People sometimes ask “Will Crowdfunding replace REITs?” That’s not exactly the right question.
A REIT – an acronym for Real Estate Investment Trust – is not a function of real estate law or corporate law. A REIT is solely a function of tax law. Section 856 of the Internal Revenue Code defines a REIT as a corporation, trust, or association that satisfies certain criteria, including these:
- At least 75% of the entity’s assets must consist of real estate assets or cash.
- The entity must have at least 100 owners.
- Interests in the entity must be transferable.
- No more than 50% percent of the interests in the entity may be held by five or fewer individuals.
There is only one benefit of qualifying as a REIT: as long as he distributes at least 90% of its income to its owners, the entity itself is not subject to tax. Only the owners are subject to tax, when they receive dividend and capital gain distributions. The whole REIT industry is built around this tax benefit.
Because the REIT label is solely a function of tax law, not corporate or securities law, a REIT can be:
- A publicly-registered company with publicly-traded securities; or
- A publicly-registered company with privately-traded securities; or
- A private company with privately-traded securities.
The second category of REIT is probably most common and, frankly, it is the category that has given REITs a bad name. Sold through the traditional broker-dealer channels, it is not unusual for the shares of publicly-registered, privately-traded REITs to carry a load of more than 10%, great for the broker, terrible for the customer. That’s why people say “Private REITS are sold, not bought.”
Compare a publicly-registered, privately-traded REIT to a garden-variety limited liability company owning real estate assets. In both cases, the entity itself pays no tax. And now, through Crowdfunding, the garden-variety LLC can solicit investors using the Internet, leading to transactions cost (load) much lower than the private REIT. Economically it’s a no-brainer: the Crowdfunded real estate LLC is better than the private REIT.
As I said, however, that’s really comparing apples with oranges. The REIT designation is about taxes; Crowdfunding is about how you find investors.
The real question is “Can I find investors for a private REIT using Crowdfunding, rather than through the traditional broker-dealer channels?” And the answer to that question is a resounding “Yes!” When you check the deals available at your favorite real estate Crowdfunding site tomorrow morning, you could well see a REIT.
And why would a sponsor offer a REIT rather than a garden-variety LLC? One reason – maybe the only reason – is tax reporting. An investor in an LLC receives a full-blown K-1 each year, and faces at least the theoretical risk of paying tax on “phantom” income. An investor in a REIT, on the other hand, receives only a simple 1099 and pays tax only on actual distributions.
Be that as it may, nobody should be paying a 10% commission. By connecting sponsors directly with investors, Crowdfunding promises to squeeze this kind of inefficiency out of the capital formation industry. Especially when Regulation A+ comes into effect, opening the market to non-accredited investors, there is every reason to believe that Crowdfunding will replace the traditional broker-dealer as the preferred method for distributing REIT shares.
Questions? Contact Mark Roderick.