There are many benefits to owning real estate – appreciation, diversification, mortgage interest deduction, and 1031 tax deferment are a few. However, not everyone has the capital to purchase high-end properties like a Donald Trump. Because of the high cost of real estate, many investors seek out angel funding and bank loans to make up their capital shortfalls. Yet, there is another way for an investor to own real estate, and that is fractional ownership. Fractional ownership is an investment structure that allows multiple investors to purchase a percentage ownership in an investment-grade asset.
Benefits of Fractional Ownership of Real Estate
Fractional ownership, formerly the province of the savvy mogul who has built a career owning, operating, leasing, and selling real estate, has attracted individual investors who seek an alternative investment to stocks, bonds, and mutual funds they may already own. Fractional real estate ownership and other alternative investments provide for diversification, and financial advisors will often dedicate 10% of a clients’ portfolio towards such vehicles.
The 3 T’s of Real Estate
Fractional ownership can be very attractive to real estate investors who wish to unburden themselves of real estate’s 3 T’s (tenants, toilets, and trash). The day-to-day realities of owning real estate - grounds maintenance, property up-keep, and leasing – are not an issue for fractional owners. Investors can enjoy all the benefits of a solid return while not laboring over the 3 T’s.
Options for Fractional Ownership of Real Estate
In the United States, there are two primary options for those interested in fractional real estate ownership: A Delaware Statutory Trust is a real estate investment vehicle that provides investors with access to investment grade real estate that is generally larger than they could have acquired on their own. The Taxpayer acquires a fractional interest (see below) in the property. Use of DSTs in 1031 exchanges was approved by the IRS in Revenue Procedure 2004-86. Delaware Statutory Trust (DST) and Tenant-In-Common (TIC) ownership. Each option has become increasingly popular as an alternative investment over the past decade because each affords opportunities for individual investors to own investment-grade property – commercial real estate with more income-generating potential than smaller residential property.
Tenant-in-common (TIC) is an investment property structure that was established during the 1990s and has grown in popularity since. Think of a TIC as a form of shared tenure rights to properties owned. Tenants-in-common each own a separate interest in the same real property. The advantages of a TIC are that each tenant-in-common has stronger buying power and fewer costs, and that each shares responsibilities for a property that is owned by the partnership.
Delaware Statutory Trusts (DSTs)
DSTs are legal entities created as trusts within the state of Delaware in which each investor owns a “beneficial interest” in the DST. DSTs have gained popularity over the last few years due to the ability to secure financing and attract more investors with lower minimum investment thresholds. Another advantage of a DST is that a lender underwrites a single borrower, as opposed to the multiple borrowers within the TIC structure. Furthermore, there is no stated IRS limit to the number of investors a DST may have, versus the 35 maximum of the TIC. Consequently, larger properties may be purchased while keeping the minimum investment size to around $100,000. Finally, DSTs do not allow for any input from beneficial interest owners, unlike TICs, which need to get unanimous approval from all TIC members.
Jokingly, a wise man once told me that a DST is the “Arnold Schwarzenegger version of a TIC.”
DSTs and TICs afford individual investors entry into large commercial property, either through a cash investment (typically $100,000 and up) or a 1031 exchange of real assets. Before investing in a DST or TIC, be certain to research the property and the company sponsoring the DST or TIC, and engage a qualified intermediary for your like-kind exchange.