What if someone offered you a chance to buy a pay phone for $7,000? Before you rush to judgment, did I tell you that because of deregulation there is tremendous opportunity for growth in this industry? Wait! Don't put down that checkbook just yet. What if I told you that I would manage and operate the phone for you, that I would pay you a 14% annual return and that I would buy the thing back for the full purchase price if you asked? Sounding a little better? Hold that thought for a few minutes.

What if instead, I gave you the opportunity to purchase a fractional interest in a piece of income-producing real property? This is your chance to own commercial real estate, occupied by a credit tenant, for as little as a couple of hundred thousand dollars. This is your chance to move money out of the woeful equity markets and to invest in something more reliable. The catch is that you will be a co-owner along with up to 34 strangers. You also will turn over day-to-day control of the asset to a company that you don't know well. Sure, they've been in business for four years and are located on the other side of the country, but you are still skeptical.

Which sounds more appealing? Well, at least 10,000 hard-working Americans chose the pay-phone deal. They lost most, if not all, of their initial investment. The second option has developed quite a following in the last few years. The results, for these faithful followers of "tax-deferred" transactions, are sure to be more profitable. This article discusses the impact of recent case law on the tenant-in-common (TIC) exchange industry.

What do these two scenarios have in common? The answer potentially is found in the United States Supreme Court. Justice Sandra Day O'Connor declared in SEC v. Edwards that the pay-phone deal qualified as a "security," subjecting the deal to the registration requirements and antifraud provisions of federal securities laws.

The Court relied on a long line of precedent involving the definition of "investment contracts" to reach its decision. Such contracts are subject to securities laws. Those cases determined that an "investment contract" is one in which the "scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others." The Court confirmed its earlier approach to applying this definition broadly and determined that it wasn't important that the scheme in question promised fixed returns.

With the issuance of Revenue Procedure 2002-22, the Internal Revenue Service opened the door for the proliferation of TIC exchanges. Although, TIC interest exchanges were already in the mainstream somewhat, this revenue procedure confirmed that such interests would be treated as "real property" for tax purposes. Rev. Proc. 2002-22 provided guidelines for obtaining a ruling from the IRS as to the structure of specific transactions.

These guidelines include, among other things, the following restrictions:

Tenancy in Common Ownership. Each of the co-owners must hold title to the Property (either directly or through a disregarded entity) as a tenant in common under local law.

Number of Co-Owners. The number of co-owners is limited to thirty-five. Husband and wife are viewed as one owner for this purpose.

No Treatment of Co-Ownership as an Entity. Basically, the co-owners cannot act as if they are part of a partnership or other organized business entity (i.e. no common name and no tax return).

Co-Ownership Agreement. Fortunately, the procedure allows the co-owners to enter into an agreement that governs property. Prior to 2002-22, drafters had to walk the tight rope between "control" of the property and avoiding classification as a partnership. Many even believed that they could not risk formalizing the agreement of the co-tenants for fear of creating a partnership.

Voting. Essentially, any significant action taken with respect to the tenants -in-common arrangement must meet with the approval of all of the members. Such actions include hiring a manager, leasing of the premises, sale of the property or obtaining any blanket financing.

Restrictions on Alienation. Fundamental to the ownership of real property is the right of the owner to transfer, encumber or otherwise dispose of such property. In the context of valid tenants-in-common arrangements the same principle applies; however, the I.R.S. has recognized the need among co-owners for some restriction on alienation. The co-tenancy agreement may grant a right of first offer in the non-selling owners or the sponsor.

Proportionate Sharing of Profits and Losses. All expenses and revenue of the property will be shared by the owners in proportion to their ownership interest. Since funds cannot be advanced to a co-owner by a co-owner or sponsor to cover costs, it begs the question of what recourse is available against a co-tenant for failure to pay its respective share.

Options. The revenue procedure allows for the owner's to issue call options at fair market value. It does not allow a co-owner to issue a put in favor of any co-owner, sponsor or related party.

No Business Activities. While the I.R.S. intends that the valid co-ownership arrangement would be one that is predominantly passive, it has recognized that certain actions must be taken in connection with the use, operation and maintenance of the property. The revenue procedure allows the co-owner's to take such actions as are "customarily performed in connection with the maintenance and repair of rental real property".

Management and Brokerage Agreements. Assisting the co-owners in the operation of the property, the I.R.S. has approved the use of management and brokerage agreements. The investor looking for a truly passive investment will benefit form this allowance. Permitted activities of the manager include: collecting rents, preparing operating statements, obtaining insurance, negotiating financing for the property, and negotiating leases.

Payments to Sponsor. As with most of the provisions of the revenue procedure, the owners and sponsor are required to treat the deal like a typical real estate deal. Thus, the amount paid to the sponsor for the interest must reflect the market value of such real estate. The purchase price cannot be based, in whole or in part, on the income of the property.

As a result, sponsors of TIC offerings have used the Revenue Procedure as a roadmap for structuring deals and generally forego a letter ruling from the IRS. Specifically, this roadmap resulted in greater confidence in sponsors offering TIC interests as a product to lure investors into the world of commercial real estate. A thriving industry of TIC offerings has emerged. As opposed to REIT ownership, TIC interests may qualify as real property, affording taxpayers the ability to purchase TIC interests as replacement property in their like-kind exchanges. REIT interests on the other hand are ineligible property for 1031 exchange purposes.

This industry allows investors to invest collectively in real estate that they could not afford individually. As with any thriving market, there is the potential for exploitation and abuse. While most TIC offerings are presented by reputable sponsors, less professional and reliable companies have emerged.

The Edwards decision is important to the TIC industry and to consumer protection. While the case revolved around a pay-phone scheme, it is applicable for at least two reasons. First, since the scheme in Edwards involved a sale and lease-back of the pay-phone sites, it is analogous in many ways to the TIC offering. Second, the confirmation by the Court of a broad reading of the precedent suggests that TIC offerings would receive similar treatment. As a result, sponsors of TIC offerings now need two sets of lawyers. One set will opine on the tax treatment of the transaction, and the other set will ensure compliance with securities laws.

Since many of the sponsors offering these TIC products were already treating them as securities, the impact of this decision may be as limited as solidifying that these interests need to be offered as securities instead of real-property interests. Many of the companies, if not most, have already taken this route and are packaging their product as securities. Those that aren't probably should seek counsel about how they can comply.

Because of the potential for prosecution under the anti-fraud provisions of Section 10(b)-5, many non-legitimate sponsors may be discouraged from "hustling" unsuspecting investors. No application of these rules can deter the truly devious mind, but perhaps this is a step that investors can look to for comfort. Legitimate companies are more likely to comply with these laws. The levels of disclosure required in offering statements and prospectuses will allow the investor to perform more readily the basic levels of due diligence and facilitate informed decision making.

And while there is no trade group governing the TIC industry, most of the reputable groups are members of the Federation of Exchange Accommodators. Confirmation of this will add more comfort, as well.