By Lawrence Fassler
Some real estate crowdfunding companies offer equity real estate investments through “direct participation” investment vehicles such as limited liability companies (LLCs). These entities, together with similar vehicles at the property title-holding level, allow for the “pass-through” of depreciation, interest expense and other deductions that can reduce or defer investors’ taxable income. In addition, the payout structures within those entities are designed to align the interests of investors with those of the sponsoring real estate company.
Passive real estate investors generally invest in or alongside a professional real estate company—a “sponsor” or “operator”—that finds the opportunity and handles the related property management tasks. Such sponsoring real estate companies typically need other investors to provide some (or most) of the capital required for any single opportunity⎯and these investors will then share in some of the project’s benefits (and risks). How best to do that?
One way is via real estate investment trusts (REITs), which operate pools of many different properties and, if publicly traded, offer some degree of liquidity. Yet recent surveys estimate that institutional investors continue to place between 80 percent and 95 percent of their real estate allocations into private real estate investments, rather than publicly traded REITs. Some of this preference may be due to the fact that many publicly traded REIT securities get caught up in market sentiment and experience severe price volatility, just like common equities. Some of the appeal, too, lies in the inability of REITs to fully take advantage of the various tax benefits available through LLC structures.
Structuring Direct Participation Vehicles
With direct participation investments, the primary “internal” structuring issues revolve around how to divide the financial benefits of the project among passive investors and the sponsor. Investors want to know that a sponsor has sufficient “skin in the game”—its own investment capital—and that any extra “carry” or “promote” compensation to the sponsor comes only after investors have received some primary level of return, so that the sponsor’s interests are better aligned with those of investors.
The negotiations involved in particular transactions result in varying outcomes, of course, but over time some common patterns have emerged for many transactions:
- Provide the vast majority of the capital (usually 80 percent to 95 percent)
- Receive a “preferred return” on their investment (often 5 percent to10 percent annually)
- Receive most of the remaining cash flow and profits (typically 50 percent to 80 percent)
- Receive the bulk of the tax benefits (depreciation and interest deductions)
- Provides a smaller portion of the capital (usually 5 percent to 20 percent)
- Receives the same preferred return as investors on its own invested capital
- Receives a “promote” (carry) share of the remaining cash flow and profits
- May receive fees relating to property acquisition, loan financing and management
- Receives some share of the tax benefits
The “preferred return” to investors assures that investors putting cash into a project receive first priority on the project’s returns before any “sweat equity” of the sponsor gets compensated. The preferred return is not a guaranteed dividend payment, but if it’s not paid then in a timely manner it continues to accrue, and investors have a first claim on such amounts when the property is sold. Conversely, providing the sponsor with a “promote” interest on excess available cash flow tends to align its interest with that of investors, by incentivizing it to manage the property to a performance level where excess cash flow is rewarding it in a way that exceeds its own investment position.
Tax Advantages vs. REITS
In addition to often being property-specific (as opposed to operations involving only “pools” of properties), pass-through investment vehicles such as LLCs not only avoid double taxation but also allow investors to obtain the full benefit of tax losses or incentives. With real estate, the magnitude of the depreciation and interest expense deductions make this advantage potentially significant. The pass-through structures allow partners/members to receive “flow-through” of these sizable tax offsets, and thus to receive periodic distributions without incurring commensurate current taxes. Investors may ultimately have some or all of this tax benefit be “recaptured” by tax authorities upon a sale or other disposition—but in the meantime, they have tax-free use of the offset distributed cash.
REIT investors also generally receive income free of an entity-level tax, but a sizable difference remains; the distributions actually received from the REIT are still fully taxable as ordinary income. In addition, that income is characterized as “portfolio” income (like dividends), which means that it cannot be sheltered by losses from other “passive activities” of an investor, as they can be with direct participation structures. REITs do not, then, allow for net operating losses (NOLs) to be used to offset income from more “passive” activities.
REITs can also be less efficient vehicles in other ways:
- Unlike pass-through vehicles, a REIT’s income that is not distributed in the year it was generated is usually subject to an entity-level tax.
- A REIT is also subject to entity-level taxes on:
- its net income from foreclosure property
- income from “prohibited transactions” (taxed instead at a 100 percent rate)
- income resulting from inadvertent failures to meet REIT income source tests (also at 100 percent rate)
- undistributed capital gains
- Excise taxes can also be applied if the REIT fails to meet certain aggregate distribution amounts (measured across ordinary income, capital gain income and prior period undistributed income).
The ability to receive tax-deferred cash flow, and in some instances to be able to utilize NOLs, are major factors in favor of “direct participation” real estate investments made through an LLC pass-through entity. Crowdfunding sites like RealtyShares allow smaller investors to follow the lead of institutions in allocating most of their real estate investments into private pass-through entity syndicates, as opposed to less tax-efficient vehicles such as REITs. These LLC structures give investors access to the full benefits of real estate ownership such as being able to fully take advantage of the depreciation, interest, and other deductions that act to shelter or defer much of the income that is distributed from the investment property.
Risk Factors for Private Direct Participation Vehicles
The direct participation vehicles discussed above still carry significant risk factors. For example, all of the investments offered by RealtyShares are private offerings, exempt from registration with the SEC. The required disclosures associated with the offerings are therefore less detailed than an investor would typically expect from a registered offering, and ongoing disclosure requirements are negligible. The offerings are also illiquid, with no preset liquidity terms. An investor should have no expectation of liquidity before the final liquidation of the real estate project. Finally, because these offerings are only available to accredited investors, the liquidity in any circumstance will be more limited than for registered, publicly-traded securities.
DISCLOSURE: Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.