtle differences in sponsor expertise can make a big difference over the life of the partnership. The building gets sold, eventually, based upon a unanimous vote of the partners.
So how does an experienced real estate investor wind his or her way through the labyrinth of choices in the TIC market?
Stearns makes it a point to start with the reputation and track record of the sponsors. A review of the product and the market is the next step. A building owned by a TIC can be an apartment, mall, office, industrial space or even a hotel. Stearns makes it a point to travel to the site and ask a lot of questions about the property, even if that means a trip to Boston, or North Carolina in his case.
Blessed with behavior that comes naturally to him, Stearns makes a nuisance of himself. However, there is no substitute for that level of due diligence in any investment research. (When once considering an investment in South San Francisco, Stearns asked the mail carrier what she thought about the neighborhood. The reply was that "a lot of packages came from Vacaville" -- a reference to the correctional facility, and the reason that he did not invest.)
An investment in a decent TIC can generate annual income in the 6 percent range, some of which is sheltered from taxes by depreciation.
Someone who has a $1 million single-family home rented out and nets about $20,000 per year after expenses could sell the house, but the tax on capital gains and recapture of past depreciation could bring the tax liability to $250,000. That leaves just $750,000 to generate income. A net after-tax return of 4 percent in bonds would generate only $30,000 per year of income.
By comparison, the entire $1 million can be preserved by rolling it into a TIC, and the 6 percent is largely sheltered by depreciation and its yield of $60,000. The higher gross rate of return (6 percent) is the "risk premium" that comes with having an asset that is largely nonliquid. You can't just dump it if you change your mind. Apart from the higher income, however, is the possibility of capital gains if the property appreciates.
Stearns is a cautious but effective softball player in the senior league today. Only rarely does he slide headfirst into second base, like former A's player Ricky Henderson. And unlike many investors who slide headfirst into bad deals at the first whiff of a tax shelter, Stearns is focused and circumspect when it comes to scoping out a deal that meets his needs.
He depends on experienced professionals such as Dave Waal to represent his interests when dealing with the sponsors. Good teamwork is the key to success both on the field and off.