Some consumers are confused by the distinctions between the numerous possibilities available to them as real estate investing becomes more popular. Should they put their money into a Delaware Statutory Trust (DSTs), a real estate fund, a tenant-in-common (TIC), a real estate investment trust (REIT), or a real estate crowdfunding website like Fundrise? All provide co-investment options, but every one has unique characteristics that could affect the choice of each investor.
The contrasts between each of these passive real estate investment vehicles are examined in this article. The possible merits and drawbacks of each will be discussed, with a focus on some of the potential tax advantages that investors may or may not be able to take advantage of with each, including 1031 exchanges.
Trusts that invest in real estate (REITs)
A company known as a "REIT," which stands for "Real Estate Investment Trust," owns and/or manages commercial real estate that generates income. REITs come in a variety of forms. Others are more open-ended in terms of product type and instead concentrate on specific geographies. Some specialize in particular product kinds, such as multifamily, retail, hospitality, senior housing, self-storage, industrial, etc (e.g., commercial real estate in the Southeast or Midwest).
A person purchases a share in the business that owns and manages the real estate when they invest in a REIT. They are not investing in a real estate asset or a portion of a real estate asset. Comparable to purchasing shares of Apple, Philip Morris, or Berkshire Hathaway is purchasing a REIT. You invest in the firm, not its particular products, when you purchase these stocks. The same idea holds true for REITs.
For those with little investment capital, REITs are a popular alternative to invest in commercial real estate. REITs have a low entrance cost; an individual share costs less than $100. The advantage of investing in REITs is that their shares are typically very liquid; publicly traded REIT investments may frequently be bought and sold with the click of a button, just like other equities or bonds. Those who wish to diversify their portfolios by investing in commercial real estate but who cannot or do not want to have their capital tied up for extended periods of time find REITs, at least those that are publicly traded as opposed to private REITs, to be particularly alluring.
An organization must satisfy the following requirements in order to be considered a REIT:
At least 75% of the total assets of the corporation must be made up of real estate;
That rental portfolio, which may comprise both rents and the sale of property, must provide at least 75% of the company's total revenue;
At least 95% of gross revenue must come from passive sources;
At least 90% of the company's taxable profits must be distributed to shareholders as dividends on a regular basis;
After the first year of operation, the company must have at least 100 shareholders, with no more than 50% of the total shares being held by five or fewer investors. Additionally, the company must be organized as a taxable organization that is governed by a board of directors or trustees.
One of the major challenges businesses encounter when attempting to qualify as a REIT is the demand for at least 100 shareholders.
Many REITs are traded openly on the stock exchange, unlike traditional real estate. REITs that are traded publicly must register with the SEC. Others are privately traded, in which case they are exempt from SEC registration requirements. Typically, privately traded REITs are only available to accredited and institutional investors.
The ability to preserve liquidity is the main advantage of investing in a publicly traded REIT. Their REIT shares are just as simple to trade as other stocks, bonds, and equity securities. REIT shares, on the other hand, are more erratic as a result. They fluctuate in value with the market, with shares sometimes doing so often on a daily basis.
The fact that REITs do not enjoy the advantages of real estate ownership, such as the mortgage interest deduction, depreciation, and 1031 exchanges, is another disadvantage of REITs. By selling an asset and then buying similar-type property with the profits, investors can use a 1031 exchange to postpone paying capital gains tax. Using 1031 exchanges, many investors can postpone paying capital gains taxes—often indefinitely—while shifting into higher-valued assets and expanding their real estate holdings. Investors in REITs are not permitted to use this significant tax-saving strategy, but DST and TIC investors are.
Property Equity Funds
Investment funds come in a variety of forms, such as mutual funds, money market funds, and hedge funds. Real estate funds are merely another category of investment funds that are solely dedicated to buying income-producing real estate.
An alternate means of investing in commercial real estate is through real estate funds. Real estate funds will combine money that has been collected from various investors and sources. Depending on the predetermined investment criteria of the fund, the fund will subsequently invest that money on behalf of the investors. Similar to REITs, some funds will define investment criteria based on the type of product (such as multifamily, retail, or office), while others will focus investments in a particular geographic area (such as the Northeast or Southwest) regardless of the type of product.
A stringent investing philosophy, such as value-add development or ground-up development, is also typically adopted by some real estate funds. Other funds can be established up to acquire and hold stabilized assets.
Typically, real estate funds are organized as either limited partnerships or limited liability corporations (LLCs) (LP).
In either scenario, they are typically led by a sponsor who has years—if not decades—of expertise in the real estate sector. The fund management will evaluate each investment opportunity and use the pooled funds to invest in a few chosen transactions depending on the fund's criteria.
Investors that prefer to be completely passive and delegate all duties to the sponsor are frequently drawn to real estate equity funds. Investors in funds should adopt a long-term mindset because assets are typically illiquid and tie up capital for years (and if withdrawn early, will be subject to fees and penalties). A fund's investment minimum is typically between $50,000 and $100,000, though it can often be significantly higher.
The sale of a property or portfolio of properties in a traditional LLC/LP offering does not provide passive investors with the same tax advantages as a TIC or DST, namely a 1031 exchange. Investors are responsible for capital gains and depreciation recapture when the property is sold, which results in a taxable event.
The "drop and swap" trade, which calls for the company (the LP or LLC) to execute "drop down deeds," which are deeds that transfer title out of the company and down to the individual members or partners as tenants-in-common (TIC) with undivided fractional interest, is the exception to this rule.
In order to comply with the 1031 rule that states that the property must be "kept for productive use in a trade or business or for investment," the TICs must continue keeping the property for a specific amount of time (usually, two years is seen to be the minimum). If not, the drop-down deeds are regarded as proof that the property is being held for sale, which disqualifies it from being eligible for a 1031 exchange. A few years of holding the property as TIC can help demonstrate investment intent. Individual investors can sell their TIC interest as surrendered property after the holding period has passed and either complete a 1031 exchange on their own or pay their respective capital gains and walk away with the sale profits.
Although drop and swap exchanges take a lot of effort and are rarely pursued by equity fund sponsors, it is important to remember that these swaps are technically feasible for those looking for the advantages of 1031 exchanges. People who want a more straightforward, well-defined method will typically choose to invest in a DST instead (see below).
Tenant-in-common, or TIC, ownership of real estate is another way to invest in it. Each co-owner of a TIC has a proportionate share of the property's title, according to their total equity contribution.
TICs are distinctive in that all participating members must agree to every choice, including the most basic ones like who to refinance with. Although the 35 members (or "co-owners") of TICs may appear like a tiny number, in reality, this might make decision-making more difficult. Additionally, it implies that investors are more active than those who participate in purely passive investment vehicles such as REITs, funds, or DSTs.
The federal government declared that TIC assets might benefit from 1031 exchanges at the beginning of the twenty-first century. Up until the Great Recession began in 2008, this led to an increase in TIC investments. When real estate prices fell, TIC popularity also fell. Investors were held individually responsible for the debt on the property (compare that to a DST in which it is the DST Sponsor that is solely liable for debt repayment, not the investors). During the economic downturn, TIC investors frequently found it difficult to come to consensus on the best course of action, and as a result, many TICs failed to survive. A number of these properties went under foreclosure, and investors completely lost their equity investments.
Due to the problems that TICs have revealed, many investors no longer like them. Instead, people seeking to co-own real estate typically make DST investments (more on DSTs below). It is important to note that TIC investors can use 1031 exchanges, which allows them to defer 100% of any potential gain and depreciation recovery from their initial investment. As a result, value-add investors seeking co-ownership will frequently choose TICs since DSTs typically only invest in stabilized, cash-flowing assets.
Deleware Statutory Trusts (DSTs)
Another form that is frequently utilized by persons looking to co-invest in real estate is a Delaware Statutory Trust, or DST. The majority of DST programs are provided by third-party broker dealers and sponsored by sizable, seasoned national real estate organizations. The property(ies) to be offered under the trust are purchased by the DST sponsor with their own money. The asset(s) are subsequently made fractionally owned by the DST sponsor available to investors. Investors are absolutely passive when it comes to DSTs.
A direct beneficial ownership interest in the underlying asset(s) is acquired by someone who invests in a DST, allowing them to report the item on Schedule E of their tax returns.
Due to this direct ownership interest, DST investors enjoy many of the same tax benefits as those who purchase and own real estate on their own, including the option to use depreciation to possibly offset income from the property. A 1031 exchange can be used by investors to invest in and out of DSTs.
Since the federal JOBS Act relaxed the restrictions on how people can raise funds for commercial real estate ventures in 2012, crowdfunding has gained popularity. Previously, project sponsors had to be personally acquainted with the investors in their projects, but today, sponsors are allowed to participate in "generic solicitation." Due to this, real estate crowdfunding websites like RealCrowd, Fundrise, and RealtyMogul among others came into existence.
In order to invest in real estate ventures, a project sponsor (often a real estate corporation, LP, or LLC) aggregates money from a large number of investors (dozens, if not hundreds).
Fundraising websites like Fundrise are essentially the same as the equity funds mentioned earlier. Instead of the sponsor having to hold individual meetings to pitch to investors, the platforms are just a tool for putting money into a fund online. These platforms allow sponsors to expedite their capital raising, but in the end, a person invests in a fund, not the platform.
As a result, much like with conventional equity funds, the investors won't be allowed to participate in a 1031 exchange when it comes time to sell the property. Investors are required to pay capital gains tax on their profits when they sell the property because this constitutes a taxable event.
Real estate co-investment can be done in a variety of ways. Each of these investment vehicles has advantages and disadvantages of its own, as well as varied levels of tax benefits. DSTs and TICs enable investors to use their 1031 exchange dollars, which is a substantial advantage.
Contact us right away if you're interested in finding out more about DST investments and 1031 exchanges. We would be pleased to go over the advantages of DST investing in greater depth with you as well as the current options.
Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
- * There is no guarantee that any strategy will be successful or achieve investment objectives;
- * Potential for property value loss - All real estate investments have the potential to lose value during the life of the investments;
- * Change of tax status - The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- * Potential for foreclosure - All financed real estate investments have potential for foreclosure;
- * Illiquidity - Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- * Reduction or Elimination of Monthly Cash Flow Distributions - Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- * Impact of fees/expenses - Costs associated with the transaction may impact investors' returns and may outweigh the tax benefits