1031 Exchanges: TIC Exchange and Delaware Statutory Trusts
1031 exchanges are complex investments that brokers might present as an excellent way to diversify an investment portfolio. In a 1031 exchange, an investor swaps one income-producing property for another and avoids incurring taxes associated with a property sale. These securities might sound like good investments because they involve real estate and offer potentially unlimited deferral of tax liability. But due to their complex nature, 1031 exchanges may not be worth their supposed advantages. The IRS has strict requirements for both Tenant and Common (TIC) and Delaware Statutory Trust (DST) 1031 investments, and any contractual mistake might negate the benefit of the exchange.
Regulation D Offerings
TIC and DST investments are usually Regulation D offerings, which means they file a limited amount of information with the SEC. Brokers can only recommend Regulation D offerings to investors who can afford to take on their risks due to their high income or significant assets. Brokers are also not allowed to advertise 1031 exchanges to the public. For a broker to know if a 1031 exchange suits their investor’s needs, they must have a pre-existing relationship.
According to Regulatory Notice 10-22, brokers cannot rely on their investor’s income as a reasonable basis for recommending a 1031 exchange. The broker must also factor in their customer’s tax situation and investing experience. Additionally, to meet the criteria for a reasonable investigation into the 1031 exchange, the broker must have researched the following:
- The issuer and its management,
- The business prospects of the issuer,
- The assets held by or to be acquired by the issuer,
- The claims being made.
Did You Lose Money in a TIC Exchange?
Tenant-in-common (TIC) exchanges involve purchasing a fractional share of an investment property. Typically, the company offering the investment will promise to manage the property, and brokers present the TIC “opportunity” as a way to make money investing in real estate without the hassles and risks of individual ownership. By reinvesting in additional properties over time, investors can continue to generate returns without incurring tax liability as a result of the like-kind exchange (LKE) provisions in Section 1031 of the Internal Revenue Code.
Investors must meet strict requirements for a like-kind exchange. You have only 45 days to identify a property for a like-kind exchange, and you cannot choose their own vacation property or a property they intend to move into right away. If you exchange land with a building for unimproved land, there could be unintended tax consequences, or a 1031 exchange may not apply. Because of these strict requirements, investors should have a tax expert review their TIC exchange before signing on a dotted line. 1031 exchanges are difficult for even experienced brokers to understand, and financial professionals should always be up-front about the limits of their expertise.
FINRA Warns Brokers to Not Recommend Unsuitable TICs
FINRA Notice to Members 5-18 reminds brokers that they must consider whether a 1031 exchange truly suits their customer’s best interests. Unfortunately, brokers often fail to take these steps and put their own interests ahead of their customers’. Promotional materials for 1031 exchanges must be fair and balanced—in other words, they must include information about risks and potential drawbacks.
Tenants-in-common exchanges present a variety of risks. Not only can the underlying investment fail to perform, but the company that is supposed to be managing the property may fail to perform as well. Sometimes, these companies will need to make “cash calls” to investors to sustain their operations. In many cases, poor property management, poor financial management, or other issues will lead to the complete loss of investors’ funds.
Other potential drawbacks include the following:
- TICs are illiquid securities with no known secondary market. This means that investors will most likely find it impossible to recover their funds from a TIC exchange.
- TICs often involve a large portion of an investor’s wealth. This can easily lead to over-concentration.
- In some cases, fees generated by the TIC may outweigh any tax deferral benefits.
In addition to investors, FINRA also wants firms to make sure they adequately supervise their brokers who recommend 1031 exchanges. Broker-dealers must have systems in place that catch red flags of unsuitable TIC recommendations.
Did You Lose Money Investing in a Delaware Statutory Trust?
Delaware statutory trust exchange investments operate similarly to TIC exchange investments and present many of the same risks. There is one major difference: in a DST, each investor obtains a fractional interest in the trust instead of a piece of real estate. However, due to the unique requirements of Delaware statutory trusts, they present additional risks—and brokers often fail to disclose these risks when making investment recommendations.
For instance, if the DST comprises hotels or office space, they may have experienced a significant drop in value following the pandemic. Many hotels rely on a good location, so a natural disaster could easily up-end a DST with hotel real estate.
Schedule a Free and Confidential Consultation at Kurta Law
If you have lost money investing in a TIC or Delaware statutory trust, you may be entitled to recover your losses from your brokerage firm or broker. Your broker may not have performed their due diligence before they recommended the 1031 exchange, and your brokerage firm could have failed to adequately supervise. To learn more, call 877-600-0098 or request a free consultation at Kurta Law. You pay nothing unless we win.