In this article, I’ll attempt to synthesize two significant topics into a single discussion. Firstly, I’ll discuss the gratifying tax and economic benefits of leading a real estate syndication as a sponsor by collaborating with investors. Secondly, I’ll delve into potential challenges and drawbacks that may arise during and after successfully closing your funding round. In both areas, I’ll prescribe solutions to help you maximize your benefits while maintaining a reputation as a reputable real estate mogul as you diversify into the commercial estate investment realm.
Benefits and Tax Savings
We all know that the most significant obstacle to real estate entry is the high capital requirement. This barrier often deters most people from exploring the market. Two strategies to overcome this hurdle include saving up enough capital for a downpayment on a rental investment or partnering with investors to use a loan to acquire a property. We refer to these alliances as real estate syndicates.
Typically, in these syndicates, one person—known as the “Sponsor”—leads the deal. The Sponsor identifies an opportunity, prepares the investment business plan, ties up the deal in escrow, performs due diligence, and then presents the opportunity via an investment memorandum to investors. These investors can be friends, family, clients, or close business associates. This approach is how I started raising funds nearly a decade ago.
As sponsors do the heavy lifting, including guaranteeing the mortgages/loans and investing some capital into the deal, they often arrange for the partnership to pay them a disproportionate share of the profits. This arrangement aligns with the value generated for the investors. The split or “waterfall” can vary significantly (30%/70%, 40%/60%, 50%/50%) depending on numerous factors, such as risk, sponsor track record, negotiating power, fees, expenses, and capital involved.
This is a great outcome for the sponsors if the deal performs well since they will receive a windfall of profits for investing relatively little cash in the deal. Of course, as mentioned above, their hard work and execution is what grants them the right to make this happen. As a sweetener to the mix, due to the nature of partnership taxation rules under Subchapter K of the Internal Revenue Code, the sponsor would receive this income, if structured correctly in the partnership agreement, in the form of capital gains in lieu of ordinary income. This is the area where a CPA and the attorneys collaborate to ensure the legal and tax structures are aligned.
One thing to consider regarding the above is IRC 1061, which relates to the revised carried interest provisions introduced in the Tax Cuts and Jobs Act of 2017. For a sponsor to realize long term capital gain allocations based on the above, the holding period of the asset and partnership interest would have to at least be 3 years. This shouldn’t be very problematic for most real estate deals, since they tend to be longer in duration anyway. IRC 1061 is a very complex piece of tax law though, so make sure to reach out to us if you need additional guidance on managing taxes around these types of investment vehicles.
Challenges and Solutions
Everything above sounds wonderful. You get to rake in big dollars with little cash invested! What can you possibly lose?
Honestly, a lot. Not just money, but probably your health and emotional well-being too. I’ll provide you a little story of how this plays out.
Simone Sponsor finds an awesome opportunity to build an apartment complex (not easy to do these days) in an up and coming neighborhood in Los Angeles. She quickly writes an offer which is accepted by the seller and opens escrow, which is due to close in 60 days. She needs to raise $1MM before the close of escrow or she’ll lose her deposit and more importantly, the opportunity to rake in big bucks. With tremendous urgency, she immediately calls all of her friends, previous investors, friends of friends, family members, and anyone who has a pulse plus money in their bank account to invest. She presents to them the proposal and a spreadsheet of the expected returns of the project which should be fully realized over the period of 5 years. After running through this pitch many times, she manages to find 14 investors who agree to fund the $1MM equity check with an average investment of around $70,000. One thing to note, the investors invested capital in a range of as low as $10,000 and as high as $150,000. She instructs them all to wire funds to a newly formed LLC bank account at least 15 days before the close of escrow.
Around day 45 of the contract period, Simone notices that she received only $800,000 in funds from her investors, with 3 of the investors all of a sudden having cold feet and backing out. In fact, these 3 investors completely ghost Simone and block her number so that she is unable to get in contact with them for an explanation. (I will write an article about investor psychology later, this happens way more often than you can believe). Panicked, Simone calls a few more people and gets a lead on 2 more foreign investors to bridge the $200,000 gap 3 days before escrow closes. This stressed her out and diverted her attention away from working with the architect and engineer on developing a plan set for submittal to the city.
After 18 months of battling with the city, her plans were finally approved and permits were able to be pulled. But alas, the economics had shifted quite a bit since her original projections. Due to a declining availability of contractors, labor costs moved up which of course negatively impacted costs. Also, interest rates spiked which also put a crunch on the budget since a bridge loan was needed to finance the construction of the apartment. Nonetheless, as Simone anticipated changes, she pressed on with the development of the apartment, hopeful that all would work out well in the end.
During construction, roughly around month 24, one of the investors who contributed $10,000 called Simone and stated that he changed his mind and needed his money right then for another investment opportunity. Simone tells this investor that the deal was at least going to take 5 years to execute and no investor can liquidate their investments per the partnership agreement. The investor replied that he didn’t read the agreement and he recalled from a phone conversation that he could pull the money out anytime he wanted and if Simone doesn’t send him back his $10,000, he’ll threaten to take part in America’s favorite pastime, by suing Simone. Annoyed and stressed, Simone agreed to buy his interest out with her personal funds to make him go away.
By sheer luck, a month later, an investor who contributed $150,000 heard about this deal and wanted out also. This time, Simone was unable to simply pay him off as she needed a supply of cash to manage any potential issues that might arise during the construction process. Simone had to spend considerable time selling the deal again to the investor and placating him, which took her focus away from the project.
Around month 48, the project was finally finished. Unfortunately, the market conditions changed, as do all things once the passage of time occurs. Rental income softened a bit since the initial projection and that impacted the valuation of the building and ultimately any chance of using a permanent loan to pay off the investors in full. She decided to sell the property which resulted in an overall gain for the investors, but at a much lower rate than initially anticipated. Also, since Simone didn’t ultimately meet the threshold to “promote”, she only received her proportionate share of the profit in relation to how much she invested. She received no additional reward for her hard work because of her failure to surpass the investment hurdles laid out in the partnership agreement.
She chalked it up as a mild victory. She gained more experience in construction and she didn’t lose anyone’s money, so that wasn’t a bad outcome. Just as she started to th