1031 TIC Exchange and REITs: SEC Commissioner's Remarks
Excerpts from SEC Commissioner's Remarks Before the NASD Spring Securities Conference
Hollywood, Florida
May 18, 2006
IV. TICs and REITs
The last two products that I would like to discuss this morning relate to real estate, which has been a very hot topic for some time now. Even as I speak, I can already see the question cards being passed down from panicked audience members that read "Do you believe that there has been a housing bubble?" and "Will you please ask your friends at the Fed to lay off the pedal on interest rates?" Well, before you begin writing on those note cards, I should tell you that I must disappoint by instead focusing on the no less interesting topics of "TICs" and "REITs."
TICs, of course, are tenants in common interests in real estate. The sale of real estate may result in the seller being responsible for capital gains taxes on any appreciation. Section 1031 of the tax code, however, permits investors in income producing or rental real estate to exchange the investment for an interest in real estate of equal or greater value in order to defer the payment of taxes on capital gains. TICs permit the investors to pool their assets with other investors in order to invest in larger real estate offerings. Thus, an investor could exchange his or her rights in a rental property for the interests in a pool of assets of a larger property offering owned by several other investors.
A 2003 NASD notice to members reminds broker dealers of their suitability obligations in selling "non conventional investments," which includes TICs. The notice explained that broker dealers engaged in the sale of non conventional investments must ensure that the products are offered and sold in a manner consistent with the member's general sales conduct obligations. Thus, broker dealers would be required to perform both reasonable basis and customer-specific suitability analyses.
Transactions in TICs present a number of suitability issues. For example, a customer may wish to exchange the total proceeds from a sale of real estate for a TIC interest. Although perhaps not a problem inherently, this exchange may result in a significant concentration of the investor's overall portfolio in real estate. Further, there isn't a secondary market for these interests, so TICs are illiquid. Also, there are fees associated with TIC exchanges that reduce or may outweigh the value of the tax benefits provided by the exchange. Last year, NASD issued a notice to members specifically highlighting these and related concerns. Broker-dealers should consider each of these issues before recommending a TIC exchange.
Also, the sponsors of TIC exchanges routinely obtain legal opinions regarding whether a particular exchange structure would qualify as a like kind exchange of real property under Section 1031. As tax considerations drive these exchanges, broker dealers should obtain a "clean" legal opinion or perform sufficient due diligence into the tax risks of the exchanges and ensure that they are disclosed to the investor.
REITs, or real estate investment trusts, are an investment that has increased in popularity among retail investors during the past few years. REITs are entities that invest in different kinds of real estate or real estate related assets, including shopping centers, office buildings, hotels, and mortgages secured by real estate. Interest in these investments has been positively correlated with the strong returns on real estate investments in recent years.
REITs that are not traded on a national securities exchange or the over the counter market present particular suitability issues. For example, because they are not traded on an exchange an investor may not be able to redeem them for years. As a result, these types of securities present liquidity issues. Investors should be informed of the difficulty that they may have in selling their investments and broker dealers should ensure that the customer will not need the money within a short time period. Also, on occasion, REITs have been marketed to customers as a conservative investment. The reality is that unlisted REITs may involve a high degree of risk. Also, they may have high costs that motivate a representative to make an unsuitable recommendation so they present particular supervisory challenges
