Real Estate Right Now is a video series covering the latest real estate trends and opportunities and how you can make the most of them. This episode discusses the difference between holders and developers, and why it makes a difference.

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An identity crisis in the real estate industry can make for costly tax obligations.  The real estate industry is diverse and there are many roles to play – investor, agent, broker, developer.  Each has its own tax ramifications. Before embarking on the purchase of a property, a buyer needs to ask himself some important questions in order to understand what role he is assuming. What is his business? Is he purchasing a property to hold and profit from as an asset? Is he purchasing a property to develop for sale?

Let’s start with some definitions. A real estate developer is someone who buys land and builds a real estate property on it or buys and improves an existing property. His intent in purchasing is to sell the property for a profit. A developer profits by creating real estate.

A holder or investor purchases a property with a long term intent. He intends to hold the property, rent it out and accrue revenues from it. A holder profits by possessing real estate.

Whether a purchaser defines himself as a holder or a developer is critical because the tax treatment of real estate holders provides certain benefits that are unavailable to developers.

A real estate holder may purchase a property, rent it out, collect income, and when he sells the property, his profit is taxed as a capital gain, as long as he’s held it for more than a year. That means that instead of being subject to the ordinary tax rate he had been paying on his rental income, his income from the sale will be subject to a lower, long term capital gains rate of 15%-20%. Holders are allowed to take advantage of a Section 1031 like-kind exchange to defer the recognition of their gains or losses that would otherwise be recognized at the time of a sale.

Because a holder may be challenged to prove that his intentions were to hold and utilize a property for the long term, it is advisable that he keep good records to support his status. Lease and rental agreements, advertising and listing information, and research efforts should be documented and saved in case his position is challenged by tax authorities after the sale of the property.

For a real estate developer, it’s a whole different picture. A developer is taxed like someone who is running a business that buys and sells real estate inventory. A real estate dealer, or developer, is defined as “an individual who is engaged in the business of selling real estate to customers for gain and profit.” Under this definition, a developer’s income, earned by the sale of his property, would be taxed as an ordinary gain, and taxed at the higher ordinary income rate of up to 37%. He may also be subject to self-employment taxes up to 15.3% (subject to OASDI limitations) as well as city taxes. Developers also cannot depreciate property held as inventory or use a Section 1031 like-kind exchange to defer income recognition. However, they may take advantage of their real estate selling expenses by taking them as ordinary business expenses and deducting unlimited ordinary losses.

Under the IRS Code, each individual property purchased is assessed independently, so one’s status as ‘holder’ or ‘developer’ is not absolute. A real estate entrepreneur may own a portfolio of rental properties which makes him a holder, and may simultaneously purchase and sell other properties, making him a developer as well. His tax status will depend on his intent for that individual property at the time of purchase.

Before purchasing, the savvy investor must be cognizant of his goals and make sure to structure his purchase properly at inception in order to avoid any tax surprises. Consult with your financial advisor regarding newly acquired or potential real estate assets.

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for, legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.

Real Estate Right Now is a video series covering the latest real estate trends and opportunities and how you can make the most of them. Part one of our mini-series on real estate investment through syndication focused on the use of a clause called a ‘waterfall provision.’ We’ll continue with part 2 of our series, which discusses syndication and carried interest.

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A real estate syndicate is an organization, or combination of investors, who pool together capital to invest in real estate.  The syndicate shares in the investment’s profits, even though it does not invest any of its own capital. When it realizes a profit, that profit  is called a ‘carried interest’ or a ‘promote.’ The carried interest serves as compensation to the syndicator for the risk it assumes during the development of the project and the efforts made prior to its sale.

If a property has been held for more than a year before it’s sold, the carried interest has traditionally been treated as a long term capital gain. This is important because Uncle Sam recognizes a carried interest as a return on investment. So, it’s taxed at a lower capital gains rate than is ordinary income.

However, the IRS later extended that holding period from more than one year to more than three years. Does this paralyze a syndicator for three years, disallowing favorable tax benefits on an earlier sale? Apparently not. On January 13, 2021, the IRS posted final Treasury Regulations for Section 1061 of the Internal Revenue Code. Section 1061 extended the 1-year holding period required for long-term capital gains treatment to a 3-year period for entities termed, “applicable partnership interests” (APIs).

Section 1061(c)(1) defines the term “applicable partnership interest” as “any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.”

There’s an interesting – and potentially profitable – caveat built into the IRS’ definition. Section 1061 rules inadvertently include a favorable exception for real estate investors. After careful review of the updated code, practitioners realized that this new restriction omitted interests resulting from certain services.  These services include investing and disposing of real estate held for rental or investment. In our scenario, the syndicate provides these real estate investment services for the investors. This means that a syndicator’s profits at the time a property is sold are the result of an allowable service that,  if held for one year, can be treated as a long term capital gain. It is free of the three year holding period requirement and subject to advantageous capital gains tax rates.

Here’s the bottom line: A syndicators’ profits at the time a property is sold will be treated as long term capital gain, free of the three year holding period requirement, and subject to advantageous capital gains tax rates.

Speak to your professional advisor about investing through syndication to build wealth.

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for, legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.

Roth&Co’s latest video series: Real Estate Right Now.

Presented by Alan Botwinick and Ben Spielman, co-chairs of the Roth&Co real estate department, this series covers the latest real estate trends and opportunities and how you can make the most of them. Part one of our mini-series on syndication focuses on the use of a clause called a ‘waterfall provision.’

Watch our short video:

A real estate syndicate is formed when an individual, partnership or organization pools together outside capital and invests in real estate. The syndicator will do all the groundwork on behalf of the investors, or “partners”, and will research, locate, purchase and eventually manage the investment property. Although the syndicator puts in sweat equity, it doesn’t invest any of its own capital.

There are several ways that a syndicator can share in the investment’s profits, and the role that each player assumes in the real estate transaction will determine its share. Those roles are explained in the “waterfall provision” found in their partnership agreement.

A ‘waterfall,’ also known as a waterfall ‘model’ or ‘structure,’ is a legal term that appears in a partnership’s operating agreement that describes how and to whom distributions are made. The property’s profits from operations, or from a “capital event” (i.e. refinance or sale), are allocated to the investors based on the terms of the waterfall provision. In the example in our video, the investors agree to contribute $2 million towards the property’s purchase. They make it a 70%/30% split and decide on an 8% “preferred return” on their $2 million capital investment.

Here’s how it will play out: The syndicator keeps an accounting of the property’s cash flow over the course of their ownership and will wait until the investors have been satisfied as specified in the waterfall agreement. In our example, the agreement ensures that the investors earn 8% of their capital investment – that would be $160,000, or 8% in preferred returns – and recoup their original $2 million investment. The syndicator will benefit from the profits of the operation, or its sale or refinance, only after the investors have recouped $2,160,000, (the amount of their capital investment and preferred returns). When the terms are satisfied, the syndicator will earn its 30% share of any residual profits, and the remaining 70% will be shared among the investors. It’s a win-win.

When distributions are made based on the profits of a property’s operations, it results in steady payments over the life of the property. However, it’s very common, and often very profitable, for an ‘event’ to accelerate the waterfall process. If the property is sold or refinanced, profits are actualized quickly and monies are released for distribution quickly. In either case, real estate investment by syndication offers an investment model that can benefit investors at many levels and presents profitable opportunities for syndicators and non-real estate professionals alike.

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for, legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.

Roth&Co’s latest video series: Real Estate Right Now.

Presented by Alan Botwinick and Ben Spielman, co-chairs of the Roth&Co Real Estate Department, this series covers the latest real estate trends and opportunities and how you can make the most of them. This episode discusses how the tax-deferred benefits resulting from a 1031 exchange can help investors build a more valuable real estate investment portfolio.

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What is a 1031 exchange?

In 1921, Section 1031 was entered in the US Internal Revenue Code and the ‘1031 exchange’ was born. Under specific criteria, a 1031 exchange allows an investor to sell his property, reinvest in a similar property of equal or greater value, and defer payment of capital gains taxes until that second property is ultimately sold.

Eligibility for a 1031 exchange is reserved for real property that is “held for productive use in a trade or business or for investment”. This kind of property could include an apartment building, a vacant lot, a commercial building, or even a single-family residence. Properties held primarily for personal use do not qualify for tax-deferral under Section 1031. There are specific types of property that don’t qualify for a 1031 exchange, including business inventory, stocks and bonds, securities and partnership interests.

Your reinvested property must be “like kind,” or of the same nature, as the property being replaced. The definition of “like kind” is fairly loose, and IRS considers real estate property to be like-kind regardless of if or how that property has been improved.

Benefits

The obvious benefit of a 1031 exchange is that you get to hold onto your money for longer and have more funds available to take advantage of other investment opportunities. A 1031 exchange could also yield tax-shielding benefits, such as depreciation and expense deductions and capital returns at a refinance. A 1031 exchange is also useful for estate tax planning. Tax liabilities end with death, so if you die without selling a property that was invested through a 1031 exchange, your capital gains tax debt disappears. Not only that, but your heirs will inherit the property at a stepped-up market-rate value.

Details and Dangers

A 1031 Exchange has a very strict timeline. The replacement property, which must be of equal or greater value, and must be identified within 45 days. The replacement property must be purchased within 180 days. One potential pitfall investors face when deciding to implement a 1031 Exchange is that, because of the time pressure, they may rush to commit to an investment choice that is less than worthwhile. For that reason, potential investors are advised to plan ahead when considering a 1031 exchange. In order to get the best deal on a replacement property, don’t wait until the original property has been sold before starting to research replacement options. 

45-Day Rule

When an investor sells his property and chooses to do a 1031 Exchange, the proceeds of the sale go directly to a qualified intermediary (QI). The QI holds the funds from the sold property and uses them to purchase the replacement property. As per IRS 1031 rules, the property holder never actually handles the funds. Also within the “45 day rule”, the property holder must designate the replacement property in writing to the intermediary. The IRS allows the designation of three potential properties, as long as one of them is eventually purchased.

180-Day Rule

The second timing rule in a 1031 is that the seller must close on the new property within 180 days of the sale of the original property. The two time periods run concurrently, so for example, if you designate a replacement property exactly 45 days after your sale, you’ll have only 135 days left to close on it. To determine the 180-day time frame, the IRS counts each individual day, including weekends and holidays.

1031 Exchange Tax Implications

What happens when the purchase price of your replacement property is less than the proceeds of the sale of your original property? That cash – known as the “cash boot” – will be returned to you after the closing on the replacement property, but it will be considered as sales proceeds and taxed as a capital gain.

Another important factor to remember is that if you have a mortgage, loan or other debt associated with the exchange, and your liability goes down, that sum will also be treated as income. For example, if you had a mortgage of $1 million on your original property, but your mortgage on the replacement property is only $900,000, you will enjoy a $100,000 gain. That $100,000 is the “mortgage boot”, and it will be taxed.

The 1031 Exchange is a tax-deferred strategy that any United States taxpayer can use. It allows equity from one real estate investment to roll into another and defers capital gains taxes. It’s like having an interest free loan, compliments of the IRS. Savvy investors can put that extra capital to work and acquire a more valuable investment property, painlessly building wealth over time. Over the long term, consistent and proper use of a 1031 Exchange strategy can provide substantial advantages for both small and large investors.

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.

Roth&Co’s latest video series: Real Estate Right Now.

Presented by Alan Botwinick and Ben Spielman, co-chairs of the Roth&Co Real Estate Department, this series covers the latest real estate trends and opportunities and how you can make the most of them. This last episode in our valuation metrics mini-series discusses one final metric: Discounted Cash Flow.

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DCF, or Discounted Cash Flow, is used to determine the total monetary value of an asset in today’s dollars and is a powerful tool for valuing businesses, real estate investments or other investments that project to generate profits and cash flow.

DCF studies a potential investment’s projected future income and then discounts that cash flow to arrive at a present, or current, value. It adds up the property’s future cash flow from the time of purchase until the time of its sale and all the activity that happens in between. It takes into account the property’s initial cost, annual cost, estimated income, operating costs, renovations, changes in occupancy and its future selling price, among other factors. At the end of the assumed investment period, an exit price is determined using the building’s metrics in the year of disposition. The entire cash flow stream, including the forecasted profit from the investment’s sale, is then discounted back to the current period using a discount rate.

The discount rate represents the rate of return that is required of the investment based on its risk. The higher the risk, the higher the return required by the investor, and the more we have to discount the investment’s value. A higher discount rate implies greater uncertainty, and that means a lower present value of our future cash flow. On the flip side, the lower the perceived risk in an investment, the lower the discount rate.

The DCF metric is an influential tool, but it has its drawbacks. The upside of the DCF model is that it is very customizable and able to be tailored to the facts and circumstances, such as projected renovation costs or market changes. The downside is that the model is very sensitive to changes in its variables. For example, a change in the discount rate of less than 1% can have a 10% effect on the value of the investment. There is a lot of assumption and estimation involved, and small changes can have a big impact on the end-result.

Whereas it may not always be accurate or applicable for every situation, the DCF calculation remains a formidable tool in the investors’ arsenal and, combined with other important metrics, allows the investor to assess the present value, risk and potential profitability of a real estate investment.

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.