Making "1031 NNN Tenants in Common Exchange" Work in Today's Economy

Many commercial property owners are continually looking for the next big opportunity to expand their real estate investments, while minimizing costs and management responsibilities. A trend in real estate ownership over the past decade—1031 triple net (NNN) tenants in common exchanges—promises to accomplish this. However, this type of property acquisition may have serious pitfalls in today's economy—namely, the bankruptcy of the property management company, or sponsor. A well-drafted tenant-in-common agreement can prepare for that risk. But the acquisition strategy won't work if you can't sell your current property at enough of a profit to make the deferral of capital gains taxes worth it.

To figure out if 1031 NNN tenants in common exchanges are both valuable and viable for you as an owner, review the concept of “tenancy in common—one of three “tenancies” recognized by law that determine what types of rights you and co-tenants who share property with you are entitled to—and what makes a lease NNN, in particular.

What Is 1031 NNN Tenancy in Common?

Tenancy in common is the joint-ownership of the same property by two or more people or entities, known as co-tenants, who may contribute different amounts to the acquisition of the property.

Specifically, 1031 NNN tenants in common are owners who invest together in the same commercial property, usually with the primary goal of receiving tax benefits—a goal that is more important now than ever before.

You may have heard about 1031 NNN tenancies in common because of their increasing popularity in the past few years, which was largely a response by sole owners of property who wanted to save money and management headaches while still owning property.

Why Try 1031 NNN Tenancy in Common?

Owners who are struggling to pay for their solely owned property have the option of sharing an interest in a commercial property with other investors—splitting the high cost of the property with other owners and shedding the usual management responsibilities.

There are three types of leases for commercial tenants. In a single net lease, the tenant pays the property taxes and the rent; the owner pays the other operating costs. In a double net lease, the tenant pays the property taxes, insurance, and rent; the owner pays the other operating costs. But when a lease agreement requires the tenant to pay property taxes, insurance, and maintenance, in addition to the rent, it's known as a NNN lease.

An owner's motivation for negotiating a NNN lease in particular may be financial, says Chicago real estate attorney Robert D. Rotman, who points out that real estate taxes are stifling to some owners, which are, as a result, forced to take tenants on a NNN basis. A tenancy in common of a commercial property with a NNN lease becomes a NNN tenancy in common.

When a sole owner of property sells it and subsequently invests in a NNN property with other investors, it is a 1031 NNN tenancy in common exchange. The “1031” part of 1031 NNN tenants in common exchange comes from Internal Revenue Code (IRC) Section 1031, the law that exchanges must comply with at every step of the way.

The biggest benefit of sharing with other owners an interest in a NNN commercial property, such as an office building or retail shopping center, is the huge tax benefit. To wit, a 1031 NNN tenants in common exchange permits commercial real estate owners to sell their solely owned commercial properties, but defer tax payments by reinvesting the proceeds into “like-kind” investments in commercial property. In other words, this exchange allows a commercial real estate owner to defer capital gains taxes while still growing wealth by asset ownership of the new property. An added bonus: Owners are no longer responsible for management.

Completing Your Own Exchange: Make 1031 Work for You

The main requirements for a 1031 exchange are: (1) a Qualified Intermediary (QI), who should painstakingly follow all the rules until what is known as a “master lease” is entered into; and (2) qualified exchange properties—that is, “like-kind” properties for commercial use. Check with the IRC and an expert for a detailed list of qualified properties.

Remember: If you undertake an exchange, you must involve the QI prior to the closing of the sale of your current property.

If your currently held and prospective properties qualify for an exchange, your QI will handle the selling and buying of the properties, most notably, the incoming and outgoing funds involved in the exchange. At a designated point in the process, your QI will transfer the new property to you, to enter into a “master lease.”

The master lease. The key to carrying out the 1031 NNN tenants in common exchange is the master lease, a plan under which all the new tenants in common put a management company, also known as a “sponsor,” in charge of: (1) collecting the rent from the commercial building tenant or tenants—for example, office tenants, retailers, hotels, or restaurants; (2) keeping an agreed-upon portion as a management fee for its services; (3) paying any debts and expenses; and (4) paying the owners an agreed-upon amount as rent.

Technically, in this arrangement, each tenant in common is a master lessor, who leases the property to the sponsor, who becomes a master lessee (and property manager) and then sublets the property to the commercial tenants. Because the sponsor is, in addition to rent, responsible for the management, taxes, repairs, assessments, and insurance for the property, the master lease is essentially a NNN lease.

1031 Exchange Advantages

Although the 1031 NNN tenants in common exchange seems complicated and lengthy, owners should consider the advantages of a master lease:

• Own real estate while getting rid of management responsibilities;

• Depend on a fixed and predictable income stream as a tenant in common;

• Defer capital gains taxes;

• Possess the same rights and benefits as a sole real estate investor of commercial real estate; and

• Own commercial real estate with comparatively minimal money invested.

1031 Exchanges May Be Risky Business

If all goes well, a 1031 exchange may be a great money and management solution for owners. However, with the state of the economy, many sponsors are falling short financially, pulling their 1031 NNN tenants in common down with them. Martin Burton, Esq., a Santa Monica, Calif., real estate expert, explains that in the past few years, deals like 1031 exchanges have been done with high debt-to-equity ratios. When the property value of a tenancy in common investment property dips below the loan amount, the sponsor isn't able to pay the debts, says Burton. That is why there are many 1031 NNN tenancies in common that are failing now.

The crucial question: If the sponsor files for bankruptcy, who will be responsible for the master lease responsibilities?

TIC agreements govern. When a sponsor goes bankrupt, the rights and responsibilities of the tenants in common are not found in the master lease, as it might seem. The master lease determines only the ministerial duties of the sponsor relating to dealing with the property, rent, etc., not the sponsor's financial or legal liability, or the liabilities of the tenants in common.

Rather, a tenant in common (TIC) agreement entered into by the members at the start of the tenancy in common controls. You have to look at the TIC agreement first, advises Larry N. Woodard, Esq., a real estate attorney practicing in Chicago, Ill., because the provisions relating to bankruptcy are going to be in there. In fact, everything pertaining to the tenancy in common is in the TIC agreement, Woodard points out, including the rights and remedies of tenants in common dealing with a bankrupt sponsor. Thus, any responsibility for the master lease responsibilities after the sponsor is out of the picture will also be in the TIC agreement, but depending on a variety of factors, there may be no responsibilities to take over.

Foreclosure. In some cases, there are no responsibilities for anyone to assume because the default is not curable by the owners and the property goes into foreclosure. Burton emphasizes that a sponsor's bankruptcy has serious ramifications for existing tenants in common: “Because everyone is an owner, and every party is related to one another, an owner cannot really extricate himself easily.”

The bottom line. A well-drafted TIC agreement should include provisions for not only sponsor bankruptcy but also every other issue tenants in common may have to deal with.

In Successful Exchanges, Everyone Wins

It's true that 1031 NNN tenants in common exchanges are not right for every owner, and there certainly are other ways to deal with a tough market. But those who are willing to try it should remember that picking a sponsor with an established history of commercial property experience—and the financial cushion to make payments in the event of a problem—can minimize bankruptcy issues. With the effect of deferring capital gains and providing rental real estate without the management headaches, it's no wonder that some owners are tempted to give 1031 NNN tenants in common exchanges a try.

Insider Sources

Martin Burton, Esq.: Partner, Gilchrist & Rutter PC; 1299 Ocean Ave., Ste. 900, Santa Monica, CA 90401; (310) 393-4000; mburton@GRLawyers.com.

Robert D. Rotman, Esq.: Partner, Rotman & Elovitz, Ltd.; 180 N. Lasalle St., Ste. 2101, Chicago, IL 60601-2701; (312) 236-2202 ext. 3.

Andrew M. Sachs, Esq.: Partner, Robbins, Salomon & Patt, LTD.; 25 E. Washington St., 10th Fl., Chicago, IL 60602; (312) 456-0197; asachs@rsplaw.com.

Larry N. Woodard, Esq.: Partner, Robbins, Salomon & Patt, LTD., 25 E. Washington St., 10th Fl., Chicago, IL 60602; (312) 456-0191; lwoodard@rsplaw.com.

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