Perch Weath Insights Blog

With real estate investing becoming more mainstream, some people are left wondering about the differences between the many options before them. Should they invest in a real estate investment trust (REIT), a real estate fund, as a tenant-in-common (TIC), through a Delaware Statutory Trust (DST), or through a real estate crowdfunding platform like Fundrise? All offer co-investment opportunities, but each has its own nuances that may influence how any investor decides to proceed.

In this article, we look at the differences between each of these passive real estate investment vehicles. The potential pros and cons associated with each will be reviewed and we will pay particular attention to some of the potential tax benefits that may or may not be available to investors with each one, including 1031 exchanges.

Real Estate Investment Trusts (REITs)

A REIT, which stands for "Real Estate Investment Trust," is a corporation that owns and/or manages income-producing commercial real estate. There are many kinds of REITs. Some specialize in specific product types (e.g., multifamily, retail, hospitality, senior housing, self-storage, industrial, etc.) whereas others are more open-ended in terms of product type and instead focus on specific geographies (e.g., commercial real estate in the Southeast or Midwest).

When someone invests in a REIT, they are buying a share of the company that owns and manages the real estate. They are not purchasing an actual property or a share of an actual property. Buying a REIT is similar to buying stock in Apple, Philip Morris, or Berkshire Hathaway. When you invest in these stocks, you are investing in the company - not their specific products. The same concept applies to REITs.

REITs are a popular way of investing in commercial real estate, especially for those who have limited funds to invest. REITs have a low barrier to entry; someone can buy a single share for less than $100. The benefit to REIT investing is that these shares are generally highly liquid; REIT investments, those that are publicly traded, can often be bought and sold with the click of a button just as you would trade other stocks or bonds. The liquidity of REITs, at least those that are publicly traded as opposed to private REITs, makes them particularly attractive for those who want 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.

In order to qualify as a REIT, a company must meet the following criteria:

Real estate must comprise at least 75 percent of the company's total assets;

At least 75 percent of the company's gross income must come from that rental portfolio, which may include both rents and the sale of property;

At least 95 percent of gross income must be generated passively;

At least 90 percent of the company's taxable income earned must be returned to shareholders on a consistent basis in the form of dividends;

The company must have at least 100 shareholders after its first year of operation, with no more than 50 percent of total shares being held by five or fewer of investors; and

The company must be structured as a taxable entity that is overseen by a board of directors or trustees.

The requirement to have at least 100 shareholders is often one of the biggest hurdles companies face when trying to obtain status as a REIT.

Unlike traditional real estate, many REITs are publicly traded on the stock exchange. Publicly traded REITs must be registered with the SEC. Others are privately traded, in which case they do not need to be registered with the SEC. Typically, only institutional and accredited investors have access to privately traded REITs.

The biggest benefit to investing in a publicly traded REIT is that it allows investors to preserve liquidity. Their REIT shares can be easily traded just as easily as other stocks, bonds and equities. Conversely, this means that REIT shares are more volatile. They experience ebbs and flows with the market, with shares sometimes fluctuating in value often on a day-to-day basis.

Another drawback of REITs is that, because of the structure of a REIT, they do not get the benefits that come along with owning real estate such as the mortgage interest deduction, depreciation, and 1031 exchanges. A 1031 exchange allows investors to defer paying capital gains tax if they take the proceeds from the sale of the asset and reinvest those proceeds into like-kind property. Many investors will use 1031 exchanges to defer paying capital gains taxes, often in perpetuity, while trading into higher-valued assets and growing their real estate portfolios. This is a major tax saving tool that is unavailable to REIT investors, but is available to those who invest in DSTs and TICs.

Real Estate Equity Funds

There are many types of investment funds, including mutual funds, money market funds, and hedge funds. Real estate funds are just another subset of investment funds in which the fund is focused exclusively on investing in income-generating property.

Real estate funds provide an alternative way for people to invest in commercial real estate. Real estate funds will pool capital that has been aggregated from multiple sources and investors. The fund will then invest that capital on behalf of investors depending on the fund's predefined investment criteria. Like REITs, some funds will set investment parameters based on product type (e.g., multifamily, retail or office) whereas others will concentrate investments in a specific geographic area (e.g., Northeast or Southwest) regardless of product type.

Some real estate funds will also usually have a strict investment philosophy, such as value-add development or ground-up development. Other funds may be structured to buy-and-hold already stabilized assets.

Real estate funds are usually structured as either a limited liability corporation (LLC) or limited partnership (LP).

In either case, they are generally spearheaded by a sponsor who normally has years, if not decades, of experience in the real estate industry. The fund manager will analyze all investment opportunities, and then invest in select deals, based on the fund's parameters, using the pooled capital.

Real estate equity funds are typically attractive to investors who want to be entirely hands-off, turning over all responsibilities to the sponsor. Fund investors should have a long-term mentality, as investments are illiquid and investors' capital is usually tied up for several years (and if withdrawn early, will be subject to fees and penalties). Funds also tend to have an investment minimum, usually no lower than $50,000 to $100,000 and often much more.

In conventional LLC/LP offerings, the sale of a property or portfolio of properties does not allow passive investors to reap the same tax benefits they would if investing in a TIC or DST-namely, a 1031 exchange. The sale of the property triggers a taxable event, with investors on the hook for capital gains and depreciation recapture.

The exception to this is when investors conduct a "drop and swap" exchange, which requires 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.

Before they can conduct a 1031 exchange, the TICs must continue holding the property for a certain period of time (generally, two years is considered the minimum) in order to meet the 1031 guideline that requires the property be "held for productive use in a trade or business or for investment". Otherwise, the drop-down deeds are considered evidence that the property is being held for sale, which disqualifies it from 1031 exchange eligibility. Holding the property as TIC for a few years helps show evidence of investment intent. Once the holding period expires, individual investors can sell their TIC interest as relinquished property and either conduct their own 1031 exchange or pay their respective capital gains and walk away with their proceeds from the sale.

Drop and swap exchanges are time consuming and one that few sponsors of an equity fund ever pursue, but it is worth noting that these exchanges are technically possible for those seeking the benefits associated with 1031 exchanges. Those looking for a simpler, more clearly defined process will generally opt to invest in a DST instead (see below).

Tenants-in-Common (TICs)

Another way to invest in real estate is as a tenant-in-common, or TIC. With a TIC, each co-owner holds a proportionate share of the title to the property based on their total equity investment.

TICs are unique in that decisions, even the most mundane like with whom to refinance, require consent of all participating members. TICs are limited to 35 members (or "co-owners), and while that may seem like a small group, in practice, this can complicate decision making. It also means that investors are more hands on than investors in a REIT, fund or DST - investment vehicles that are fully passive in nature.

In the early 2000s, the federal government announced that TIC investments may take advantage of 1031 exchanges. This caused a spike in TIC investments until the Great Recession hit in 2008. When real estate values plummeted, so did TIC popularity. Individual investors found themselves personally liable 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). TIC investors often struggled to compromise on how best to proceed during the economic downturn, and as a result, many TICs did not make it through to the other side. Several of these properties were lost to foreclosure and investors lost their equity investments altogether.

TICs have shown their flaws, and in turn, have fallen out of favor among many investors. Instead, those looking to co-own real estate will usually invest in a DST (more on DSTs below). However, it is worth noting that TIC investors can utilize 1031 exchanges and in turn, investors can defer 100 percent of the potential gain and depreciation recapture coming out of their initial investment. As such, TICs will often be used by value-add investors interested in co-ownership as DSTs generally invest only in stabilized, cash-flowing assets.

Delaware Statutory Trusts (DSTs)

A Delaware Statutory Trust, or DST, is another structure often used by those wanting to co-invest in real estate. Most DST programs are sponsored by large and experienced national real estate companies and offered through third-party broker dealers. The DST sponsor uses their own capital to acquire the property(s) to be offered within the trust. The DST sponsor then makes the asset(s) available to investors on a fractional ownership basis. DSTs are completely passive in nature to investors.

Someone who invests in a DST acquires a direct beneficial ownership interest in the underlying asset(s), meaning they can list the property on Schedule E of their tax returns.

Because of this direct ownership interest, DST investors benefit from many of the same tax advantages that investors realize if buying and owning property individually, such as the ability to use depreciation to potentially offset income generated from the property. People can invest in and out of DSTs using a 1031 exchange.

Crowdfunding Platforms

Crowdfunding has made a splash over the last several years, particularly since 2012 when the federal JOBS Act loosened the regulations for how people can raise capital for commercial real estate deals. Whereas project sponsors once needed to have a personal relationship with those who invested in their deals, now, sponsors could engage in what's called "general solicitation". This is what led to the emergence of real estate crowdfunding platforms like RealCrowd, Fundrise and RealtyMogul among others.

In short, real estate crowdfunding is when a project sponsor (usually a real estate corporation, LP or LLC) pools capital from many (dozens, if not hundreds of) investors to invest in their deals.

Crowdfunding platforms like Fundrise are really no different than the equity funds described above. The platforms are simply a tool for raising capital online, into a fund, instead of the sponsor having to host individual meetings to pitch to investors. Sponsors can streamline their capital raising using these platforms, but ultimately, an individual is investing in a fund and not the platform itself.

As such, and as is the case with traditional equity funds, when it comes time to sell the property, the investors will be unable to take part in a 1031 exchange. The sale of the property triggers a taxable event and investors must pay capital gains tax on their earnings.

CONCLUSION

There are many ways to co-invest in real estate. Each of these investment vehicles has its own pros and cons, including varying degrees of tax benefit. A significant benefit of DSTs and TICs is that they allow investors to utilize their 1031 exchange dollars.

If you are interested in learning more about DST investments and 1031 exchanges, contact us today. We would be happy to discuss the benefits of DST investing with you in more detail, as well as the offerings currently available.

General Disclosure

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 Arkadios Capital, member FINRA/SIPC. Advisory Services offered through Arkadios Wealth. Perch Wealth and Arkadios are not affiliated through any ownership.

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