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The past five years of low interest rates, gradual economic recovery and lack of confidence in the stock market have created a boom market in the buying and selling of commercial real estate. While the headlines in major markets have been grabbed by institutional players, such as real estate investment trusts, foreign investors and even hedge funds, across the balance of the United States virtually all commercial real estate is owned by individuals and families. Those individuals and family owners have been extremely active over the past five years despite the concern that selling property required either finding a replacement property and doing a like-kind exchange, or paying substantial capital gains taxes. In 2002, the Internal Revenue Service (IRS) opened the door to a technique that made it easier to defer capital gains taxes. That solution is embodied in the newest form of real estate equity syndication, referred to as tenant-in-common (TIC) offerings. That solution has also had the unintended, but welcome, effect of providing a source of lower-cost equity for owners and developers who wish to continue buying or developing commercial real estate. For real estate, tax and securities lawyers old enough to remember the tax-advantaged real estate equity syndications market pre-1986, it feels like old times. What did the IRS do in 2002? The IRS issued Revenue Procedure 2002-22, which provided standards for determining whether an arrangement for owning real estate by individuals constitutes a tenancy in common or a partnership. The distinction is crucial, as a seller trying to do a like-kind exchange cannot use the proceeds to buy an interest in a partnership that owns real estate. Owning a partnership interest is not equivalent to owning a direct interest in real estate, the sine qua non of a successful real estate like-kind exchange. What the IRS did in Revenue Procedure 2002-22 was describe standards that could act as guidelines for practitioners trying to avoid partnership treatment for their clients’ investments. What those practitioners then had to do was brush up on the state law concept of tenancy-in-common, which most of them remembered only from property law courses in law school, not from practice. They then had to adapt the fairly arcane common law of tenancy-in-common to fit as many of the Revenue Procedure 2002-22 guidelines as possible. The result of the issuance of Revenue Procedure 2002-22 was the development of a commonly accepted structure for doing private placements of tenant-in-common interests through complex private placement memoranda that include “should” tax opinions-that is, tax opinions that arrive at the conclusion that the IRS “should” recognize the TIC interests as like-kind exchange property. This is the structure that is now commonly referred to as a TIC offering. It has been far from a perfect solution. Even aggressive lenders have been reluctant to deal with more than 10 to 15 tenants in common as co-owners of a piece of real estate. Broker-dealers selling the offerings have also met resistance marketing tenant-in-common interests with minimum amounts higher than $500,000. The result has been that the typical TIC offering seeks to raise $5 million to $15 million in equity, a relatively small amount for such a complex money-raising technique. In addition, state tenancy-in-common law and Revenue Procedure 2002-22 make it difficult to do TIC offerings on multiple properties. Huge growth quickly Notwithstanding these problems, from its birth in 2002, the TIC offering industry grew to more than $2 billion in equity raised in 2004. Where did this money come from? Prior to the issuance of Revenue Procedure 2002-22, as much as $35 billion in proceeds from commercial real estate transactions each year became subject to capital gains taxes because sellers were unable to find suitable exchange property. The TIC offering industry stepped into that $35 billion void. Recognizing that Revenue Procedure 2002-22 posed problems, in 2004 the IRS blessed a new and apparently better structure, employing a specific form of entity, the Delaware statutory trust (DST). This blessing was in the form of Revenue Ruling 2004-86. This did away with the tenant-in-common ownership requirement, substituting ownership of beneficial interests in a specific form of trust. This made it possible to eliminate lender concerns about dealing with multiple owners of the underlying real estate, allowing offerings to more than just 10 to 15 individual investors. This in turn allowed offerings to be larger, up to $50 million in equity or more. Unfortunately, the DST structure has proven to have its own limitations. Revenue Ruling 2004-86 requires a rigid structure, not unlike the structure used for fixed-unit investment trusts in non-real estate offerings. The key is that the trustee must not have the power to “vary” the investment. That limitation removes the power to refinance, meaning that any loan on the property must be in place at the initial closing and remain in place for the life of the investment. The DST offering thus is for a fixed term, typically five or 10 years. The “do not vary the investment” condition also makes renegotiating leases or entering into new leases problematic. This leasing issue can be dealt with through a master lease structure that passes the lease negotiation authority/obligation down to a master lessee, but that adds a level of complexity in an already complicated structure. The fixed-term and master-lease solutions to DST offering problems will probably work in the marketplace, but there is another, even more fundamental problem. What happens if something goes wrong? There is no flexibility to restructure, recapitalize, refinance or pursue other options if circumstances change in a negative way, for example, if a major tenant files for bankruptcy. This is not only unacceptable to potential investors, it is also unacceptable to lenders, who do not want to be faced with a borrower who cannot make decisions if a default looms. Converting to an LLC The best, and really only, solution to this issue that has been found is to require in “default-looming” circumstances that the trustee convert the DST into a limited liability company, a so-called “springing LLC.” The form of operating agreement for the springing LLC and the identity of the springing LLC’s manager (the trustee departs from the scene) are pre-approved by the lender. Tax lawyers issuing opinions in these circumstances have gotten comfortable that the conversion to a limited liability company does not trigger a tax sale or unwind the original like-kind exchange treatment for the investors. However, after the looming-default problem is cured, the springing LLC must do a further transaction, known as a “drop and swap,” to allow the investors to be eligible for like-kind exchange treatment on the sale of the real estate. Lenders are still working through these issues, particularly so-called “B-piece” buyers of conduit loans. A number of DST offerings have been successfully completed, including ones with conduit loans. As the issues are worked through, DST offerings should become more common, although the rigidity of these offerings will still drive many deals back into the traditional TIC offering structure. The complexities and issues with both TIC offerings and DST offerings have not dampened the enthusiasm of investors. The TIC industry should raise close to $4 billion in equity this year, and projections suggest that figure could rise to $7 billion by 2007. A part of that growth will come from the slow progression of this technique from the West Coast to the East Coast. While most offerings and issuers are still west of the Mississippi, there is increasing awareness on the East Coast now, and deals are cropping up in Eastern and Midwestern locations. Who can benefit? How does a lawyer, typically a tax or real estate lawyer, help his or her client decide whether a TIC offering might make sense? Examples of clients who might benefit from knowing more about TIC offerings would be: Real estate owners. Because of the offering costs, that is, the costs of sale, TIC offerings might not make sense for a client who owns investment-grade real estate in a major market, for example a Class A downtown office building in Washington or a good-quality apartment building in Chicago, as those owners will get attractive offers from institutional buyers of real estate. However, if the property is too small (less than $25 million), out of the core areas of major markets, not class A in quality or an unusual property type, for example hotels or self storage, a TIC offering might yield higher net sales proceeds than a conventional sale. In addition, in a TIC offering the property owner can retain management of the asset if he or she chooses, and also have a fair market value option to reacquire it, which is important for clients who want to maintain some measure of control over their real estate even if they sell it, for example an operator of a senior living facility or a golf course. Real estate acquirers. Some real estate owners are ground-up developers, others are buyers and “fixer-uppers.” For real estate owners in this latter category, TIC offerings can be a good option. Doing a TIC offering to raise the equity to allow an issuer to acquire a property is frowned on in the industry as involving too much closing risk for investors caught within IRS- mandated deadlines (45 days to identify, 135 days to close on exchange property). Nonetheless, real estate owners are forming acquisition programs around doing TIC offerings on properties already in their portfolios, while retaining management and “call” rights, and using the low-cost equity this provides, typically in the 7% to 9% range, to fund new acquisitions. Clients who have sold real estate. Any clients who have sold real estate and are looking feverishly for replacement properties should look at TIC offerings now on the market as one possible solution. Other than availability, investing proceeds in TIC offerings allows diversification of risk, that is, the client can buy relatively smaller pieces of three to four deals, not just one piece of real estate. These are just a few examples of clients who may find this of interest. Others might include accountants, financial advisers, securities broker-dealers, commercial real estate brokers and corporate clients who might be interested in moving their real estate off balance sheet but for whom a traditional sale-leaseback might not work. The potential candidates also extend across many property types, including hotels, golf courses and senior living facilities. TIC and DST offerings may not fit every situation, but they fill a multitude of needs in an asset class, real estate, that needed more options than direct ownership or buying shares in a large real estate investment trust. The best evidence that they are filling a need is the continued rapid growth of the industry. Stephen I. Burr is of counsel to the Boston office of Foley & Lardner. He represents issuer/sponsors and broker-dealers in TIC and DST offerings nationally, including owners of multifamily residential, office, industrial, hotel, senior living and golf course properties. He can be reached at [email protected].

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