Exempt Offerings  JOBS Act Solutions





advising on exempt offerings to find investors.  

Blog

view:  full / summary

Real Estate Funds and Rule 506

Posted on August 7, 2018 at 10:40 PM Comments comments (0)

The overwhelming majority of real estate funds rely on Rule 506 under Regulation D of the Securities Act to raise capital.

Previously, Rule 506 required hedge fund managers to have a pre-existing relationship with investors and it placed a firm prohibition on general solicitation and advertising practices. Under Rule 506(c), issuers may engage in general solicitation and advertising practices when offering securities, although purchasers of the securities must be verified as accredited investors.

Under an expanded Rule 506 framework, issuers have the option to continue to rely on the original Rule 506 exemption—now found under Rule 506(b)—which still prohibits general solicitation and advertising practices. Although Rule 506(c) removes the general solicitation and advertising prohibition—effectively freeing fund managers to advertise fund offerings through television, newspapers, websites, etc.—surprisingly few issuers have taken advantage of it.

In 2016, SEC Chair Mary Jo White stated that from September 2013 through late 2015, 506(c) offerings only had a $71 billion market as opposed to the $2.8 trillion market for 506(b) offerings. This is partially due in part to the heightened verification requirement of Rule 506(c): whereas Rule 506(b) allows potential investors to self-certify their accredited status, Rule 506(c) requires issuers to take reasonable steps to verify the accredited status of each investor.

Rule 506(c) sets out three primary methods of verification: Income: Issuers can review any I.R.S. form that reports the investor’s income for the two most recent years. This includes Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040. In addition to I.R.S. forms for the two most recent years, an investor must represent that she or he has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor.

Net worth: Issuers review documents dated within the prior three months to determine whether an investor meets the requisite net worth.

For assets, issuers review bank statements, brokerage statements, certificates of deposits, tax assessments, and appraisal reports. For liabilities, issuers can use a consumer report from a consumer reporting agency.

Professional Verification: Issuers can obtain written confirmation from persons or entities that have taken reasonable steps to verify the investor is an accredited investor within the prior three months and has determined that the investor is an accredited investor. This includes: a) a registered broker-dealer; b) an investment adviser in good standing with the SEC; c) a licensed attorney, or d) a CPA.

The SEC has indicated issuers may be able to satisfy verification obligations through other means. Accordingly, there has been an increase in independent, third party verifiers who conduct accredited investor status verification and certification.

Please feel free to contact Private Placement Advisors LLC if you have any questions about exempt offerings under Rule 506(c) or other aspects of Regulation D.

Cannabis Appellations

Posted on July 31, 2018 at 10:30 PM Comments comments (0)

Cannabis Appellations? 

CalCannabis Cultivation Licensing, a division of the California Department of Food and Agriculture (CDFA), will host public workshops this September to provide information and gather feedback from workshop participants on the development of the new CalCannabis Appellations Program.

CalCannabis is being tasked to develop a process to license California cannabis and to establish state cannabis appellations.

What is a cannabis appellation?

Think wine. An appellation is a certified designation for standards, practices, and varietals of cannabis grown in given geographical area. The term refers to the “appellation of origin” which identifies geographical origin and sometimes how a product was produced.

If you have questions, send an email to [email protected]

Rule 506(c & Regulation S

Posted on June 7, 2018 at 3:55 PM Comments comments (0)

The ideal exempt offering is offered globally with online general solicitation. In the U.S., it is illegal to sell securities that are not registered or exempt. The most popular exemption, Rule 506(c, covers accredited investors who are U.S. persons and whose accreditation status can be verified. Regulation S exempts offerings made to non-U.S. persons.

If an issuer only uses Regulation S, sales can only be made to non-U.S.persons. Launching two side-by-side offerings with one relying on Regulation S and the other on Rule 506(c, therefore, has compelling advantages to most issuers.

Note: If an issuer only uses Rule 506(c, it must verify every investor as accredited, even non-U.S. investors.

Take care to treat each offering as a separate offering.

• Insure best practices for a 506(c offering, including third-party verification of your investors’ accredited status.

• Insure best practices for a Regulation S offering, including qualification of its investors.

The dual offerings must clearly delineate between U.S. and foreign investors. Practice tip: Before launching a dual offering, set up two separate websites.

Resale Restrictions

Both Rule 506(c and Regulation S have important resale restrictions; they are different and they are state and fact distinct.

Douglas Slain https://www.linked com/in/douglasslain/

ISOs using Regulation S

Posted on May 31, 2018 at 8:40 PM Comments comments (0)

ISOs using Regulation S

What type of documentation is typically involved in a Regulation S offering of debt securities? What are the holding periods for the sale of Regulation S securities? How is the distribution compliance period measured for different types of securities? How are Regulation S transactions structured? What are the holding periods for the sale of Regulation S securities? What is the due diligence process for initial purchasers in a Regulation S offering? 

What type of documentation is typically involved in a Regulation S offering of debt securities?

A Regulation S offering is often combined with a Rule 144A and/or a Rule 506(c offering. The same disclosure package is used with debt and equity offerings, with or without Regulation S. Documents include: The PPM or private placement memorandum for a Regulation D [Rule 144A and/or Rule 506(c] must stress restrictions on re-sales. The SAFT (simple agreement for future tokens) documents the transaction and serves as a form of purchase agreement. The Operating Agreement contains representations, warranties, and covenants specific to each offering. The Subscription Agreement commits the investor to the investment. Practice Note: The Regulation S offering may be conducted using documents that are based on the country‐specific practices of the relevant non‐U.S. jurisdiction or jurisdictions. With equity securities offered by U.S. issuers, the legend must state that hedging transactions may not be conducted. The same legend must also be printed in any advertisement made or issued by the issuer, any distributor, and their respective affiliates or representatives. All investors must be given the same “disclosure package.” Only changes in the issuer’s business, financial condition, or other circumstances need to be reported to the SEC, following the initial Form D filing.

What are the holding periods for the sale of Regulation S securities?

Securities cannot be offered or sold to a U.S. person during the distribution compliance period. But there is no distribution compliance period in connection with securities sold in a Category 1 transaction, and the distribution compliance period for Category 2 transactions for both equity and debt, and for Category 3 transactions involving debt securities, is only 40 days. The distribution compliance period for Category 3 offerings of equity securities is six months if the issuer is a reporting company, and one year if not.

How is the distribution compliance period measured for different types of securities?

Medium‐Term Notes. In the case of continuous offerings, the distribution compliance period is deemed to begin at the completion of the distribution. • Warrants. Securities underlying warrants are considered to be subject to a continuous distribution as long as the warrants remain outstanding. A sample Rule 903 legend reads, “These securities will be offered only outside of the United States to non‐U.S. persons, pursuant to the provisions of Regulation S of the U.S. Securities Act of 1933, as amended. These securities will not be registered under the Securities Act, and may not be offered or sold in the United States absent registration or an applicable exemption from the registration requirements.”

How are Regulation S transactions structured?

If there is no SUSMI in a foreign issuer’s debt securities, the issuer need only comply with the general Regulation S requirements (i.e., offshore transaction and no directed selling efforts). A SUSMI in debt securities exists if the issuer’s debt securities are held of record by 300 or more U.S. persons, and U.S. persons hold of record at least 20% and at least $1 billion or more of the principal amount of debt securities, plus the greater of 14 liquidation preference or par value of non‐participating preferred stock, and the principal amount or balance of asset‐backed securities. Foreign issuers of debt securities (and U.S. issuers of non‐convertible debt securities) may rely on the Category 1 safe harbor if the transaction qualifies as an overseas directed offering. An offering of non‐convertible debt securities of a U.S. issuer must be directed into a foreign country in accordance with that country’s local laws and customary practices, and the securities must be non‐U.S. dollar denominated or linked securities in order to qualify as an overseas directed offering. T

The provisions of the issuer safe harbor specific to offerings of equity securities are summarized below.

(A) Category 1 Safe Harbor The Category 1 safe harbor is available for equity offerings if a foreign issuer reasonably believes at the beginning of the offering that there is no SUSMI in the equity securities. A SUSMI in equity securities exists if, during the shorter of the issuer’s prior fiscal year or the period since incorporation, either: • The U.S. securities exchanges and inter‐dealer quotation systems in the aggregate, constituted the single largest market for a class of the issuer’s securities; or • At least 20% of all trading in a class of the issuer’s securities occurred on the facilities of U.S. securities exchanges and inter‐dealer quotation systems, and less than 55% of such trading occurred on the facilities of the securities markets of a single foreign country. If there is no SUSMI in a foreign issuer’s equity securities, the issuer need only comply with the general Regulation S requirements to make offers and sales.

(B) Category 2 Safe Harbor The Category 2 safe harbor is only available for equity offerings by a reporting foreign issuer. Even if there is a SUSMI in the securities, reporting foreign issuers who implement the Category 2 offering and transactional restrictions for the distribution compliance period may rely on the safe harbor. This is the issuer safe harbor available to foreign issuers (both reporting and non‐reporting) and reporting U.S. issuers of debt securities.

(C) Category 3 Safe Harbor The issuer safe harbor is available to non‐reporting U.S. issuers of debt securities, provided that the debt securities are not offered or sold to a U.S. person, other than a distributor, during the 40‐day distribution compliance period, except pursuant to the registration requirements of the Securities Act or an exemption from registration. Issuers must comply with the offering and transactional restrictions applicable to Category 2 offerings and Rule 903(b)(3)’s additional transactional restrictions during the distribution compliance period. Only changes in the issuer’s business, financial condition, or other circumstances need to be reported to the SEC, following the initial Form D filing.

What is the due diligence process for initial purchasers in a Regulation S offering?

Modest due diligence is more acceptable in standalone Regulation S offerings that do not involve financial intermediaries. Due diligence can be divided into financial, business and management due diligence, and into documentary or legal due diligence. Necessary due diligence varies by whether the issuer is a new entity, whether the business of the issuer is risky, and based on the nature of the tokens or securities offered. Practice tip: The PPM and other offering documents are not subject to SEC review. File the Form D, use it to “notice file” state regulators, and otherwise just follow rules. 

Cryptocriminals & State Regulators

Posted on May 27, 2018 at 9:45 PM Comments comments (0)

The North American Securities Administrators Association (NASAA) last week announced a large crackdown on fraudulent Initial Coin Offerings and cryptocurrency offerings.

State regulators identified hundreds of ICOs in the final stages of preparation before being launched to the public. These pending ICOs were advertised and listed on ICO aggregation sites to attract investor interest. Many have been and are being examined; some are under active investigation, and some have already resulted in enforcement actions.

State regulators found approximately 30,000 crypto-related domain name registrations, almost all of which made in 2017 and 2018. For more information about ICOs and cryptocurrencies, watch NAASA’s video “Get in the Know About ICOs” or read NASAA’s Investor Advisories: “What to Know About ICOs” and “Be Cautious of the Crypto Investment Craze.”


ISOs using Regulation S

Posted on May 25, 2018 at 10:45 PM Comments comments (0)

What type of documentation is typically involved in a Regulation S offering of debt securities?

What are the holding periods for the sale of Regulation S securities?

How is the distribution compliance period measured for different types of securities?

How are Regulation S transactions structured?

What are the holding periods for the sale of Regulation S securities?

What is the due diligence process for initial purchasers in a Regulation S offering?

___________________

What type of documentation is typically involved in a Regulation S offering of debt securities? A Regulation S offering is often combined with a Rule 144A and/or a Rule 506(c offering. The same disclosure package is used with debt and equity offerings, with or without Regulation S. Documents include:

The PPM or private placement memorandum for a Regulation D [Rule 144A and/or Rule 506(c] must stress restrictions on re-sales.

The SAFT (simple agreement for future tokens) documents the transaction and serves as a form of purchase agreement.

The Operating Agreement contains representations, warranties, and covenants specific to each offering.

The Subscription Agreement commits the investor to the investment.

Practice Note: The Regulation S offering may be conducted using documents that are based on the country‐specific practices of the relevant non‐U.S. jurisdiction or jurisdictions.

All investors must be given the same “disclosure package.”

Only changes in the issuer’s business, financial condition, or other circumstances need to be reported to the SEC, following the initial Form D filing.

What are the holding periods for the sale of Regulation S securities?

Securities cannot be offered or sold to a U.S. person during the distribution compliance period. But there is no distribution compliance period in connection with securities sold in a Category 1 transaction, and the distribution compliance period for Category 2 transactions for both equity and debt, and for Category 3 transactions involving debt securities, is only 40 days.

The distribution compliance period for Category 3 offerings of equity securities is six months if the issuer is a reporting company, and one year if not.

How is the distribution compliance period measured for different types of securities?

Medium‐Term Notes. In the case of continuous offerings, the distribution compliance period is deemed to begin at the completion of the distribution. 

Warrants. Securities underlying warrants are considered to be subject to a continuous distribution as long as the warrants remain outstanding.

A sample Rule 903 legend reads, “These securities will be offered only outside of the United States to non‐U.S. persons, pursuant to the provisions of Regulation S of the U.S. Securities Act of 1933, as amended. These securities will not be registered under the Securities Act, and may not be offered or sold in the United States absent registration or an applicable exemption from the registration requirements.”

How are Regulation S transactions structured?

If there is no SUSMI in a foreign issuer’s debt securities, the issuer need only comply with the general Regulation S requirements (i.e., offshore transaction and no directed selling efforts). A SUSMI in debt securities exists if the issuer’s debt securities are held of record by 300 or more U.S. persons, and U.S. persons hold of record at least 20% and at least $1 billion or more of the principal amount of debt securities, plus the greater of 14 liquidation preference or par value of non‐participating preferred stock, and the principal amount or balance of asset‐backed securities.

Foreign issuers of debt securities (and U.S. issuers of non‐convertible debt securities) may rely on the Category 1 safe harbor if the transaction qualifies as an overseas directed offering.

An offering of non‐convertible debt securities of a U.S. issuer must be directed into a foreign country in accordance with that country’s local laws and customary practices, and the securities must be non‐U.S. dollar denominated or linked securities in order to qualify as an overseas directed offering.

The provisions of the issuer safe harbor specific to offerings of equity securities are summarized below.

(A) Category 1 Safe Harbor The Category 1 safe harbor is available for equity offerings if a foreign issuer reasonably believes at the beginning of the offering that there is no SUSMI in the equity securities. A SUSMI in equity securities exists if, during the shorter of the issuer’s prior fiscal year or the period since incorporation, either: • The U.S. securities exchanges and inter‐dealer quotation systems in the aggregate, constituted the single largest market for a class of the issuer’s securities; or • At least 20% of all trading in a class of the issuer’s securities occurred on the facilities of U.S. securities exchanges and inter‐dealer quotation systems, and less than 55% of such trading occurred on the facilities of the securities markets of a single foreign country.

If there is no SUSMI in a foreign issuer’s equity securities, the issuer need only comply with the general Regulation S requirements to make offers and sales.

(B) Category 2 Safe Harbor The Category 2 safe harbor is only available for equity offerings by a reporting foreign issuer. Even if there is a SUSMI in the securities, reporting foreign issuers who implement the Category 2 offering and transactional restrictions for the distribution compliance period may rely on the safe harbor. This is the issuer safe harbor available to foreign issuers (both reporting and non‐reporting) and reporting U.S. issuers of debt securities.

(C) Category 3 Safe Harbor The issuer safe harbor is available to non‐reporting U.S. issuers of debt securities, provided that the debt securities are not offered or sold to a U.S. person, other than a distributor, during the 40‐day distribution compliance period, except pursuant to the registration requirements of the Securities Act or an exemption from registration.

Issuers must comply with the offering and transactional restrictions applicable to Category 2 offerings and Rule 903(b)(3)’s additional transactional restrictions during the distribution compliance period. Only changes in the issuer’s business, financial condition, or other circumstances need to be reported to the SEC, following the initial Form D filing.

What is the due diligence process for initial purchasers in a Regulation S offering? Modest due diligence is more acceptable in standalone Regulation S offerings that do not involve financial intermediaries. Due diligence can be divided into financial, business and management due diligence, and into documentary or legal due diligence. Necessary due diligence varies by whether the issuer is a new entity, whether the business of the issuer is risky, and based on the nature of the tokens or securities offered.

Practice Note: The PPM and other offering documents are not subject to SEC review. File the Form D, use it to “notice file” state regulators, and otherwise just follow rules.

_______________________

More questions? Contact [email protected]


With equity securities offered by U.S. issuers, the legend must state that hedging transactions may not be conducted. The same legend must also be printed in any advertisement made or issued by the issuer, any distributor, and their respective affiliates or representatives. All investors must be given the same “disclosure package.”

ICOs & Regulation S

Posted on May 5, 2018 at 3:55 PM Comments comments (0)

Outside the United State, ICO issuers can offer securities in reliance on Regulation S.

When a U.S. company relies on Regulation S, there is a period during which the securities cannot be transferred to “U.S. persons” which is a year for equity securities and 40 days for debt securities. This means that it is important to establish whether the securities are equity or debt. As with Regulation D, issuers must reflect these requirements in the smart contracts that govern trading.

Regulation S securities cannot be “offered” to U.S. persons. There cannot be an open-to-everyone website that describes Regulation S securities, even if the site says, “We must not and cannot sell these to U.S. persons.” That is still an offer (hard to believe but true).

It is best to put the website that describes Regulation S securities behind a firewall that requires investors to certify their non-US status before allowing them to view the offering. Some use Geofencing technology to block all US IP addresses.

Investors should certify that they are not “U.S. persons” and that they promise not to resell to U.S. persons. Those certifications should be made in the investor’s real name, not as a “check the box” entry. Additionally, while initial sales under Regulation D and Regulation A+ are “pre-empted” from state regulation, that is not the case for Regulation S. There are some states that regulate offerings made from those states.Check on those requirements before undertaking a Regulation S offering.

Regulation S only instructs on how to deal with U.S. Federal and state regulations. Issuers need to make sure that they comply with the regulations of the countries where the investors are located. They should block IP addresses from any jurisdictions where the securities cannot be sold.

__________

Join the State Securities Regulation LinkedIn discussion group and go down the crypto rabbit hole with us to learn 1) what will constitute securities in the eyes of state regulators and the SEC, and 2) what will constitute best practices for exempt offerings of ICO offerings. Members of the discussion group are entitled to any of 21 audio handbooks on exempt [email protected] https://www.audible.com/search/ref=a_hp_tseft?advsearchKeywords=Douglas%20Slain&filterby=field-keywords

No ICOs Registered with the SEC

Posted on May 4, 2018 at 10:35 PM Comments comments (0)

The SEC says no ICOs have been “registered” -- but the SEC is not really keeping score.

The SEC says no ICOs have been “registered” but that doesn’t count the growing number of exempt offerings under Rule 506(c.

Is there a path from a pre-ICO fund raise using Reg CF to a Form D Rule 506(c offering and then to a Reg A+ offering? And then even to a full registration?

Securities and Exchange Commission Chairman Jay Clayton has repeatedly reassured the public that no initial coin offerings have been “registered” with the SEC, but plenty of them are coming onto the market through the back door. Eventually, these ICOs could get distributed beyond just accredited investors and into the hands of retail consumers.

There’s been significant growth in ICOs using Rule 506(c since the beginning of 2017.

Period Number of ICO-Related Form Ds

1Q 2017 0

2Q 2017 1

3Q 2017 11

4Q 2017 32

1Q 2018 (Through Feb. 20) 39

With tokens or coins issued to accredited investors under Rule 506(c of Regulation D, one year would be the minimum timeframe for transfers under Rule 144. Most of the ICOs filed using Form D since mid-2017 have used Simple Agreement for Future Tokens, or SAFT, as their legal framework.

Telegram used the SAFT structure to raise money from accredited investors. As for the transition form accredited investors to retail investors, “There is still significant uncertainty about how to go beyond the SAFT accredited investors to the retail investor under the current regulatory environment.” 

__________

Join the State Securities Regulation LinkedIn discussion group and go down the crypto rabbit hole with us to learn 1) what will constitute securities in the eyes of state regulators and the SEC, and 2) what will constitute best practices for exempt offerings of ICO offerings. 

Members of the discussion group are entitled to any of 21 audio handbooks on exempt [email protected] https://www.audible.com/search/ref=a_hp_tseft?advsearchKeywords=Douglas%20Slain&filterby=field-keywords

ICOs are so 2017

Posted on May 1, 2018 at 5:35 PM Comments comments (0)

Is there really a new term for fundraising?

STO?

Some in the industry are opting for "security token offerings," a term that the CEO of Overstock (which is under SEC investigation itself) advances. "The ICO craze of last year created a toxic waste dump of financial assets," says Patrick Byrne.

"What we're developing is a mechanism so that there will be a legal way to go forward, and not create any new toxic waste." "It's the new term," Byrne said. "The industry is distinguishing very clearly now between ICOs and STOs." Overstock has invested $2.5 million in start-up Elio Motors. The company is launching "ElioCoin” to fund production and other costs.

ElioCoin made clear this is a "security token offering" in a company statement. "It is a very clever offering, and could represent a whole new model for American entrepreneurship," Byrne said.

In an ICO, coins or tokens are put up for sale as a form of crowdfunding. There are no voting rights or dividends as with shares of a company. Instead, "utility tokens" give the bearer access to a network, platform, and services. Whoppercoin, Pandacoin, Trumpcoin, and PutinCoin have all raised money through ICOs.

In a security token offering, you also buy coins or tokens. However, these tokens must be backed by something tangible such as assets or a revenue stream. They are similar to a share of a company in that they are "programmable" to do things like conduct proxy voting, "You can program a token, but a static share certificate just sits there and collects dust," said Trevor Koverko, CEO of Polymath. The SEC has said that all ICOs constitute securities.

By using the term "security token offering" or STO, issuers are being more upfront with regulators, Byrne said. "I think the SEC should essentially shut down the utility token world," Byrne said. "Eventually the STO security offerings will be done in lieu of the IPO."

Join the LinkedIn discussion group, State Securities Regulation, and go down the rabbit hole with us to learn what is and what will be a security in crypto world (the metaphysics of it) and how do we know that (the epistemology of it).

Enjoy securities law history in the making.

Douglas Slain

Members of the State Securities Regulation LinkedIn discussion group are entitled to any of 21 audio law handbooks @ https://www.audible.com/search/ref=a_hp_tseft?advsearchKeywords=Douglas%20Slain&filterby=field-keywords

Securitized Real Estate and 1031 Exchanges

Posted on April 10, 2018 at 6:45 PM Comments comments (0)

I. What is Securitized Real Estate?

II. What is a 1031 Exchange?

III. What is a Delaware Statutory Trust (DST)? I

V. Related Topics

Securitized real estate is a real estate interest that is packaged and sold as a security. It is regulated by Federal and state securities law and requires more disclosure than most real estate offerings. Real estate has the well-known advantage of depreciation and it also usually provides income as well as the potential for appreciation. When real estate is offered in the form of securities, investors must be given a professionally prepared private placement memorandum (PPM) as well as other offering documents.

These offering documents must reflect due diligence appropriate to a securities offering. Typically, these are larger, institutional grade investments, managed by experienced sponsors. What due diligence is performed? Due diligence, or the analysis of the facts and circumstances associated with an investment, provides investors full disclosure of the facts and risks before they arrive at an investment decision. Initial due diligence will be performed by the sponsor, the lender, legal counsel, and then by a broker/dealer or other securities licensee.

Due diligence includes: 1) examination of the sponsor); 2) analysis of the properties; 3) analysis of the market; and 4) review of the structure of the project. If a 1031 transaction is contemplated, there will also be analysis of 1031 tax compliance Reasons for rejection of a real estate offering by securities professionals vary; the property, the sponsor, the financing, or the market--each may be judged problematic.

Advantages of Securitized Real Estate Access to institutional grade investment properties

Securitized real estate offers accredited investors the opportunity to join with other accredited investors to own investment-grade real estate. Normally, these properties are financially secure, with creditworthy tenants under long-term triple net (NNN) leases, and under professional management. Asset classes include multifamily housing, NNN retail properties, office buildings, industrial complexes and warehouses, and hotels Management free Real estate professionals structure the property acquisition, maintain and lease the property, collect rent, service the mortgage, and eventually sell the property.

Combined with the 1031 exchange process, such a portfolio can grow tax-deferred over a number of years. Income and appreciation Investment-grade properties typically offer stable cash flow from rental income, paid monthly or quarterly. As the debt is serviced, the investor’s equity in the property increases even if the value of the property does not. Also there is the potential for appreciation. T

Tax-Sheltered Cash Flow Some of the cash flow from these investments can be tax-sheltered and/or tax deferred by depreciation pass-through and interest deductions. If an investor has held a property where the depreciation deductions have run out, or will do so soon, a 1031 exchange gives the investor an opportunity to restore these deductions in a replacement property if the DST or TIC has more debt than the debt on the investor’s property. The additional debt offers a new tax basis to the investor—resulting in greater depreciation expense to shelter rental income from Federal and state taxes. Many DST/TIC properties are leveraged with up to 75% non-recourse debt financing. Diversification With minimum investment requirements as low as $100,000 for a 1031 exchange, investors hedge risk by diversifying their real estate portfolio to include multiple properties in different geographic locations, as well as in different asset classes such as residential apartment complexes, retail shopping centers, office buildings, and industrial parks.

What are the risks of securitized real estate?

All investment real estate can have substantial risks, such as no guaranteed income, lack of liquidity, possible conflicts of interest with managers and affiliated persons or entities, risks associated with leverage, declining markets, and challenging economic conditions. The ultimate risk of investing in real estate is the total loss of the investment. What is a 1031 Exchange? Under IRS section 1031, an investor can defer capital gains tax and depreciation recapture by reinvesting the proceeds from the sale of investment property into replacement property. 1031 exchange tax deferrals can be continued through as many exchanges as the investor wishes. Of course if at any time the investor sells the property without reinvesting in a new property, there is capital gains and depreciation recapture.

In addition to tax deferral, a 1031 exchange permits investors to purchase a leveraged replacement property and thus increase their basis in the amount of additional debt assumed. This allows for additional depreciation pass-through which can shelter as much as 50% to 60% of the rental income cash flow. On an after tax basis, the rate of return (ROR) for a 1031 exchange into securitized real estate is comparable to RORs on investments with significantly more risk. With any additional return from appreciation of the property, the after-tax return on investment on an annualized basis can be even greater. Some of the most important requirements for an IRS approved 1031 exchange: •

The exchange process must be facilitated by a Qualified Intermediary: The Qualified Intermediary (QI) is the professional responsible for the mechanics and process of an exchange. It holds the proceeds from the relinquished property until reinvested in the exchange property. An "exchange agreement" must exist in writing between the QI and the investor to prevent the investor from having "constructive receipt" of the funds during the exchange period. The use of a qualified intermediary as an independent party to facilitate a tax-deferred exchange is a safe harbor established by Treasury Regulations.

The properties must be “like-kind”: Virtually all real estate properties, whether raw land or with substantial improvements, qualify as like-kind. REITs, real estate funds, or other securities do not qualify for 1031 exchanges. Types of like-kind properties include: Raw Land Multi-Family Rentals Single-Family Rentals Retail Shopping Centers Office Buildings Industrial Facilities Storage facilities Rules for a 1031 exchange must be followed:

The investor must identify in writing the exchange properties within 45 days of closing on the relinquished property in accordance under one of the following: o Three-Property Rule: Identification of up to three properties regardless of the value of property identified o 200% Rule: Identification of any number of properties wherein the combined FMV (fair market value) does not exceed 200% of the relinquished properties' FMV o 95% Rule: Identification of any number of properties regardless of the aggregate FMV, as long as at least 95% of the property is ultimately acquired. • The investor must close on the replacement property or properties within 180 days of the closure of the relinquished property. The properties must be held in a business or for the purpose of investment. The replacement property must be of equal or greater value than the relinquished property.

The equity of the replacement property must be of equal or greater value than the equity of the relinquished property. The debt held by the replacement property must be of equal or greater value than the debt held by the relinquished property. All net profit from the relinquished property must be used in the purchase of the replacement property.

Ownership Structures Used for 1031 Exchanges

The two most common ownership structures for 1031 exchanges are a Delaware Statutory Trust (DST) and a Tenancy in Common (TIC). Both of these structures can be used to hold like-kind interests in real estate for the purpose of a 1031 exchange. The tenancy-in-common structure dates from earliest common law and was the traditional vehicle for multiple-owner 1031 exchanges in the US. In the last 10 years, however, most exchangers have begun to use the DST structure because it is simpler and more flexible. Both DSTs and TICs are available as turnkey, pre-packaged investments, with management and non-recourse financing in place. They both offer superior efficiencies in the identification, acquisition, financing, and operating stages of real estate ownership.

These efficiencies are especially helpful given the strict time restrictions when using a 1031 tax-deferred exchange. In addition to DSTs and TICs, investors seeking real estate for the purpose of a 1031 exchange can consider oil and gas offerings or direct ownership of NNN leased properties. While most oil and gas programs are not viable for a 1031 exchange, some are designed specifically for this purpose. An investor may find direct ownership of a NNN leased property more suitable.

While not securitized offerings, NNN leased properties are often attractive to investors seeking to own a piece of high quality retail real estate with just a few other owners. 1031 Exchange Guidelines Advanced planning is necessary and particular attention must be given to the timing of the sale of the relinquished property. The property owner must satisfy equity and debt replacement objectives to avoid boot. The IRS will not honor the exchange if either the 45-day identification period is missed or if replacement property is not acquired within the 180 day exchange period. If a property owner finds an ideal replacement property before the relinquished property is sold, he may have to negotiate a reverse exchange; i.e., buy before selling. The IRS provides guidance on this type of reverse exchange in Revenue Procedure 2000-37. A reverse exchange requires the replacement property or the relinquished property to be parked with an “exchange accommodator titleholder” for 180 days pending the successful completion of the exchange.

Caveats: Trading down in total value? You are potentially taxable to the extent of the trade-down. • Trading down in equity? You are potentially taxable to the extent of the trade-down.

Depreciation Recapture Capital gain tax rates are currently low, but tax rules require investors to recapture at a high tax rate, typically 25%, on the portion of the gain that relates to allowable depreciation over the period the asset was held. Depreciation recapture is a significant factor in motivating an investor to participate in a like-kind exchange. If an investor’s marginal income tax bracket is greater than 15%, and the real estate sold is the only business asset sold in the tax year of the sale, the tax should not be higher than 15%. The gain from the sale by a non-corporate taxpayer of real estate that is a capital asset, or is used in a business, and is held more than 12 months, is not normally taxed at a rate higher than 15%.

When the asset sold is depreciable real estate, a maximum rate of 25% applies to "non-recaptured Section 1250 gain" and a maximum rate of 15% applies to the balance of the gain. Non-recaptured Section 1250 gain refers to the portion of gain that is eligible for capital gains treatment even though it is attributable to previously allowable depreciation. Property placed in service after 1986 For real estate placed in service after 1986, all depreciation deductions allowable before the sale of the real estate give rise to non-recaptured section 1250 gain. Property placed in service between 1981 and 1986 For real estate placed in service after 1980 but before 1987, the treatment of gain on sale depends on whether the real estate is residential or non-residential. Residential Depreciated residential pre-1987 real estate, using straight-line depreciation, results in the same tax consequence as for a sale of post-1987 property, as described above. If you used a declining balance method to depreciate the real estate, the gain on the sale would be taxed as follows: 

Gain, to the extent of the depreciation claimed that exceeds what would have been allowable under straight-line depreciation, will be recaptured as ordinary income, and taxed at rates as high as 35% (ordinary income rates), but the amount of excess depreciation subject to recapture may be less for certain low-income housing. • Gain, to the extent of the depreciation that is not recaptured as ordinary income, will be taxed at a rate of 25%. 

The balance of the gain will be taxed at a rate of 15%. Non-residential As is the case for residential pre-1987 real estate, if you depreciated non-residential pre-1987 real estate using just straight-line depreciation, the tax results when you sell it will be the same as for a sale of post-1986 property, as described above. But if you used a declining-balance method to depreciate, the gain on sale would be taxed as follows: • Gain, to the extent of the full amount of depreciation allowable to the time of sale, is recaptured as ordinary income, and taxed at ordinary income rates; • The balance of the gain is taxed at 15%. Pre-1981 Property The following rules apply if you sell real estate placed in service before 1981: • The excess of depreciation claimed over straight-line depreciation is recaptured as ordinary income, and thus taxed at ordinary income rates (but the amount of excess depreciation subject to recapture may be less for certain residential real estate or for real estate acquired before 1970). • Gain, to the extent of the balance of depreciation allowable, is non-recaptured Section 1250 gain, taxed at a rate of 25%.

The balance of the gain, if any, would be taxed at a rate of 15%. Ownership Structures Used for 1031 Exchanges The two most common ownership structures are a Delaware Statutory Trust (DST) and a Tenancy in Common (TIC). Both of these structures can qualify as a like-kind interest in real estate for the purposes of a 1031 exchange. The tenancy-in-common structure dates from earliest common law and was the traditional vehicle for multiple-owner 1031 exchanges in the US. In the last 10 years, however, most people have been using the DST structure, which is both simpler and more flexible. Both DSTs and TICs are available as turnkey, pre-packaged investments, with management and non-recourse financing in place. They both offer superior efficiencies in the identification, acquisition, financing, and operating stages of real estate ownership. These efficiencies are especially helpful given the strict time restrictions when using a 1031 tax-deferred exchange. In addition to DSTs and TICs, investors seeking to purchase real estate for the purpose of a 1031 exchange can consider the options of oil and gas offerings or direct ownership of NNN leased properties. While most oil and gas programs are not viable for 1031 exchange, some are designed for this purpose.

Lastly, an investor may find direct ownership of a NNN leased property most suitable. While not securitized offerings, NNN leased properties are often attractive to investors seeking to own a piece of high quality retail real estate themselves, or together with one or two other owners. Changing how title to your property is being held or dissolving partnerships during the exchange may cause the exchange to be dishonored due to holding-period issues. Two cautions •

If you are trading down in total value, you are potentially taxable to the extent of the trade-down; • If you are trading down in equity, you are potentially taxable to the extent of the trade-down. Depreciation Recapture Capital gain tax rates are currently low, but tax rules require investors to recapture at a higher tax rate (typically 25%) the portion of the gain on the sale that relates to allowable depreciation over the period the asset was held. Depreciation recapture is a significant factor in motivating an investor to participate in a like-kind exchange. If an investor’s marginal income tax bracket is greater than 15%, and the real estate sold is the only business asset sold in the tax year of the sale, the tax should not be higher than 15%. Generally, the gain from the sale by a non-corporate taxpayer of real estate that is a capital asset, or is used in a business, and is held more than 12 months, is not taxed at a rate higher than 15%. However, when the asset sold is depreciable real estate, a maximum rate of 25% will apply to "non-recaptured Section 1250 gain" and a maximum rate of 15% will apply to the balance of the gain .Non-recaptured Section 1250 gain refers to the portion of gain that is eligible for capital gains treatment even though it is attributable to previously allowable depreciation.

A further complication is that the portion of the gain that is non-recaptured Section 1250 gain depends, as discussed below, on when the property was placed in service. Property placed in service after 1986 For real estate placed in service after 1986, all depreciation deductions give rise to non-recaptured section 1250 gain. Property placed in service between 1981 and 1986 For real estate placed in service after 1980 but before 1987, the treatment of gain on sale depends on whether the real estate is residential or non-residential. Residential Real Estate Depreciated residential pre-1987 real estate, using straight-line depreciation, results in the same tax consequence as with a sale of post-1987 property, as described above. If a declining balance method is used to depreciate the real estate, the gain on sale would be taxed as follows: 

Gain, to the extent of the depreciation claimed that exceeds what would have been allowable under straight-line depreciation, will be recaptured as ordinary income, and taxed at rates as high as 35% in 2003 and later years (ordinary income rates), but the amount of excess depreciation subject to recapture may be less for certain low-income housing. • Gain, to the extent of the depreciation that is not recaptured as ordinary income, will be taxed at a rate of 25%. • The balance of the gain will be taxed at a rate of 15%. Non-residential Real Estate As is the case for residential pre-1987 real estate, if you depreciated non-residential pre-1987 property using straight-line depreciation, the tax results if you sell it will be the same as for a sale of post-1986 property. But if you used a declining-balance method to depreciate, the gain on sale would be taxed as follows: • Gain, to the extent of the full amount of depreciation allowable to the time of sale, would be recaptured as ordinary income, and, thus, taxed at ordinary income rates;

The balance of the gain would be taxed at a rate of 15%. Pre-1981 Property The following rules apply if you sell real estate placed in service before 1981: • The excess of depreciation claimed over straight-line depreciation is recaptured as ordinary income, and thus taxed at ordinary income rates (but the amount of excess depreciation subject to recapture may be less for certain residential real estate or for real estate acquired before 1970). • Gain, to the extent of the balance of depreciation allowable, is unrecaptured Section 1250 gain, taxed at a rate of 25%. • The balance of the gain, if any, would be taxed at a rate of 15%. If you have further questions about the above rules, or would like to compute the potential tax that you face, please contact your tax advisor. What is a Delaware Statutory Trust? A Delaware Statutory Trust (DST) is a separate legal entity created as a trust under Delaware statutory law. Investors in a DST own a pro rata interest in the trust and have the right to receive distributions from the operation of the trust, from rental income and from the eventual sale of the property. Investors do not have deeded title to the property; the trust has deed to the property and, through the signatory trustee, makes the decisions regarding the property. The beneficiaries of the trust have no authority over the day to day handling of the property or the timing and details of its eventual sale. While initially this may seem to be disadvantageous to the investor, this structure actually opens up the possibility for significant advantages

For the purposes of a 1031 tax-deferred exchange, the purchase of a beneficial interest in a DST is treated as a direct interest in real estate, satisfying that requirement of IRS Revenue Ruling 2004-86. An IRS Revenue Ruling, dissimilar to an IRS Revenue Procedure, may be relied upon by other taxpayers in defense of a 1031 exchange position. A DST can also be an attractive investment vehicle for investors even without the 1031 exchange. Because it is a direct interest in real estate the investor can conduct a 1031 tax deferred exchange if and when the property is sold, thus beginning the cycle of tax deferred real estate ownership at that time. Due to legal limitations and the nature of DST financing, the use of a DST is generally limited to: a) long-term “A” credit, triple-net leased properties, and b) properties leased to an affiliate of the sponsor (master tenant) who operates the property on a triple-net basis (master lease).

A Delaware Statutory Trust is similar to a unit investment trust. Securities or real estate are purchased for the trust and held until such a time as the proceeds are distributed to the investors. The trust is not considered a taxable entity so all profits and losses are passed through. The concept for business trusts, especially those that involve the holding of property, dates back to early English common law. With the passage of the Delaware Statutory Trust Act in 1988, statutory trusts can be legal entities separate from their trustees. The act allows the trustees to structure the entity in a way that is most beneficial to the relationship of all parties while offering liability protection similar to that of a limited liability company or partnership. Delaware statutory trusts are being used as a form of tax deferral, asset protection, and balance sheet advantages in real estate securitization. For the purposes of owning a “direct interest in real estate,” which is critical to qualify for a 1031 exchange, IRS Revenue Ruling 2004-86 opened the way for DSTs to become a common ownership structure.

A beneficial interest in a DST which owns real estate is now considered a “direct interest in real estate” and thus qualifies for a 1031 exchange. Risks of Delaware Statutory Trusts The risks of investing in a DST include the risk of relying on the program sponsor; the risk of sponsor insolvency; and the risks associated with giving decision-making to any third party. If the property held by the DST is leveraged, there is the also the risk of being unable to re-finance the project at the end of the term of the loan. There is also the risk of conflicts of interest with program sponsors, trustees, property managers, or other affiliates. In addition, there are tax-related risks when using a DST ownership structure for the purpose of a 1031 exchange. While the DST offerings are generally accompanied by a legal opinion that they are suitable for a 1031 exchange, there is no guarantee that the IRS will approve any given offering. Benefits of a Delaware Statutory Trusts In addition to other benefits of securitized real estate, DST investors enjoy the following: No need for unanimous owner approval Unanimous approval of the individual investors is not required to deal with unexpected, adverse developments.

The signatory trustee is empowered to take necessary action, such as restructure financing or renegotiate leases. Less expensive; easier financing One advantage of the DST structure is that the lender deals with the trust as the only borrower, making it easier and less expensive to obtain financing. This is in contrast to a TIC arrangement where the lender needs to approve up to 35 different borrowers. Because the loan is obtained by the trust, there is no need for the individual investors to be qualified. Also, their participation in the trust does not affect their credit rating. No fraud carve-outs Since the investors’ only right with respect to the DST is to receive distributions (they have no voting rights), investor fraud carve-outs are eliminated. The lender looks only to the sponsor with regard to carve-outs from the non-recourse provisions of the loan. Lower minimum investment Private placement DST offerings may have up to 499 investors so the minimum investment amounts are lower. Most DST sponsors will set arbitrary minimum investment levels to limit the number of investors to a manageable number, but investments can be as low as $25,000, although 1031 exchange minimums are often $100,000. No Need for an LLC DST investors do not have to pay annual state filing fees.

No trustee term time limit The signatory trustee of the DST or one of the sponsor’s affiliates will be the sponsor of the private placement offering. Unlike a TIC, there is no one-year time limit on the trusteeship or the term of the property manager. This gives the lender comfort that the sponsor will maintain involvement with the property. No inadvertent termination A DST has a Delaware trustee as required by statute so the trust cannot inadvertently terminate. What is a tenancy in common? Tenancy in common is a co-ownership structure under which multiple investors pool their funds to own one property. Each investor owns an undivided fractional interest and participates in a proportionate share of net income, tax shelters, and appreciation. Each owner receives a separate property deed and title insurance for their percentage interest in the property, and has all the same rights and privileges as a single, fee simple owner.

Like a DST, the purchase of a TIC interest is treated as a direct interest in real estate, qualifying as “like kind” real estate for 1031 exchange purposes. However, because each TIC investor holds title, there may be the need to sign multiple “carve-outs” related to investor fraud and environmental issues. Due to stricter underwriting standards, the recent trend has been to limit TIC offerings to all cash. TIC investors typically set up limited liability corporations (LLCs) for the purpose of TIC ownership, providing another level of protection. Financing issues The DST structure has simplified the financing process for securitized real estate. It also offers the investor access to very competitive interest rates usually only available to institutions. The trust will own 100% fee interest in the real estate and is the sole borrower. Unlike a tenancy-in-common where there can be up to 35 individual borrowers, each of whom needs to be approved by the lender, with a DST the lender only makes one loan to one borrower.

A well-structured DST which owns investment-grade real estate can be attractive to institutional lenders due to a track record of the sponsor in property management, and because DSTs are bankruptcy remote. DST agreements contain special purpose entity provisions which prevent the bankruptcy creditors of the beneficiaries from reaching the DST’s property. This assures the lender that it can foreclose on its first mortgage of the real estate should the need arise. The lender does not need to underwrite or qualify any investors. Other than Patriot Act considerations, due diligence investigations of investors is normally not necessary. And if the sponsor only sells to accredited investors, the lender does not need to monitor transfers of beneficial interests.

The DST Master Lease Tax law requires that the DST trustee is prohibited from taking certain actions with respect to leasing, financing and capital-raising. Since the beneficiaries have no control over the operations of the mortgaged property, either a master lease or a long-term triple-net lease to a credit tenant is required. In the case of a master lease, the master tenant, who is generally an affiliate of the sponsor, will sublet the property to residential or commercial tenants. The master tenant also handles maintenance and repairs, or contracts with a management agent, often an affiliate of the sponsor. The master tenant is empowered to do everything that an owner of the property would be empowered to do. Such master lease arrangements satisfy requirements of the law and are very attractive to institutional lenders because they eliminate the concern with how to ensure the unanimous consent of the tenants-in-common to management actions. Special purpose entity structure The master tenant is structured as a special purpose entity. This gives the lender more bankruptcy protection.

Most master tenants are only minimally capitalized and the sponsors must have the requisite net worth and liquidity to satisfy lender requirements. The master lease will generally provide for rent to be paid by the master tenant to the DST in a set amount equal to debt service plus a market rate of return. The master lease incentivizes the master tenant to maximize the mortgaged property’s net operating income. The master tenant retains all net operating income over and above debt service and rent payments under the master lease. What is a 1031 Exchange? Under IRS section 1031, an investor can defer capital gains tax and depreciation recapture by reinvesting the proceeds from the sale of investment property into replacement property. 1031 exchange deferrals can be continued through as many exchanges as the investor wishes.

Of course, if at any time the investor sells the property without reinvesting in a new property, there will be capital gains and depreciation recapture and consequent tax liability. In addition to tax deferral, a 1031 exchange permits investors to purchase a leveraged replacement property and thus increase their basis. This allows for additional depreciation pass-through which can shelter as much as 50% to 60% of the rental income cash flow from income taxation. On an after tax basis, the rate of return (ROR) for a 1031 exchange into securitized real estate is comparable to RORs on investments with significantly more risk. With additional return from appreciation of the property, the after-tax return on investment on an annualized basis is even greater.

Some of the most important requirements for an IRS approved 1031 exchange: The exchange process must be facilitated by a qualified intermediary: The qualified intermediary (QI) is the professional responsible for the mechanics and process of an exchange. It holds the proceeds from the relinquished property until reinvested in the exchange property. An "exchange agreement" must exist in writing between the QI and the investor to prevent the investor from having "constructive receipt" of the funds during the exchange period. The use of a qualified intermediary as an independent party to facilitate a tax-deferred exchange is a safe harbor established by Treasury Regulations. The properties must be “like-kind.” Virtually all real estate properties, whether raw land or with substantial improvements, will qualify as like-kind. Securities offered by REITs, real estate funds, or other securities, do not qualify for 1031 exchanges. Types of like-kind properties include: • Raw Land

Multi-Family Rentals • Single-Family Rentals • Retail Shopping Centers • Office Buildings • Industrial Facilities • Storage facilities Rules The investor must identify in writing exchange properties within 45 days of the closure of the relinquished property, as follows: Three-Property Rule: Identification of up to three properties regardless of the total value of property identified 200% Rule: Identification of any number of properties wherein the combined FMV (fair market value) does not exceed 200% of the relinquished properties' FMV 95% Rule: Identification of any number of properties regardless of the aggregate FMV, as long as at least 95% of the property is ultimately acquired The investor must close on the replacement property or properties within 180 days of the closure of the relinquished property. The properties must be held either for productive use in a business or for the purpose of investment.

The replacement property must be of equal or greater value than the relinquished property. The equity of the replacement property must be of equal or greater value than the equity of the relinquished property. The debt held by the replacement property must be of equal or greater than the debt held by the relinquished property. All net profit from the relinquished property must be used in the purchase of the replacement property. This incentivizes the master tenant to cover short-term operating deficits, if necessary. Self-reserve Sponsors self-reserve from net operating income, over and above typical lender replacement reserves, for unanticipated repairs and uninsured losses. The investors have no vote in the operations of the property and there is usually no need for them to sign any non-recourse loan carve-outs. As with the primary loan, the lender deals directly with the trust on the matter of carve-outs. Standard carve-outs for environmental damages and investor fraud are executed by the DST trustee, according the DST investor an absolute non-recourse loan. The DST investor is not personally liable for the repayment (non-recourse) of the loan, and the loan does not affect the investor’s personal credit report. DST trust agreement restrictions IRS Revenue Ruling 2004-86, which forms the basis for a DST transaction in a Section 1031 exchange program, has prohibitions on the powers of the trustee. These restrictions must be incorporated into the trust agreement. Prohibited Activities • There can be no future contributions to the DST by either current or new beneficiaries. 

The trustee cannot renegotiate the terms of the existing loans and cannot borrow any new funds from any party unless a loan default exists following a tenant bankruptcy or insolvency.

The trustee cannot reinvest the proceeds from the sale of the real estate. • The trustee is limited to making capital expenditures with respect to the property for normal repair and maintenance, minor non-structural capital improvements, and those required by law.

Any reserves or cash held between distribution dates can only be invested in short-term debt obligations. • All cash other than necessary reserves must be distributed on a current basis.

The trustee cannot enter into new leases or renegotiate the current leases, unless there is a tenant bankruptcy or insolvency. Because of these IRS restrictions, the only forms of a real estate transaction that make sense in a DST are a master lease transaction, whereby the master tenant takes on all of the operating responsibilities, or a triple net long-term lease to an “A” credit tenant. The sponsor should also attempt to mitigate against the effect of these seven prohibitions by: 

Acquiring only new or recently rehabilitated Class A properties •

Raising substantial funds for capital reserves in the offering • Having financing terms which go out 7 to 10 years, but are shorter than the terms of the master lease • Planning for the sale of the property prior to the maturity date of the loan. The Springing LLC If the loan is endangered a provision in the trust agreement should provide that if the trustee determines that the DST is in danger of losing the mortgaged property due to default on the loan, and tax-related restrictions limit the trustee’s ability to act, Delaware law permits conversion to a LLC by a simple election which does not constitute a transfer under Delaware law.

This “springing LLC” will permit the raising of additional funds, the raising of new financing or renegotiation of the terms of the existing financing, and the renegotiation of leases. In addition, it will provide that the trustee (or sponsor) will become the manager of the LLC with full operating control. Summary Various financing sources have embraced the DST structure. A steady market has been developing for DSTs. They are much less complex than the structure of TIC transactions, they shield investors from liabilities with respect to the mortgaged property, and they remove the investors from involvement in operation of the property.

Related Topics

Private Placement Memorandum Securitized real estate offerings are SEC Rule 506 exempt offerings regulated under the 1933 Securities Act. They require the sponsor to provide a private placement memorandum (PPM) to investors. The PPM is a detailed description of the property, the sponsor, and financial details (including projected return on the investment). The PPM will include due diligence reports, leases, and contracts, as well as a discussion of the risks. A qualified expert must opine on whether the offering, as structured, meets the provisions for IRS Revenue Ruling 2004-86 or Revenue Procedure 2002-22 and qualifies for 1031 exchange treatment. Each accredited investor must be given a copy of the PPM and other offering documents before making a decision to invest. Direct Investments Direct investments in real estate include real estate investment trusts (REITs), real estate private funds, and oil & gas royalty programs.

None of these are eligible for 1031 exchanges. Direct ownership of a triple net leased property as well as some oil and gas royalty programs are eligible for a 1031 exchange. These private placements are available only to accredited investors under SEC Rule 506. They are not publicly traded and should be considered illiquid. They require a private placement memorandum and other offering documents. Real Estate Investment Trust (REIT) A REIT is a corporation which invests in real estate, either properties or mortgages.

An interest in a REIT is a security. REITs typically raise up to 1 billion dollars in capital and purchase a portfolio of properties over a period of several years. These properties produce rental income. A REIT must abide by specific rules. It is not required to pay corporate income taxes as long as it distributes at least 90 percent of its taxable income to shareholders annually. All dividend distributions made to investors are taxed only at the investor level, avoiding double taxation. REITs can either be offered as private placement investments to accredited investors under the exemptions offered by Rule 506, or they can be publicly traded. The private offerings should be considered illiquid investments. One goal of many REITs is to be acquired by a larger REIT. Types of REITs Equity REITs buy and own properties and are measured by the equity or value of their real estate assets. Their revenue is in the form of rent. Mortgage REITs buy and own property mortgages.

These REITs lend money for mortgages to owners of real estate, or purchase existing mortgages or mortgage-backed securities. Their revenues are generated by the interest that they earn on the mortgage loans. Hybrid REITs combine the strategies of equity REITs and mortgage REITs by investing in both properties and mortgages. Real Estate Funds Real estate funds are usually larger than DSTs or TICs but smaller than REITs. They often seek to raise up to $100 million to purchase income-producing real estate. Many funds use leverage to increase their purchasing ability and projected returns (and risk). With a more manageable size (compared to REITs), real estate funds are able to focus on particular asset classes or regions of the country. Some funds will also focus on purchasing real estate from certain institutional sellers, allowing them access to discounts or benefits not normally available to the smaller investor. Just as with DST or TIC offerings, real estate private funds typically have a projected period for holding the property, usually 5 to 7 years.

The actual date of sale will depend upon a number of factors related to the specific property and to the overall market. Investments in real estate funds are not considered an interest in real estate and are not eligible for 1031 exchange purposes. As there is no established secondary market for these interests, they should be considered illiquid. Oil & Gas Offerings These interests lie underground and are commonly referred to as “subsurface interests.”

Subsurface interests are mineral rights. There are two types of mineral rights. One is a royalty interest, where landowners are entitled to a percentage of any extracted minerals from the efforts of others, contracted to enter the land for exploration and drilling. The other kind of interest in mineral rights is called a working interest, giving exclusive authorization to enter the land to extract oil and gas--but with the land owners sharing in development and operating expenses as well as revenues. Both working and royalty interest investment programs feature advantages similar to many DST and TIC investments, such as monthly cash flow, tax deferral, and a depreciation or depletion allowance. In many oil and gas programs, there are no closing costs.

These investments are not dependent on real estate values or rent collections. The opportunity to diversify out of real estate makes these programs appealing to some high net worth individuals interested in alternative class investments. Some oil and gas programs are designed to meet the qualifications of “like-kind” replacement property, and are thus eligible for 1031 exchange purposes. NNN Leased Properties In addition to securitized real estate offerings, some investors purchase NNN leased investment-grade real estate directly. These properties produce both monthly income and have the potential for appreciation. T

They enjoy the tax benefits of real estate and they are eligible for 1031 exchanges. An investment in a NNN leased property can be attractive for a larger investor who desires to have more direct input in the oversight of the property or who desires to own a property with just a few other investors. Glossary for Securitized Real Estate and 1031 Exchanges Accredited Investor The SEC defines an accredited investor as an individual with either $1 million in net worth (all assets, excluding primary residence, less all liabilities) or net income for the last two years of $200,000 or greater ($300,000 if spouse has income) with a reasonable expectation of such earnings in the current year. Basis (Cost Basis) Basis is the original cost of property plus the cost of improvements, adjusted for depreciation.

When property is sold, the taxpayer pays/saves taxes on a capital gain/loss that equals the amount realized on the sale minus the property's basis. Cost basis is needed because tax is due based on the gain in value of an asset. IRS Publication 551 reads: "Basis is the amount of your investment in property for tax purposes. Use the basis of property to figure depreciation, amortization, depletion, and casualty losses. Also use it to figure gain or loss on the sale or other disposition of property." Boot Boot is the face amount of money or debt and the fair market value of non-like-kind property received in an exchange.

The fact that boot is received does not disqualify an exchange; the boot is, however, subject to capital gains tax to the extent of recognized gain on the sale of relinquished property. Constructive Receipt Income not actually received or possessed is "constructively received" and reportable if it is within the Exchanger's control. Delaware Statutory Trust (DST) A separate legal entity created as a trust under Delaware statutory law that permits a flexible approach to the design and operation of the entity to be used in in a Section 1031 exchange. Depreciation Recapture Depreciation recapture refers to the portion from the sale of a property which has been previously deducted as depreciation. If a property purchased for $100,000 is sold for $125,000 and during the time of ownership $50,000 was claimed as depreciation deductions, this $50,000 is depreciation recapture and taxed as such while the additional $25,000 would be considered capital gain and taxed at a different rate.

Direct Participation Program (DPP) A business venture designed to let investors participate directly in the cash flow and tax benefits of the underlying investment. The DPP is generally a passive investment in a real estate or energy-related project. Also known as a "direct participation plan,” DPPs are organized as limited partnerships, subchapter S corporations, or general partnership, and do not qualify for a 1031 exchange. While DST and TIC offerings are technically DPPs, they still qualify for a 1031 exchange. Exchanger This is a taxpayer seeking to defer capital gains tax under the provisions of IRC Section 1031 by means of a real estate exchange. Exchange Period The period of time in which the Exchanger must acquire title to replacement property to qualify under the safe harbor for the exchange. The period ends 180 days after the relinquished property is transferred or the due date (including extensions) of the Exchanger's federal income tax return for the year in which the Exchanger relinquished the property in the exchange, whichever is earlier.

Like-Kind Property This refers to the nature and character of the property, not to its grade or quality. One class of property may not be exchanged, under Section 1031, for property of a different class or kind. As a general rule, as long as the purpose of the taxpayer is to hold the property as an investment, real property will be deemed like-kind with other real property. Real property cannot be exchanged for personal property. Master Tenant In a DST, the trust will often lease the entire property to a Master Tenant, who then subleases the property to the actual tenants. This allows the investors in a DST to have a direct interest in real estate; and it removes both the trust and the investors from the direct day-to-day management of the property and the subleases, which are the responsibility of the Master Tenant.

The same results occur when the entire property of a DST is leased to one tenant on a NNN basis. Mortgage Boot This represents the liabilities assumed or taken subject to an exchange. It is not as recognizable as cash or other non-like-kind property. The taxpayer is considered to have received mortgage boot even if the buyer refinances the property as part of the exchange and used the proceeds to pay off the taxpayer's mortgage. NNN Lease A NNN Lease is a net lease, structured as a turnkey investment property. The tenant is responsible for paying the property tax, insurance, and maintenance. "NNN" stands for "Net-Net-Net" and is called "Triple Net.” The rent collected under a net lease is net of expenses. It therefore lower than rent charged under a gross lease. Net lease types include single net, double net, triple net and even bondable triple net leases. The term "net lease" is often used as a shorthand expression when referring to NNN leases. Private Placement or Exempt Offering Private placements are a way of raising money outside of public markets.

The placement does not have to be registered with the SEC but it must qualify as an exempt offering under SEC Rule 506. Private placement offerings can be made to institutional investors or to accredited investors. Property Boot A taxpayer who receives money or non-qualifying property is considered to have received property boot. Qualified Intermediary (QI) A qualified intermediary is a third-party that facilitates a section 1031 exchange on behalf of the exchanger.

The qualified intermediary will work under an agreement with the exchanger to take possession of proceeds from the escrow of the relinquished property and use those proceeds to fund the escrow of the replacement property. This is a tax safe harbor that avoids the exchanger from having constructive receipt of the funds. Real Estate Fund (Private Equity Real Estate Fund) A mutual fund which pools capital from investors and invests primarily in equity or debt of real estate in order to produce income and capital gains for its unit holders. These investments involve an active management strategy, releasing properties for development or extensive redevelopment. These funds typically have a limited life span, consisting of an investment period during which properties are acquired, and a holding period during which active asset management is carried out and the properties sold.

Real Estate Investment Trust (REIT) A REIT is a corporation which invests in real estate either through properties or mortgages, sold as a security. REITs can raise unlimited amounts of capital and purchase a portfolio of properties over a period of years. A REIT must abide by specific rules and restrictions so that it is not required to pay corporate income taxes. All dividend distributions made by a REIT to its investors are taxed only at the investor level, thereby avoiding double taxation. REITs can either be offered as private placement investments to accredited investors or they can be registered with the SEC and offered publically.

Relinquished Property

The relinquished property, also known as the exchange property, is the property originally owned by the exchanger and sold by the exchanger in a like-kind exchange. Replacement Property This is the acquisition property or the property acquired by the exchanger in a like-kind exchange process. Royalty Royalties are payments for the use of an asset. Oil and gas royalties are paid based upon the amount of oil and gas produced from a lease. Oil and gas royalty interests are classified as real property and they may be bought and sold privately or through public forums, like other real estate. Sponsor The sponsor acquires the assets and offers a securitized real estate offering such as a DST, a TIC, a REIT, or a real estate fund. With DSTs, the sponsor will acquire the real estate, structure the trust, and make the private placement offering to accredited investors through one or more brokers. The sponsor will contract with the master tenant and professional management company, both of which are often affiliates of the sponsor. Tenancy-in-Common (TIC) A co-ownership structure under which an investor may own an undivided fractional interest in an entire property and participate in a proportionate share of the net income, tax shelters, and growth. Undivided Fractional Interest With the tenancy-in-common ownership structure, each tenant owns an undivided fractional interest. Each tenant owns a fraction of the property, but they do not own a particular part of the property, meaning a specific area or section. Instead, they have fractional ownership of the entire undivided property. 

The author, Douglas Slain, is the managing partner of Private Placement Advisors LLC. He teaches online courses on equity and debt crowdfunding and private placements, and he has been involved with real estate securities for 40 years. Slain received his J.D. from Stanford Law School and taught there as a clinical adjunct law professor for one term. LinkedIn: http://www.linkedin.com/privateplacementadvisors/


Rss_feed