Tag Archives: REIT Crowdfunding

REITS vs. Pass Through Entities: Section 199A and Real Estate Crowdfunding

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The 2017 tax act added §199A to the Internal Revenue Code and, with it, two complementary tax deductions:

  • A deduction of up to 20% of the income from a limited partnership, limited liability company, or other “pass through” entity.
  • A deduction equal to 20% of “qualified REIT dividends.”

Which is better for sponsors and investors?

As described here, the 20% deduction for pass-through entities is enormously complicated. Most important, the deduction can be limited for taxpayers whose personal taxable income exceeds $157,500 ($315,000 for a married couple filing jointly). These limits depend on the W-2 wages paid by the pass-through entity (not much for most real estate syndications) and the cost of the entity’s depreciable property (pretty substantial for most real estate syndications). And, naturally, those limits are themselves subject to special rules and definitions.

In contrast, the 20% deduction for qualified REIT dividends (which includes most dividends from REITs, other than capital gain dividends) is straightforward, with no cutdown for higher-income taxpayers.

Does that mean §199A favors REITs over LLCs and other pass-through entities? Not necessarily.

The key is that most real estate syndications don’t generate taxable income. Typically, the depreciation from the building “shelters” the net cash flow, at least during the early years of the project. The tax-favored nature of real estate is, in fact, part of what makes it such an attractive investment in the first place.

If an investor in an LLC is receiving cash flow from the syndication and paying zero tax, the 20% deduction of §199A is irrelevant. And, for that matter, so is the 20% deduction for REIT dividends. If a REIT isn’t generating taxable income because its cash flow is sheltered by depreciation, then its distribution will probably treated as a non-taxable return of capital rather than a taxable dividend.

As discussed here, the key advantage of a REIT over an LLC or other pass-through entity is that the LLC investor receives a complicated K-1 while a REIT investor receives a simple 1099. The relative simplicity of the 20% deduction for REIT dividends over the 20% deduction for pass-through entities is nice, but wouldn’t tip the balance in favor of a REIT by itself.

Questions? Let me know.

Amendments and Supplements in a Regulation A Offering

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Your Offering Statement has been qualified by the SEC. Now something changes. Do you have to file something with the SEC? If so, what and how?

Changes Reported on Form 1-U

Some changes must be reported using Form 1-U:

  • If the issuer has entered into or terminated a material definitive agreement that has resulted in or would reasonably be expected to result in a fundamental change to the nature of its business or plan of operation.
  • The bankruptcy of the issuer or its parent company.
  • A material modification of either (i) the securities that were issued under Regulation A, or (ii) the documents (g., a Certificate of Incorporation) defining the rights of the securities that were issued under Regulation A.
  • A change in the issuer’s auditing firm.
  • A determination that any previous financial statements cannot be relied on.
  • A change in control of the issuer.
  • The departure or termination of the issuer’s principal executive officer, principal financial officer, or principal accounting officer, or a person performing any of those functions even if he or she doesn’t have a title.
  • The sale of securities in an unregistered offering (g., Rule 506(c)).

Form 1-U may be used, at the issuer’s discretion, to disclose any other events or information that the issuer deems of importance to the holders of its securities.

NOTE:  If an event has already been reported on an annual or semi-annual report, the same event does not have to be reported again on Form 1-U.

NOTE:  A report on Form 1-U must be filed even if the Regulation A offering has ended.

Amendments

After the offering is qualified by the SEC, the issuer must file an amendment of its Offering Statement “to reflect any facts or events arising after the qualification date. . . .which, individually or in the aggregate, represent a fundamental change in the information set forth in the offering statement.”

Examples of fundamental changes:

  • A change in the offering price of the security.
  • A change in the focus of the issuer’s business, g., we were going to focus on cryptocurrencies, but now we’re pivoting to blockchain-based financial services.
  • The bankruptcy of the issuer.
  • A change in the type of security offered, g., from preferred stock to common stock or vice versa.

An amendment of an Offering Statement must be approved by the SEC before it becomes effective, which means waiting.

Even more important, depending on the nature of the change, the issuer might be required to stop selling securities or even stop offering securities (i.e., shut down its website and all marketing activities) while the amendment is pending.

Supplements

After the offering is qualified by the SEC, the issuer must file a supplement of its Offering Circular to reflect “information. . . .that constitutes a substantive change from or addition to the information set forth” in the original offering circular.

Examples of substantive changes or additions:

  • A new Chief Marketing Officer joined the management team.
  • The issuer’s patent application, disclosed in the original Offering Circular, was approved.
  • The issuer moved its principal office.

Unlike amendments, supplements do not require SEC approval and do not require that that the issuer stop selling or issuing securities. Instead, the supplement must be filed with the SEC within five days after it is first used.

Real Estate Supplements

While its offering is live, an issuer in the real estate business — a REIT, for example — must file a supplement “[w]here a reasonable probability that a property will be acquired arises.” Not when the property is purchased, but when there is a “reasonably probability” that it will be purchased.

The SEC doesn’t specify what information to include in these supplements, except to disclose “all compensation and fees received by the General Partner(s) and its affiliates in connection with any such acquisition.” Including a statement of any significant risks associated with the property is a good idea, too.

Having filed a separate supplement for each property, the real estate issuer must then file an amendment at least once every quarter that consolidates the supplements and includes financial statements for the properties. Notwithstanding the general rule for amendments, however, the issuer doesn’t have to stop offering or selling securities pending SEC approval.

Supplement vs. Amendment

An amendment is required for “fundamental changes,” while only a supplement is required for “substantive changes.” Where to draw the line?

There’s a lot at stake. If an issuer uses a supplement where it should have used an amendment, it will be using an Offering Statement that has not been qualified by the SEC. Meaning, the whole offering will be illegal.

The SEC won’t say whether it believes a given change requires a supplement or an amendment, leaving the decision to the issuer and its lawyer. The SEC will, however, allow an issuer to file an amendment even for non-fundament changes, i.e., where a supplement would have done the trick. Filing an amendment takes a little longer, costs a little more, but eliminates the risk of guessing wrong.

Often, however, an issuer wants to make a change but doesn’t want to go through the amendment process. In those cases, the rule of thumb should be as follows:

Would an investor of ordinary prudence want to re-think his investment decision based on the new information?

If the answer to that question is Yes, the new information should be provided via amendment. If the answer is No, it can be provided supplement.

For example, an investor who liked the cryptocurrency space might not be interested in the financial services space, while the addition of a new CMO might be interesting and useful, but unlikely to affect the investment decision.

Contrary to popular belief, the main risk of this or any other violation of the securities laws is not that the SEC will bring your offering to a screeching halt or fine you. Those things are possible, but the SEC has more important things on its plate. The main risk is that an investor will lose money and hire a clever lawyer, who will then seize on your mistake (or your alleged mistake) as grounds to get the investor’s money back.

Supplement vs. Form 1-U

If a change falls within any of the specified categories of Form 1-U, then it should be reported on Form 1-U rather than via supplement.

If the offering has ended, then supplements are no longer relevant and changes should be reported on Form 1-U.

If the offering is still live and the change does not fall within any of the specified categories of Form 1-U, then it can be reported on either Form 1-U or via supplement, take your pick. However, supplements may not be accompanied by exhibits. So if you need to change or add an exhibit (e.g., you’ve modified your Subscription Agreement or entered into a material contract that doesn’t constitute a fundamental change), you should use form 1-U.

Questions? Let me know.

Two Related Party Rules In Title III Crowdfunding

Title III includes two definitions about related parties, similar but not identical.

The first definition dictates who is subject to the $1 million-per-year limit on raising money. There, the regulations provide that the limit applies not only to the issuer itself (the company raising money), but also to “all entities controlled by or under common control with the issuer and any predecessors of the issuer.” To determine who controls whom, the regulations borrow the definition from SEC Rule 405:

The term ‘control’ means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of the entity, whether through the ownership of voting securities, by contract or otherwise.

This means, for example, that if Company X is raising money using Title III, then Company X and all members of the same corporate family are subject to the same $1 million cap, even if other members of the corporate family are engaged in very different businesses.

(Don’t even think about having your husband or girlfriend or best friend from college own the other businesses get around the rule. It doesn’t work.)

This is a very broad rule and, like so much of Title III, very different than anything we’ve seen before in the U.S. securities laws. For example, while Issuer X may include only 35 investors in an offering under Rule 506(b), Issuer X is allowed to have multiple offerings – an apartment building in this offering, an oil and gas development in this offering, a social media app in a third offering – and include 35 non-accredited investors in each.

Similarly, in Title IV an issuer can raise up to $50 million for a mortgage REIT. Nothing stops a company under common control with the issuer from raising another $50 million for a REIT that buys office buildings.

Why the stricter rule for Title III? I would say that, consistent with the whole Title III paradigm, the goal was to reserve Title III for little guys, the neighborhood businesses, while keeping the professional financiers from Wall Street and Silicon Valley out. It’s part of the big compromise that allowed enactment of Title III in the first place.

The second definition around related parties in Title III dictates who on the portal side may own securities of the issuer. The rule is that:

  • The portal itself may own a financial interest in the issuer only if (1) the portal received the financial interest as compensation for the services provided to or for the benefit of the issuer, and (2) the financial interest consists of the same securities that are being offered to investors on the portal’s platform.
  • No director, officer, or partner of the portal, or any person occupying a similar status or performing a similar function, may own a financial interest in an issuer.

The term “financial interest in an issuer” means a direct or indirect ownership of, or economic interest in, any class of the issuer’s securities.

This rule means, for example, that:

  • A portal may not raise money for itself on its own platform.
  • Neither the portal nor any of its directors, officers, or partners may invest in an issuer before it raises money on the portal (they could invest afterward).
  • Purely contractual arrangements, not relating to the securities of the issuer, are okay.

The rule about financial interests doesn’t use the words “common control” but, because a portal is controlled by its directors, officers, and partners, the result is nearly the same. But not identical. In a typical Crowdfunding structure, for example, the Title III portal is owned in a separate company. Key contributors to other parts of the corporate family who are not directors, officers, or partners of the portal itself should be allowed to invest without violating the rule, even where all the companies are under common control.

Questions? Let me know.

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