Glossary
1031 Exchange
Section 1031 of the Internal Revenue Code allows taxpayers to defer gains taxes by exchanging qualified, real or personal property (relinquished property) for qualified "like-kind" property (replacement property). Property involved in a 1031 tax deferred, exchange must be held for investment or for use in a trade or business.
45-Day Rule
An Exchanger has 45 calendar days to properly identify one or more replacement property with his or her Qualified Intermediary (Accommodator). The identification period starts the day after the relinquished property closes escrow, and is based on calendar days, including weekends and holidays. The Exchanger has until midnight of the 45th day to make a proper identification to the Accommodator. In most cases, a fax will suffice (check with your Accommodator to make sure).
180-Day Rule
An Exchanger has 180 calendar days after the relinquished property closes escrow to complete an exchange transaction.
Accommodator
An Accommodator (or Qualified Intermediary) is a required party to a 1031 exchange. An Accommodator is a disinterested third party that facilitates the exchange for an Exchanger in accordance with 1031 exchange rules. The Accommodator holds the exchange funds until a replacement property is purchased, and is the recipient of replacement property identification.
Accredited Investor
An Accredited Investor is someone who is financially qualified to participate in a Regulation D private placement offering (such as a TIC offering). There are several ways to be meet the requirements to be considered an Accredited Investor (you only have to meet one of them). They include:
- An individual with an annual income of $200,000 or more (past two years)
- A household with an annual income of $300,000 or more (past two years)
- A household net-worth of $1 million or more (inclusive of house and autos)
- A trust or qualified plan with $5 million or more in assets
Appreciation
Appreciation is the increase in the value of a property versus its original purchase price. For tax purposes, appreciation includes both the increase in value as well as the amount of depreciation that has been taken against the property.
Basis
Basis is an investor's adjusted cost in a property. Basis is calculated by taking the original cost, plus improvements, minus depreciation taken.
Boot
Boot is the fair market value of non-qualified (not like-kind) property received in an exchange transaction. Examples include: cash, notes, seller financing, furniture, supplies, and a reduction in debt obligations.
Broker Dealer
A firm that recommends, offers or sells investments to the public, which is required to be registered with the SEC, FINRA, and the state securities divisions in every state in which the firm operates or the customer resides.
Capitalization Rate (Cap Rate)
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of an income producing property. A property's Cap Rate is calculated by dividing its annual net operating income by its market value, expressed as a percentage. Investors, lenders and appraisers use the Cap Rate calculation to estimate the value of different types of income producing properties.
Cash on Cash Return
Cash on Cash Return is the pre-tax annual cash flow derived from an income property based on the equity investment in the property. For example, if a person invested $500,000 equity in a property and the annual cash flow from the property is $35,000 (net of all expenses and loan payments) then the Cash on Cash Return would be 7%.
Delaware Statutory Trust (DST)
A Delaware Statutory Trust (DST) provides an alternative to the TIC structure for a co-ownership program that meets 1031 exchange requirements. To use a DST in a Section 1031 co-ownership program, it is necessary to comply with IRS Revenue Ruling 2004-86 requirements and to meet lender requirements so that the loan can be securitized on a secondary market. The DST structure allows the lender to treat the trust as a single borrower (rather than underwriting each TIC investor separately) thus simplifying the underwriting process. The minimum investment of DST offerings is generally lower than TIC offerings since up to 95 investors are allowed to participate (Vs a maximum of 35 investors in a TIC offering).
Due Diligence
Due Diligence is the process of verifying all material facts and risks, which could affect the outcome of an investment. Due diligence in a TIC offering is conducted separately by the TIC Sponsor, the lender, the broker dealer and the registered representative prior to making it available to clients.
Exchanger
An Exchanger is a property owner (taxpayer) seeking to defer capital gains taxes by utilizing a Section 1031 exchange.
Equity Investment
Equity investment is the portion of project financing provided by an investor. The portion not provided by equity is debt (or mortgage) financing. The primary difference between equity and debt financing is that the equity portion represents ownership, while debt portion is a considered a loan.. As such an investor's equity will appreciate (or depreciate) along with the value of the property, while the lender is only entitled to repayment of the loan (plus interest).
Financial Industry Regulatory Authority (FINRA)
FINRA is a self-regulatory organization that supervises the activities of broker dealers and registered representatives, ensuring compliance with all SEC rules. Broker dealers are required to be members of FINRA
IRR (Internal Rate of Return)
Internal Rate of Return (IRR) is the yield, which equates the Net Present Value of a stream of cash flows to zero. Conversely, it is the annual return one expects to receive based on an initial cash outlay and a stream of future cash flows. IRR is the preferred method of evaluating investment projects, as it takes into account the time value of money.
Like-Kind Property
Any property held for investment or use in a business can be exchanged for any other "like-kind" property held for investment or use in a business. This definition covers a wide variety of developed and undeveloped real estate. Properties, which are clearly not like-kind, are an investor's primary residence or property "held for sale." The relinquished and replacement properties need not have identical functions. For example, you can exchange an apartment building for a commercial office building, raw land for a shopping center, a farm for a rental house, etc. Again, the main requirement for "like-kind" property is that it be held for investment or use in a business.
Master Lease
A Master Lease is a primary lease that controls subsequent leases and which may cover more property than subsequent leases.
Net Operating Income (NOI)
Net Operating Income (NOI) is the sum derived after deductions from gross income for vacancy and expenses. To calculate a property's NOI, subtract vacancy and operating expenses from a property's potential gross income. Operating expenses include advertising, insurance, maintenance, property taxes, property management, repairs, supplies, utilities, etc. Operating expenses do not include improvements such as a new roof, personal property such as a lawn mower, mortgage payments, income and capital gains taxes, loan origination fees, etc.
Private Placement Memorandum (PPM)
A Private Placement Memorandum (PPM) is a document prepared by the TIC sponsor that provides detailed information on a TIC offering. The PPM discloses the facts of the property, terms of the investment offering, and potential risks associated with an investor's participation in the investment.
Qualified Intermediary (QI)
A Qualified Intermediary (QI) is the entity that facilitates the exchange for the Exchanger. The term "facilitator" or "accommodator" is also commonly used, although the Treasury Regulations specifies the term "Qualified Intermediary".
Real Estate vs. Securities
The offering of undivided interests in real estate, where the Sponsor sources the property and provides ongoing services with the expectation of profits, meets the definition of an offering of securities in the nature of an investment contract. A TIC interest is a deeded fractionalized interest in real estate, and as such is capable of satisfying 1031 exchange rules. However, when undivided interests in a single property are offered to multiple investors and a Sponsor is sourcing the real estate and providing ongoing services for an expectation of profit, the TIC interest generally meets the definition of a security and is subject to federal and state securities laws and rules of distribution to investors.
Recapture
Recapture (or depreciation recapture) is the amount of tax to be paid on the difference between book value after depreciation deductions and the sales price of a property. The tax rate on recapture is 25%.
Regulation D Offering
A safe harbor exemption for TIC investment offerings where participating investors must be qualified as Accredited Investors. This is the most frequent type of TIC investment offering used by TIC sponsors.
Registered Representative
An individual who recommends, offers, or sells investments in return for a commission. A registered representative must be associated with a broker dealer and licensed as a securities professional with the SEC, FINRA and all states in which he or she conducts business. Any unlicensed individual or firm involved in recommending, offering, or selling TIC investments is in violation of federal and state securities laws.
Relinquished Property
The property sold by the Exchanger. This is sometimes referred to as the "exchange" property of the "down-leg" property.
Replacement Property
The property acquired by the Exchanger. This is sometimes referred to as the "acquisition" property or the "up-leg" property.
Revenue Procedure 2002-22
On March 19, 2002, Revenue Procedure 2002-22 was issued providing guidance regarding the conditions under which the IRS will entertain a private letter ruling that a TIC interest will not be treated as a partnership interest for tax purposes. The guidance clarifies the criteria which the IRS views as distinguishing a real estate TIC arrangement from a partnership, and enables sponsors to create rental real estate structures that have ownership units capable of being used in a like-kind exchange.
Securities and Exchange Commission (SEC)
The Securities and Exchange Commission (SEC) is the government agency that defines the rules by which broker dealers and registered securities representatives must operate when offering investments to the public.
Suitability
Suitability is a requirement that any investment strategy fall within the financial means and investment objectives of an investor. A guideline stated or implied by various securities regulatory bodies, which requires that brokers determine the suitability of investments for customers before making recommendations.
Tenants-In-Common (TIC) Ownership
With the TIC ownership structure, multiple investors own an undivided fractional interest in an entire property and share in the net income, tax shelters, and appreciation. Each TIC owner receives a separate property deed and title insurance for their portion in the property investment. TIC ownership provides the same rights of ownership that a single owner would enjoy.
TIC Sponsor
A TIC sponsor is a well-financed and experienced real estate organization that specializes in acquiring, syndicating, and managing commercial property on behalf of TIC investors. In structuring a TIC offering, it is important for the TIC sponsor to adhere to IRS guidelines (IRP 2002-22) so that 1031 exchange investors can participate.
