The biggest financial fear about so-called "1031 TIC" real estate investment deals appears to be turning into reality: One of the largest "tenants in common" or "TIC" firms -- with 8,300 individual investors and office and retail properties valued at $2.4 billion -- has filed for Chapter 11 bankruptcy protection.

The firm, DBSI of Boise, Idaho, was part of an investment wave that followed a 2002 ruling by the IRS. That ruling said owners of commercial and residential income properties could fulfill the tax-deferral requirements of Section 1031 of the Internal Revenue Code by investing in tenants-in-common ventures.

Under Section 1031, investors who seek to avoid or defer capital gains taxes on their properties can exchange their interests for "like kind" real estate, provided they follow IRS guidelines.

In 2002, the IRS ruled that tenants-in-common arrangements -- under which as many as 35 investors own fractional interests in individual properties -- can qualify as vehicles for 1031 exchanges. For example, an owner of a small retail shopping strip might exchange into a TIC that owns a much bigger and more valuable downtown office building.

The tenants-in-common owners could thereby avoid immediate taxation of capital gains and end up with bigger and theoretically higher-quality real estate - tax free - in the process.

The TIC structure comes with built-in problems, however. Their fractional interests generally are not liquid investments -- it's tough to sell them if you need to pull out money..

Some critics also say TIC ventures pay too much for their commercial properties, and that investors have been charged excessive fees to participate.

DBSI managed the activities of dozens of office, retail and other commercial properties in 30 states, but says it got caught up in the real estate downturn and credit crunch.

Now its eight thousand-plus individual investors are stuck in illiquid TICs … and waiting to hear what happens to them next.

The DBSI bankruptcy comes on the heels of recent advisories from the Federal Trade Commission and the Treasury Department warning investors about potential dangers in 1031 exchanges.

Bottom line: Section 1031 exchanges -- structured and facilitated by independent, qualified intermediaries -- can be a great way for small scale and large investors to save on taxes.

TICs may also fit into the equation, but only if investors fully understand all the risks, including, now in the wake of the DBSI implosion, the possibility that their TIC may go belly up, leaving investors waiting in line at the bankruptcy court hoping for pieces of the remains.

Published: November 28, 2008

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consmer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.