From the June 2006 issue of Investment Advisor • Subscribe!

June 1, 2006

The Next Investment Scandal?

The IRS issued guidelines on 1031 exchanges to tenants-in-common properties (TIC) in 2002. Since then, billions of dollars have poured into investments loaded with promoter fees and compensation that may eventually reach or exceed one-half of an investor's contributions. Frequently, these conflicts and fees are concealed by these unregulated private placements. A 1031 exchange allows sellers of highly appreciated real estate to sell the property and exchange it for other property without paying taxes. On the surface, TIC exchanges appear to be an excellent way to harvest tax savings, but behind the hype you will frequently find more than six layers of fees and expenses that easily could be greater than the tax you are trying to avoid on clients' behalf.

When the real estate market is growing, those expenses may be hidden. If the market turns south, the expenses may lead to the kind of collapse in values that we saw in the 1980s in limited partnerships. Boomers preparing for retirement are eager to sell highly appreciated property to create an income without the headaches of property management. The 1031 to a TIC offers that potential, but without due diligence big mistakes can be made. Frequently, there is little time to examine the new investment because of the 45-day compliance timeframe. The most important piece of paper an investor should read before investing is the private placement memorandum, particularly the section under "risks." You will quickly understand the many layers of fees and conflicts. Promoters often hold back this private placement memorandum until all the sales hype has the deal well on its way. Once in the deal, there is absolutely no written guarantee of any liquidity from the promoter. Recent media has reported horror stories of TICs that are not working out for the investor.

Boomers can handle their highly appreciated real estate through other strategies, such as private annuity exchanges and charitable remainder trust exchanges and, in the end, paying the tax and diversifying the proceeds may be the best solution for some.

Diversification has to be the number one priority for people preparing for a lifetime of income needs in retirement. We helped a client understand all of the risks in a $850,000 tenant-in-common deal in which he was about to invest. Then we helped him understand the advantages and disadvantages of private annuity exchanges and charitable remainder exchanges (both are capital-gains bypass trusts). After careful consideration, he chose the charitable remainder trust and 100% of the proceeds were invested in Treasuries and exchange traded index funds. He still owns other real estate investments, but the new trust allowed him to diversify into a portfolio more suited for retirement.

REITS currently are not an option for a 1031 exchange, even though they buy and bid on the same properties that TICs buy. REITS are regulated, liquid, transparent, and, most people agree, overpriced. When the inevitable correction comes, REIT investors can and will sell. The sale of REITs declining in value could negatively impact the value of the TIC owner's shares.

Clients selling investment real estate could consider exchanging into a single-family house in a resort of their choosing managed by a trusted realtor. The client still has the real estate risk, but some control over costs and liquidity.

"Let the buyer beware" is particularly meaningful when someone invests in a TIC 1031 exchange. Helping clients understand the risks and alternative strategies is our responsibility.

Seth Pearson, CFP

Pearson Financial Services

Dennis, Massachusetts

The IA Soapbox is reserved for Investment Advisor readers to sound off about an issue of importance to them. Please e-mail Jamie Green at jgreen@investmentadvisor.com.

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