June 2007
Is a Tenant-in-Common Interest a Security or Fee-Simple Real Estate? Caution Is the Better Part of Valor
by Wes Larson
The popularity of tenant-in-common investments (TICs) has grown rapidly since the Internal Revenue Service (IRS) released Revenue Procedure 2002-22 on May 8, 2002 (Rev Proc 2002-22). That procedure specifies the conditions under which the IRS will consider a request for a private letter ruling that a fractional interest in rental real property (a TIC) is not an interest in a business entity (such as a limited liability company or a partnership) and therefore may qualify as real property held for investment purposes eligible for tax deferred treatment under IRC Section 1031.
With the guidance provided by Rev Proc 2002-22, TIC sponsors, or promoters, have structured TIC transactions that qualify as an interest in real property for IRC Section 1031 purposes. Real estate investors, searching for ways to own real estate without day-to-day management headaches, have been feasting on these TICs ever since. According to data maintained by the Tenant-in-Common Association (TICA), since Rev Proc 2002-22 was released, the TIC industry nationwide has grown from total equity of $166 million in 2001 to an estimated $4 billion by the end of 2006.
While the IRS may have concluded a properly structured TIC interest (that is, structured in accordance with Rev Proc 2002-22) is real estate and not an investment in a business entity (a security), the security regulators seem to have reached the opposite conclusion about most syndicated TIC interests sold through private equity markets. Most regulators have decided TIC interests are securities subject to federal and state security laws. Whether a TIC interest is a security or a fee-simple interest in real estate is an important question for attorneys, accountants, and brokers to consider when advising their clients on TIC transactions.
In 1946, the U.S. Supreme Court decided SEC v. W. J. Howey Co., 328 U.S. 293 (1946), the seminal case on the definition of a security. In Howey, the Court held a security is any investment contract “whereby the profits are derived solely through the entrepreneurial efforts of others.” Howey, 328 U.S. at 3. Because most TICs marketed through private equity markets are combined with a management agreement to manage the real estate (investors rely on the efforts of others for their profit), almost all (48 of 50) state agencies charged with enforcement of state securities laws have issued advisory opinions that syndicated TIC investments offered through private equity markets are, in general, a security and not a fee-simple interest in real property. In 2005, the Washington State Department of Financial Institutions’ Securities Division issued its own opinion that most of the TICs on the market today will be treated as securities subject to Washington state securities laws.
In a recent article, Dick Lipton, senior tax counsel at the law firm of Baker & McKenzie, argued that a TIC may not be a security if the management contract is excluded from the offering, allowing the investors to choose the manager, and provided the manager is not the sponsor or an affiliate of the sponsor company (TICTALK, 4th Quarter, 2006, copyright OMNI Brokerage, Member NASD SIPC). Although the offeror of the TIC may have undertaken all other entrepreneurial efforts, including the acquisition, due diligence, and financing of the TIC, so long as the investors retain direct control over the future management of the asset, it should be treated as a “non-securitized” offering, eligible for sale by a licensed real estate broker. In other words, if the investors retain management rights, then the profits will not be derived “solely” by others, and therefore the investment contract is not a security. However, this opinion is not universally accepted among industry observers. Much recent case law, at the federal as well as the state level, suggests otherwise.
What is not disputed is that if the TIC structure includes a management agreement as part of the “package,” it is a security. If a TIC transaction includes a master lease whereby the sponsor/promoter or affiliate of the same is also the master tenant, it will also be considered a security. See SEC v. Edwards, 540 U.S. 389 (2004) and Triple Net Leasing, LLC, SEC No Action Letter, SEC No-Act. LEXIS 824 (Aug. 23, 2000). In either of the foregoing instances, there is no question that the promoter is providing all the entrepreneurial activities.
Are TICs offered without post-sale management services necessarily real estate and not securities? What is the SEC’s position?
This is the key question. Real estate brokers are offering a plethora of TIC investments to the general public in a “non-securitized format,” as suggested by Mr. Lipton. May promoters or investors rest assured that they have found a safe harbor?
The answer is apparently “no,” so far as the SEC is concerned. At the 2007 Tenants-in-Common membership symposium, David Lynn, chief counsel in the SEC Division of Corporate Finance, cited SEC v. Mutual Benefits Corporation, 408 F. 3d 737 (11th Cir. 2005) as reflecting — in his opinion — the SEC’s position on the issue.
That case concerned viatical settlement contracts. According to Lynn, the case did away with “the artificial distinction between pre-sale and post-sale efforts.” In Mutual Benefits, the court concluded that: “While it may be true that the “solely on the efforts of the promoter or a third party” prong of the Howey test is more easily satisfied by post-purchase activities, there is no basis for excluding pre-purchase activities from the analysis. Significant pre-purchase managerial activities undertaken to insure the success of the investment may also satisfy Howey.”
The courts have uniformly recognized that Congress intended to make the definition of “security” as broad as possible. Although the courts may approach the issue differently, the courts of appeal have been unified in refusal to give literal meaning to the word “solely,” and have held, rather, that “the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the success or failure of the enterprise.”
In SEC v. Glenn W. Turner Enterprises, 474 F. 2d 476 (9th Cir. 1973), the court held that “in light of the remedial nature of the legislation, the statutory policy of affording broad protection to the public, and the Supreme Court’s admonitions that the definition of securities should be a flexible one, the word ‘solely’ should not be read as strict or literal limitation on the definition of an investment contract, but rather must be construed realistically so as to include within the definition those schemes which involve substance, if not form, securities.”
Further, the NASD, in its Notice to Members 05-18 (2005), has stated its position that “when TICs are offered and sold together with other arrangements, they generally would constitute investment contracts and thus securities under the federal securities laws.”
Should one successfully argue that federal law does not mandate that all syndicated TICs are securities, each state has its own securities laws, and these must be contended with as well? At a recent WSBA CLE on TIC/1031 exchanges (January 8, 2007), associate counsel for the Washington State Securities Division took the position that where TICs are being structured pursuant to an investment scheme, and post-sale management services are not included as part of that scheme, the investment contract test may still be considered satisfied.
Some states have openly clashed with the federal courts’ position on TICs as securities or real estate. In Utah, for example, state law provides that TICs may be sold only as real estate. In other states, such as Idaho and Oregon, legislation is being proposed that would specify conditions under which TICs may be sold as real estate and not be considered securities. This legislation notably includes the critical provision (as stated by Mr. Lipton) that the investors control the management. This obviously relies on a narrow definition of the Howey test, one that the SEC and the federal courts may not recognize.
If a TIC is a security, it can be brought to the market only by the issuer or a NASD (National Association of Securities Dealers) licensed broker dealer and a securities licensed registered representative who is subject to supervision of the broker dealer (NASD Rule 3010). The typical TIC is sold as a private placement exempt from the registration process pursuant to Regulation D, and marketed, in general, only to accredited investors (those who have a net worth of greater than $1 million and/or net income of $200,000 for the prior two years; $300,000 in the case of a married couple, or who meet other criteria listed in Regulation D Rule 501A) with whom the issuer or broker/dealer has a pre-existing relationship. General solicitations to the public, including any form of public advertisements, are strictly prohibited. Rule 506 also requires federal and state notice filings, and no more than 35 accredited investors. Fees may not be shared with non-securities licensed individuals or entities (NASD Rule 2420). NASD NTM 03-71 also sets forth industry standards for a member’s due diligence, as well as for investor suitability analysis, promotion, and implementation of internal controls.
A TIC offered as real estate, and sold by real estate brokers, may or may not include the same level of disclosure as a securitized TIC offering, but a security is generally held to a much higher standard of disclosure.
Should the sale of the TIC interest be considered as real estate, the investors’ right to receive information would be limited, in any case, to the four corners of the purchase and sale agreement. The duty to inquire and conduct due diligence is shifted to the investor. The Latin caution caveat emptor (let the buyer beware) typically applies at some point in a real estate transaction, whereas the operating term in a securities transaction may best be stated, in contrast, as caveat vendor (let the seller beware).
Given the rapid growth of the TIC industry, and what many experts claim is an overheated real estate market, the caution flag should be raised. If one is reviewing a proposed TIC transaction, caution is the better part of valor. The advisor is better served viewing any syndicated TIC as a security. Regardless of the perceived quality of a real estate TIC offering, the fact is that the distribution channel will be called into question if and when a securities action is filed; specifically, to whom and by whom was the investment offered, and how was it offered into the market place. One should inform one’s client that a violation of the securities laws and resultant legal action may likely result in a default under the loan documents with the bank financing the TIC, with potentially significant economic consequences for all investors. Indeed, a failure by the attorney to make his client aware of these issues could even result in a malpractice claim. An accountant or broker advising his client that the law authorizes investment in such a transaction is in any case offering a legal opinion that he or she is not authorized to make. Penalties for violation of securities laws are considerable. In the worst case, for the promoter of a TIC offering, a claim for securities fraud may result not only in civil liability, but criminal penalties as well.
One may argue that there is a “substantial chance” a TIC may be structured and offered as real estate, and not as a security, but that view is far from the safe harbor your client rightfully expects, and the professional advisor is better off counseling his client to invest in an offer of a TIC only if done so pursuant to Regulation D of the 1933 Securities Act, and subject to the attendant oversight and rules of the SEC and NASD.
In an effort to resolve some of the differences between the real estate and securities industries, including resolution of the issue of sharing fees between real estate and securities practitioners, NASSA, NAR, and TICA have formed a joint task force to review the issues surrounding TICs as securities or real estate. In addition to reviewing proposals for real estate brokers to share in fees, the task force is also considering increased standardization of state securities rules regarding administration of the TIC industry.
Wes Larson is a partner in ClearView Wealth Management, LLC in Issaquah. The company is a branch of Pacific West Securities in Renton. Larson is a WSBA member and a licensed real estate dealer in Washington, and holds Series 22 and Series 63 securities licenses.
