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The Pros and Cons of Doing a Tenants in Common 1031 Exchange: What You Need to Know Before Choosing This Type of Ownership

This type of 1031 exchange can have big benefits for investors.

[Updated: Mar 03, 2021 ] Jun 20, 2020 by Tara Mastroeni
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Many real estate investors look into doing 1031 exchanges for tax purposes. However, few investors know that you can do them even if your name isn't the only one on the deed. With that in mind, below is an overview of a tenants in common 1031 exchange. We'll cover what this type of exchange is and how it works plus the advantages and disadvantages of entering into this type of partnership.

What is a tenants in common 1031 exchange?

Let's begin by exploring the terms "1031 exchange" and "tenants in common" individually. Then we'll look at how they work together.

What is a 1031 exchange?

Named for Section 1031 of the IRS tax code, a 1031 exchange allows an investor to avoid paying some or all of their capital gains tax on the sale of an investment property by reinvesting the proceeds from the sale into a similar, or "like-kind," property.

A savvy real estate investor could effectively use this investment strategy to grow their business by rolling one piece of real estate into another on a tax-deferred basis, only paying for a one-time capital gain when they eventually sell their final investment for cash.

That said, if you are going to go this route, it's important to do your due diligence and read up on the specifics of doing a Section 1031 exchange. There are rules you need to follow and specific time frames to adhere to in order to gain access to these tax benefits.

What does it mean to be a tenants in common (TIC) owner?

Ownership of a property can be defined in a few different ways, and tenants in common is one of them. With TIC ownership, two or more people can hold an ownership interest in the property. In this scenario, each property owner or business entity holds its own separate stake in the property, and their interests do not have to be equal.

Notably, with this type of arrangement, each owner is entitled to withdraw or mortgage their fractional ownership of the property without the consent of the other owners. In the event of a property owner's death, the ownership interest passes to their heirs rather the on to the other owners.

Putting it all together

With those two definitions in mind, a tenants in common 1031 exchange occurs when two or more real estate investors share common ownership and a fractional interest in a property that was purchased via a Section 1031 exchange.

Again, if you are considering going this route, it is essential to do your due diligence beforehand. In particular, you'll want to read over IRS Revenue Ruling 2002-22, which established a set of guidelines under which a TIC arrangement will qualify as a 1031 exchange replacement property.

What does IRS Revenue Ruling 2002-22 say?

Though it's not a replacement for doing your own reading of the revenue ruling, here is an overview of what IRS Revenue Ruling 2002-22 specifies:

  • All owners must hold title as tenants in common under local law.
  • There can be no more than 35 co-owners.
  • The co-owners cannot file a partnership tax return.
  • The co-owners may enter into a co-ownership agreement that runs with the land.
  • The co-owners must retain their voting rights in a specific manner.
  • Each co-owner must have the right to transfer, partition, or encumber their interest in the TIC investment without agreement.
  • If the property is sold, any debt on the property must be satisfied before the proceeds can be split among the co-owners.
  • Each co-owner must share all proceeds from and costs for the property in proportion to their ownership stake in the property.
  • A co-owner may issue an option to purchase their interest in the property, provided that the price reflects the fair market value for the relinquished property.
  • The co-owners may enter into a management or brokerage agreement, but it must be renewable annually.
  • All leasing agreements must be bona fide leases for federal tax purposes.
  • The lender for any loan agreements may not be related to anyone involved with the property.
  • Any payments made to the sponsor for the 1031 exchange must reflect the fair market value of the services rendered.

The pros and cons of participating in a tenants in common 1031 exchange

Pros Cons
Low minimum investment and flexible investment amounts. Shared risk means shared rewards.
Higher potential for diversification and safety. Little potential for unilateral decision-making.
Access to higher-quality real estate.
Greater ease of ownership.

The advantages of choosing a tenants in common 1031 exchange

In truth, there are many reasons why a real estate investor might choose to do a TIC investment for a 1031 exchange. They are as follows:

Low minimum investments and flexible investment amounts

Since multiple people are investing in the same asset, the minimum investment on a TIC property is usually lower than one might expect. Additionally, since a tenants in common ownership arrangement allows each person to maintain a different fractional interest in the property, the amount you can expect to invest may be flexible, depending on the size of your ownership stake.

Opens up the potential for diversification and safety

Given that the barrier to investment is lower with a TIC property, that offers many investors the chance to diversify their portfolios and invest in multiple properties. This, in turn, makes each investment a little safer because it reduces the effect that experiencing a loss will have on your wallet.

In addition, during tough financial times, multiple people are likely to have a greater pool of resources to draw upon than a single person. With that in mind, there is also less of a risk that you'll no longer be able to afford the investment property.

Access to higher-quality real estate

Again, since many people are pooling their money, the TIC investor often has access to higher-quality real estate than they would be able to afford on their own. This also opens up the opportunity to attract tenants with higher levels of income.

Ease of ownership

Finally, the fact that the property has multiple owners means that there are multiple sets of hands to take care of the day-to-day operations of managing an investment property. While you will have to pull your weight, the amount of work you'll be expected to do will be much less than if you owned the property all on your own.

The disadvantages of choosing a tenants in common 1031 exchange

That said, like any trade-off, there are a few disadvantages to doing a tenants in common 1031 exchange as well. We've listed them below for your consideration.

Shared risk means a shared reward

Sharing a portion of the risk for the investment means you're also required to share any rewards from it as well. The portion of any rent or sale proceeds that you receive from a TIC property will undoubtedly be smaller than what you would get if you were the sole investor. After all, you'll have to share it with the rest of your co-owners.

You have to vote on most major decisions

Having co-owners also takes away your right to make most unilateral decisions about the property. For the most part, IRS Revenue Ruling 2002-22 requires that a vote take place before moving forward with any major decisions. If you're not the type of person who does well with group decision-making, this may not be the best type of investment for you to enter into.

The bottom line

Like any investment, doing a tenants in common 1031 exchange has its potential risks and rewards. Ultimately, it's up to you to weigh those against each other before deciding whether this kind of 1031 exchange is right for you.

However, before you make your final decision, we strongly recommend that you read up on all the IRS requirements for these exchanges so you'll have a good idea of what will be expected of you when you enter into this type of partnership.

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