The Wall Street Journal online has an interesting article this week on securities often called tenancies-in-common, or "TICs," TICs are fractional-ownership type investments where several investors come together to purchase and operate a large piece of real estate – generally a residential or commercial development. This allowed people who otherwise would never have been able to own such a large property on their own to get involved - and entitled them to a portion of the profits. When the real estate market was booming, these investments generally offered an attractive return on investment which was attractive to many investors.
However, a TIC is a relatively complex investment and can involve much more risk than more common, traditional investments. As the WSJ discusses, one of the main attractions of these types of investments is their ability to escape capital gains taxes. Section 1031 of the income tax codes provides an exception to the capital gains tax, allowing one to postpone paying tax on any gain if he or she reinvests the proceeds in similar property as part of a "qualifying like-kind exchange."
Financial professionals began recommending TICs to investors who had a large amount – if not majority – of their savings tied up in real estate. Instead of selling that real estate, paying the capital gains tax, and then looking for a suitable investment for the proceeds, people could sell the property and invest it in another piece of real estate using the TIC structure. This allowed them to avoid the 15% capital gains tax on the sale.
The problem, of course, was that TICs are very complex investments and are not compatible with the risk tolerance level of many investors. Despite advertising an attractive annual return on investment, they contained risks that are not commonly found in more traditional, liquid investments.
With the downturn in the housing market, many of these real estate ventures have declined in value or ended in bankruptcy, failing to bring in any return on investment and, in many cases, leaving investors with nothing. Additionally, because the ownership interests are very hard to sell, investors with liquidity issues or persons looking to exit the investment have considerable trouble doing so. The losses can be extreme – as was the case with the couple profiled in the WSJ article who lost nearly everything when the apartment complexes they invested in went bust.
For many sophisticated investors, the risks associated with the TICs were well known. However, the boom real estate market, attractive returns, and ability to avoid the capital gains tax landed TICs on the radar of some investment professionals who saw it as an attractive option for customers with a significant amount of their worth tied up in real estate. For some investors, their real estate holdings comprised their entire net worth. And for many, it has all been lost.
The Wall Street Journal article is available here.