Controversial technique provides benefits for investors.

When SCI Real Estate Investments LLC bought the Puente Hills Shopping Center for $36 million earlier this year, the company and 16 investors used proceeds from other property sales, pooling their money to defer paying taxes on individual capital gains.

It's a newer, growing and sometimes controversial twist on the 1031 exchanges that have been used for nearly two decades, allowing sellers to roll proceeds into an equal or more valuable property without paying taxes.

What's changed is a 2002 ruling by the IRS that qualified tenants-in-common to use the 1031 exchange--spawning a fast-growing niche in the real estate industry. Now, companies like SCI are creating TIC funds structured to give investors a stable return of 6 percent to 7.5 percent, supported by the project's rents.

It's attractive because real estate prices are so high--and the available supply of office, retail and apartment properties so tight--that buyers are having a hard time finding 1031 replacement properties on their own.

"There's a tremendous amount of equity that has been locked for years inside families that own real estate," said Marc Paul, president and co-chairman of SCI Real Estate, based in Brentwood, which has closed $1 billion in tenant-in-common transactions. "We believe real estate shouldn't be a life sentence and that families should be able to sell their properties and receive steady income."

In a TIC transaction, the sponsoring company acquires a property, arranges the debt financing and sells fractional interests to a maximum of 35 investors. The investors receive a steady income stream that is higher than they would get on most income-producing properties these days.

To comply with IRS rules, the sponsor cannot manage the property directly, but must hire an outside management firm--an issue that has drawn the interest of regulators.

SCI takes a 20 percent stake in each property and pockets a fee that amounts to 4.5 percent of the building's purchase price. Its investors receive an average 6 percent annual return, Paul said.

Warning signs

Gary Beynon, founder and chief executive

Omni Brokerage Inc. in Salt Lake City, said there is increasing concern that tenant-in-common transactions could suffer a downturn similar to limited partnerships of the 1980s and 1990s, particularly if interest rates rise and property values drop.

"This is a fast-growing industry, commercial real estate is hot, and prices of the assets are reflecting the euphoria in the market," he said. In the past three years, tenant-in-common transactions have skyrocketed--and 60 percent to 80 percent of the investors are concentrated in Southern California, according to Omni, a real estate brokerage that tracks industry data. Still, the industry, with about $10 billion invested, is only a fraction of the overall $250 billion market for 1031 exchanges.

Several large real estate firms are joining the tenant-in-common bandwagon, including Parthenon Realty LLC of Atlanta and Adler Group of Miami, which now operates a 1031 exchange tenant-in-common unit. Meridian Realty Investments, of Boston and Starpoint Properties LLC, of Los Angeles, two private real estate companies, also have launched tenant-in-common programs focused on 1031 exchange investments.

The three-year-old industry has drawn the eyes of the Securities and Exchange Commission and the National Association of Securities Dealers. In March, the NASD published a notice to its members stating that tenant-in-common investments "generally are securities for purposes of federal securities laws and NASD rules."

The key issue is that some tenant-in-common sponsors structure their transactions as real estate investments, giving deeds and titles to investors for their fractional interest in a property. Others structure the sales as securities, distributing prospectuses similar to a private placement of stock.

Under both structures, investors end up paying either a finder's fee to their real estate broker or a commission to a securities broker.

But transparency is becoming a big issue. Some critics claim that real estates sponsors could be hiding fees or marking up the purchase price on properties and not fully disclosing those charges to investors. "It's a very uncertain area," said Jim Shaw, president and chief executive of Cap Harbor, a Beverly Hill real estate brokerage firm that is minority owned by East-Dil Realty Co., a unit of Wells Fargo & Co. "What really matters is who is the sponsor and how is the property being operated?"

In order to meet 1031 exchange guidelines, tenant-in-common sponsors that sell the investments as real estate cannot control the management of their properties. If they do so, they lose their tax status.

Two of the largest tenant-in-common sponsors, Triple Net Properties LLC in Santa Ana and Inland Real Estate Exchange Corp., a unit of Inland Real Estate Group of Companies Inc., of Chicago, sell their investments as securities. SCI sells its investments as real estate, but does not manage properties.

"We're somewhat controversial," said SCI's Paul, adding that the company has received legal opinions that support its structure.

Jean Harris, a lawyer at Greenberg Traurig LLP in Phoenix who specializes in tenant-in-common transactions, said she believes investors receive additional protection of regulators and more substantial disclosure if the investments are sold as securities.

"This is a new industry and investors have to realize that when they're in a tenant-in-common transaction, they have other people, other investors, to worry about," she said. "It's not the same as owning property yourself, outright."