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May 23, 2024 | read

Navigating the Intricacies of Real Estate Syndications and Funds

Thomas Castelli

Understanding Syndication

‘Syndication’ is a term in the real estate world that can serve both as a noun and a verb. When we speak of the act of raising money, we could refer to it as syndicating. In contrast, syndication as a noun typically denotes a particular type of real estate investment arrangement.

According to the WG&L Tax Dictionary, a syndication involves limited partners who passively invest their capital. This differentiates it from a typical real estate partnership. In a typical partnership, all partners participate actively. However, when a partnership starts raising funds from a significant number of investors who passively contribute their funds, it evolves into a syndication.

As a General Partner (GP), you are responsible for identifying the asset and managing the syndicate. Your role bridges the gap between a typical partnership and a syndication. Syndications generally involve substantial capital raising and are governed by specific rules, especially when it comes to allocating losses.

A Fund in Real Estate

In the real estate context, a “fund” is often a collective pool of money gathered to invest in specific types of assets. Funds can either be open or closed. An open-ended fund allows for continuous contributions from investors. The GP, in turn, finds new assets to invest these funds into. Conversely, a closed fund involves one or two rounds of capital raising, after which no further money is added. The GP then deploys this capital into assets such as real estate.

Syndicate Vs. Real Estate Partnership

While a real estate partnership can exist between just two individuals, a syndicate involves a GP and multiple limited partners. The GP manages the entire deal, while limited partners invest money without making operational decisions. When you enter into this type of arrangement, you encounter additional challenges, particularly in loss allocation.

For instance, if a syndication with more than 35 limited partners sees losses (perhaps through depreciation of a real estate asset), certain rules and regulations apply for reporting and other requirements. This type of partnership is often known as a syndicate.

In a syndicate, general partners (also referred to as sponsors or syndicators) assemble and manage the deal, while limited partners (or passive investors) provide the capital but are not involved in decision-making or daily operations.

Advantages of Deferred Fees and Profit-Sharing Strategies for General Partners

Deferred fees and profit-sharing strategies can be vital for aligning the interests of General Partners (GPs) and Limited Partners (LPs), often manifesting in increased fees that incentivize GPs to ensure deal success. By “reinvesting” a portion of a fee typically taxed as ordinary income into the deal as a profits interest, GPs strategically tie their rewards to project success, motivating them to work harder and benefiting LPs.

There’s also a tax advantage, as deferred income potentially qualifies for lower long-term capital gains tax rates rather than higher ordinary income tax rates. This advantage, however, relies on an entrepreneurial risk tied to the profits interest, differentiating it from guaranteed payments or ordinary income.

One common arrangement is a general partner catch-up or ‘supercharged profits interest’. Here, LPs’ initial investment is returned first, then the deferred acquisition fee to the GP, and only then are profits distributed based on agreed splits, ensuring alignment of GP’s and LPs’ interests.

While this approach provides tax advantages and an increased share of profits, it requires confidence in project success and willingness to delay gratification from GPs. Moreover, its suitability varies, necessitating careful evaluation of risk, rewards, and tax implications before opting for such fee structures. Consulting a tax professional is recommended to understand potential tax benefits and drawbacks. These strategies, while not universally applicable, can reduce tax liability and improve profit share when applied judiciously.

Strategic Approaches for General Partners (GPs)

Use of Tenancy in Common (TIC)

One beneficial strategy for GPs is the use of a tenancy in common (TIC) structure when raising 1031 exchange capital in a syndication. Despite potential challenges—like IRS scrutiny to ensure TIC arrangements do not operate as partnerships—this approach can cater to investors seeking a more passive role if successful.

Special Allocation in Syndications

Depreciation allocation is a critical aspect of syndications. A strategic allocation of depreciation can yield significant benefits, provided there’s a thorough understanding of its application.

The Role of ‘Substantial Economic Effect

The principle of ‘substantial economic effect’ is essential in partnerships. Allocations should closely align with the economic realities faced by partners. Misalignments can result in the unfair distribution of losses or gains, emphasizing the need for professional guidance.

Recognizing the Downsides of Self-Directed IRAs

Unlike typical IRAs that limit investments to stocks and bonds, self-directed IRAs offer more control over assets, including the ability to invest in alternative assets like real estate. While these types of IRAs provide regular IRA benefits, including tax advantages, there are potential pitfalls, such as Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI).

Note that income generated from certain business activities by your IRA could be subject to tax, a characteristic contrary to the typical tax-free nature of IRAs. For instance, rental income from real estate, when arising from a leveraged asset, could be subject to UDFI, thus taxable.

Comparing an investment in an ETF like the S&P 500 and real estate, the latter could introduce potential taxes, particularly if financed with a mortgage. Real estate’s tax-advantaged status, coupled with benefits like depreciation, may make investing in real estate through non-IRA accounts more sensible in some situations. However, a self-directed IRA could be a viable choice if you have limited capital outside of your IRA.

Looking at Solo 401Ks

Solo 401Ks are an alternative retirement account that can be used to invest in real estate. Unlike self-directed IRAs, Solo 401Ks are generally not subject to UDFI, making them a potentially more attractive option. 

Still, financial advisors should always be consulted when considering investing in real estate through these types of retirement accounts. 

 

In conclusion, real estate investing is a labyrinth of intricate concepts and rules. However, with a comprehensive understanding of the different elements involved, investors can make informed decisions, maximizing their returns while minimizing their tax liabilities.

Interested in building your wealth through syndications and funds? Contact us today.