The drawbacks of fractional real estate investments

Mortgage interest tax deductions cost the federal government $68.2 billion in 2012, according to an expert.
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John Corretti likes investing in real estate but buying locally doesn’t make a lot of sense.

“It’s very expensive and not very landlord-friendly, plus I don’t have several hundred thousand dollars and rents aren’t that great,” says the project manager for a New York software company. That leaves investing in real estate in other U.S. cities, but Corretti admits he doesn’t have the time or expertise to research those markets.

Even so, Corretti owns six properties: two in Cleveland and one each in Pittsburgh; Columbia, South Carolina; Atlanta; and Birmingham, Alabama. He bought them through HomeUnion and Roofstock — two online companies that convert real estate from an active to a passive investment.

“They do the research, crunch the numbers, and hook you up with a property manager,” Corretti says. “All I do is pay out the money. It’s like shopping on Amazon for real estate.”

And for Austin, Texas-based software developer Kevin Kaplan, New York is an attractive real estate option.

“Owning an apartment in New York would be awesome, but that’s a lot of capital, plus I’d need to hire a property manager,” he says.

Instead, Kaplan has bought slices of property through Compound, a New York-based company that launched in January and sells shares in real estate in New York, Miami, Nashville and Austin, Texas. He has also invested in properties through RealtyMogul, Fundrise, Sharestates and YieldStreet.

“I’m a fractional investor in both commercial and residential real estate,” he says.

Raising a red flag for some advisors, however, neither Kaplan (who has held now-expired Series 6, Series 63 and Series 65 licenses) nor Corretti used financial planners in weighing the pros and cons of these investments.

“These aren’t terrible investments,” says Gregory Young, a planner in North Kingston, Rhode Island. “But without a strategy and discipline, plus maybe a little help from an objective professional, it’s no longer investing. It’s speculating.”

“It’s very expensive and not very landlord-friendly, plus I don’t have several hundred thousand dollars and rents aren’t that great,” project manager John Correti says about buying locally in New York.

Nevertheless, Jennie Stewart, a partner and tax attorney at Kutak Rock LLP in Little Rock, Arkansas, says interest in online passive real estate companies is high, so planners should be aware that their clients may take an interest in fractional real estate ownership.

Highly specific bets
Fractional ownership lets clients make a highly specific bet on a city, neighborhood, and property — even when they don’t know enough about a city to make an educated call.

“These services offer easy access to the economics of rental property, without having to spend the time sourcing properties or performing normal landlord chores,” says Andy Panko, a CFP in Iselin, New Jersey.

However, he says, investors pay a premium for the access and convenience, and those extra costs can hurt the bottom line.

The other substantial drawback, Panko says, is the lack of liquidity. “Stocks, bonds, and mutual fund shares can be sold in a few days, but it takes a few weeks to a few months to consummate a real estate transaction.”

Moreover, he says, there’s an established market for selling homes and commercial properties. There’s no established market for a fraction of a condominium, though most fractional ownership companies say they hope to create one.

Nashville planner Shaun Melby adds that investors who want passive real estate exposure might be better off with a traditional, exchange-traded REIT, which diversifies by investing in hundreds or thousands of properties, rather than in one specific property.

Fixed-upper
Compound, the company Kaplan used to buy real estate shares, picks the property, acts as a sales broker and handles property management. The firm exclusively buys middle-market, single-family and residential properties in good condition, it says.

“This isn’t affordable housing or ultra luxury, and we’re not buying fixer-uppers,” says Janine Yorio, Compound’s CEO. “We’re buying new or near-new condos in good shape and renting them on 12-month leases.”

Each condo is owned by a single-purpose equity REIT, and a client can buy some or all of a particular property, with a $50 investment minimum. Shareholders receive semi-annual dividends from rental income and their share of the property’s appreciation when it’s sold. Business models vary between companies. The aim might be to rent the property, in which case the startup company finds a tenant before investors get involved. Or maybe the company’s goal is to renovate and flip the structure, paying off investors when the home or business is resold.

The client never paints a wall, runs a credit check, shampoos a carpet, argues with a contractor or fishes Legos out of a tenant’s plumbing.

In every case, however, the client never paints a wall, runs a credit check, shampoos a carpet, argues with a contractor or fishes Legos out of a tenant’s plumbing. The real estate company handles everything.

Ownership is typically wrapped as either shares of an equity REIT or of a Delaware statutory trust. Investments aren’t liquid until the property is sold. Investors take on market risk and pay income taxes on dividends and capital gains taxes when a property sells.

1031 exchange advantages
Depending on the legal structure, however, a fractional ownership investment can do something a REIT cannot: fit the needs of investors who want a 1031 exchange.

To be eligible as a 1031 exchange, fractional real estate investments must be shares in a Delaware statutory trust (some online real estate companies, including Roofstock, use this model). REITs and DSTs differ in their tax treatment. A DST is a direct interest in real estate, and so it is eligible for 1031 exchange rules and tax deferral. REIT shares are not.

DST shares also garner the tax benefits of direct real estate investments: taxable income gained through DST shares can be written off through deductions for interest and depreciation. REIT shares aren’t eligible for that treatment.

Planners should be aware that their clients may take an interest in fractional real estate ownership, says Jennie Stewart, a partner and tax attorney at Kutak Rock LLP in Little Rock, Arkansas.

Michael Whitman, a planner in Chapel Hill, North Carolina, has two clients who are using 1031 and 1033 real estate exchanges to invest in DSTs. The first client owned a beach house on the Jersey shore that she rented to vacationers throughout the summer.

“She was sick of dealing with tenants and tired of marketing the property, even though she liked the income,” Whitman says.

So Whitman and his client looked at alternative real estate investments and settled on private placement DSTs for accredited investors. His client, Whitman says, will get the main thing she wants: passive real estate income. She’ll also have some diversification — because she plans to choose a trust that owns multiple properties — tax deferral, and some depreciation. The client’s estate will get a step-up in basis when she dies.

1033 option
One of Whitman’s client families is pursuing the less common 1033 exchange. The clients own a farm in Tennessee and the government wants to put a road on the land where the farm currently stands.

Because the land has been transferred via gift over time, there’s been no step-up in basis over the years. “Three hundred years makes for a lot of capital appreciation, so they’re looking at millions of dollars in capital gain,” Whitman says.

Under eminent domain rules, these clients have three years to either reinvest the money in real estate or pay capital gains tax. A natural disaster, the other circumstance that creates an opportunity for a 1033 exchange, gives owners two years.

The farm was used for business income, so the family can’t use the money to buy new homes for themselves.

“The clients have the option of becoming direct property owners, or they could hand off the purchase and management completely,” Whitman says.

Direct ownership would let the family control everything: tenant choice, buy-date, sell-date, insurance company. But they would also have the headache of managing thse many complexities. With a DST, the family would give up control — and the headaches — while keeping passive income, depreciation and a future 1031 option.

Cash flow option
As for solo investors, Kaplan says it’s too soon to measure returns, while Corretti likes what he sees. From a cash-flow perspective, he’s simply paying off his mortgages. Counting cash flow, equity and appreciation, however, Corretti figures that he is earning 19.22% percent annually — not a bad return, he figures, on a property he’ll never see in person.

Young allows that, with professional guidance, fractional ownership could add diversity to an established investment plan. Even with that proviso, however, he says he would not recommend such an addition to the portfolio of a rookie client.

“I don’t think I would have a younger client that’s new to planning or investing move to this avenue,” Young says. “Maybe I would explore it as a viable source of income planning and income diversity for more established clients — maybe.”

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