Advisors with clients who want to move money into real estate investments known as tenant-in-common offerings under section 1031 of the Internal Revenue Code need to be wary.
These products present numerous potential pitfalls, and they’ve come under regulatory fire.
“TICs can involve high risks and liquidity problems and in many cases brokerage firms misrepresent these risks and instead focus on the income stream that is promised [and sometimes guaranteed]by these investments,” as the White Law Group, a securities fraud litigation and FINRA arbitration investor protection firm, warns on its web site.
In January, FINRA issued a regulatory notice assessing the risk of TICs and other complex real estate investments, including the possibility “that the product will not perform as many investors anticipate, or that it might be sold on the basis of enhanced yield.”
The following month a FINRA arbitration panel awarded $1.37 million to San Diego clients of the California law firm of Miller & Milove against LPL Financial, which serves more than 13,000 financial advisors with research and investment products, as well as administrative services.
Miller & Milove charged that LPL was aware that the properties were incapable of generating income to pay the projected returns. Instead, the plan all along was to repay the investors with their own money.
LPL says it only offers such investments to accredited investors through trained advisors.
Through spokesman Michael Herley, LPL said: “1031 tenant-in-common offerings are complex investments. As such, the programs and program sponsors are subject to a rigorous due diligence process. These offerings must have investment merit before they are approved for sale, and many are rejected. In addition, because of their complexity, these offerings are available only to accredited investors under Regulation D, and usually require that prospective investors have significant prior real estate experience.
“After an offering is approved, it may be offered only by trained advisors to their existing customers who are accredited investor, and advisors must prequalify any customer before the offering documents are released. After a prospective investor is prequalified, he receives the offering documents and reviews those with his legal and tax advisors and his financial advisor. If the investor decides to move forward, he completes a detailed offering questionnaire that is reviewed by the broker dealer and the sponsor, who determine whether or not to approve the investments.”
Separately, in February, a FINRA arbitration claim was filed by the White Law Group against Sigma Financial, a Michigan financial services firm with 600 representatives, to recover TIC investment losses of more than $1.7 million.
The claim was submitted on behalf of two California investors and alleges claims for fraud, breach of fiduciary duty, negligence, and negligent supervision. The claim specifically alleges that the investors were unsuitably invested in various TIC investments and that Sigma Financial only selected these investments because of the commission generated as a result of the recommendation. The claim further alleges that Sigma Financial failed to perform the proper due diligence on the TIC investments prior to offering them for sale.
Sigma did not respond to a request for comment.
A TIC is a real estate investment in which two or more parties own a fractional interest in a given property, usually commercial real estate. TICs are securities and regulated by both the Securities and Exchange Commission and the Financial Industry Regulatory Authority.
The interests held by different investors do not have do be equal. They can be purchased and sold separately from each other.
They became popular as a way for a seller of real estate to qualify for a so-called 1031 Tax Free Exchange by selling one property and acquiring an ownership interest in another property. Under a qualifying IRS Code 1031 exchange, the tax involved in selling a real estate property can be deferred.
With TICs, a buyer also gets a property “that is professionally managed, trading the phone calls in the middle of the night to unplug the stopped up toilet for a "hands off" monthly check,’’ according to promotional copy on the web site of McVaughn & Co., a commercial real estate services firm in Pasadena, Calif.
Sales of fractional ownership interests to sellers of appreciated realty have become an attractive business for many FINRA brokerage firms, which marketed this transaction as a way to preserve the tax-free status of a property exchange for investors who want to defer capital gains taxes.
“The tax benefits can be substantial. At the same time, the costs of buying only a fraction of a property are far less than buying the entire property, which is also an advantage” says Andrew Sirkin, who heads up Sirkin & Associates in San Francisco. The boutique law firm specializes in real estate co-ownership including TICs.
Sirkin says that TIC investments may generate yields of 6% to 6.5% annually, which appeals to retired investors in need of income. TICs are also frequently presented as investments with appreciation potential and liquidity.
Financial advisors often consult in the TIC investment process and in some instances sell these investments themselves. As an example, Sigma Financial's financial advisors sold TICs to clients.
In the LPL hearing, attorney Brian Miller of Miller & Milover claimed that LPL presented “a fraudulent picture painted of investors receiving monthly income checks from the properties.”
After a few years, when the investors’ money was gone, cash distribution halted abruptly. “The investor would than call the broker, who would say, ‘Hey, the economy is in the tank. Sorry,' ’’ Miller says.
He also asserts that the LPL advisors had no idea how the highly complex investments they were selling worked and were ill-equipped to adhere to the FINRA suitability rule which requires that a firm or registered rep determine that a recommendation to purchase a security is suitable for the particular customer involved.”
LPL says such investments have to be thoroughly reviewed, by both the advisor and the customer.
Sirkin argues that with the proper due diligence and sound financial and legal advice, TIC investments can produce as advertised. “You have to look at each deal individually,” he says.