Bear Market Has Investors Taking Closer Look at Real Estate — But Make Sure Investments Can Leverage All Potential Tax Benefits

Recent turmoil in the public markets has many investors moving away from volatility and scrambling for assets that make them feel more secure. In times of uncertainty, investors tend to move to a “risk-off” approach, moving away from perceived volatile assets to perceived stable assets. And in an already yield-starved environment, private commercial real estate is one of the few assets that act as a store of wealth and may produce meaningful current income.

Though most investors recognize the potential benefits of commercial real estate, historically, it has been a difficult asset class to access with underlying property values well beyond the means of the average investor. While publicly-traded REITs may provide more accessible exposure to commercial real estate, they tend to exhibit much of the instability of the greater public equity market.

When the Jobs Act was signed into law in April of 2012, it eased many stringent SEC regulations around private investing and crowdfunding. The law also opened the door for both novice and experienced private market real estate investors to access a much wider range of private market investment opportunities through crowdfunding.

Private investors no longer have to meet accredited investor status. This means that retail investors now can purchase equity positions in any number of multifamily or commercial real estate investments. These deals are available through real estate crowdfunding portals that provide opportunities to generate cash flow and gain appreciation.

The long-term and relatively stable nature of commercial real estate can make it an appealing investment option. However, investors should be aware that the way they begin their real property investment careers could have major financial implications when they are ready to cash out.

Crowdfunded LLCs and LPs don’t qualify for 1031 exchange tax benefits.

Despite the many benefits of real estate crowdfunding, there are some drawbacks. The majority of co-investment opportunities are formed as either limited partnerships or LLCs. While these investment entities have many advantages, they miss out on one of the most powerful wealth-building tools in real estate — the 1031 exchange.

1031 exchanges, also known as “like-kind exchanges” by the IRS, allow investors to defer capital gains taxes from the sale of real property if proceeds are reinvested in investment property. According to the IRS, like-kind exchanges are properties of the same nature, character, or class regardless of quality or grade. Examples include exchanging a multifamily complex for a warehouse, or raw land for a multifamily rental property.

Investors who participate in a 1031 exchange can potentially realize added growth from their initial capital investment without the burden of immediately paying taxes. Here’s a hypothetical example:

• An investor buys into a syndicated crowdfunding offering for a multifamily apartment building. If that property appreciates and is sold, the investor faces a depreciation recapture tax of 25 percent, and federal capital gains tax up to 20 percent. Additional taxes include state capital gains taxes and Medicare surtax. All in, the investor could potentially face as much as 45 percent tax on any realized gains.
• That same investor who participates in a 1031 exchange can defer 100 percent of potential gain and depreciation recapture taxes. The investor also can potentially continue generating cash flow and real property appreciation in the exchanged property.

Real estate crowdfunding provides everyday investors with increased access to deals they’d never see otherwise — but most fail to provide 1031 exchange eligibility. Fortunately, there are real estate crowdfunding investments that do qualify for 1031 exchange treatment: Delaware Statutory Trusts.

These investment vehicles have been around for nearly two decades now, and they continue to grow in popularity with both seasoned and novice real estate investors, due in large part to their tax deferment optionality. The tax deferral applies on the front end of the investment as replacement property for investors who have sold investment property. It also applies on exit for all investors, providing the opportunity to reinvest in DSTs or purchase direct investment property on a tax-deferred basis.

The Jobs Act significantly changed the real estate investment landscape. Crowdfunding portals boosted deal flow access and created a new class of retail real estate investors. However, syndicated investment opportunities structured as DSTs may provide the added benefit of allowing investors to defer any capital gains taxes and keep more of their equity working for them.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Examples are for illustrative purposes only.

Equity securities offered exclusively through Thornhill Securities, Inc., a registered broker/dealer and member of FINRA/SIPC("Thornhill"). Investment advisory services are offered through Thornhill Securities, Inc. a registered investment adviser. Realized Holdings, Inc. has a minority ownership interest in Thornhill Securities, Inc.

There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to sell any securities.