Crowdfunding Lawyers

What Are REITs and Series LLCs?

February 11, 2023
What Are REITs and Series LLCs?

Series LLCs simplify the process of raising funds for those who want or need to issue multiple offerings. Series LLCs can be used with Regulation CF and Regulation D offerings, but they can also be used with Regulation A offerings. That includes REITs (real estate investment trusts). REITs offer some unique benefits that deserve some of our attention, particularly as they relate to series LLCs.

 

REITs: A Recap

Before we go too far, let’s have a quick recap about REITs. Real estate investment trusts can be excellent vehicles, but they need to meet some specific criteria:

  1. 75% of the assets in the REIT must be real estate.
  2. That 75% can include first-lien mortgages, just owning the real estate, or buying businesses that are involved and backed by real estate. A good example of this is a car wash because they often include land in addition to the business.
  3. REITs must distribute at least 90% of their taxable profits.
  4. REITs have several penguins (yes, penguins – we’re not sure who decided to use that term in relation to real estate investment trusts, but for whatever reason, it stuck). These include the following:
  • REITs must be held by 100 or more people each year after their first taxable year.
  • Private REITs can hire shareholder accommodation firms to raise money from minority investors to meet that requirement. Note that these firms can charge substantial fees for their services.

We’ll discuss those in greater detail later in this article.

 

REITs vs. Partnership Taxation Pass-Throughs

Many people previously used a partnership taxation arrangement that allowed profits, losses, and depreciation to flow through to all investors via K1s. However, when you get into Regulation A series funding, you could be talking about 45,000 investors. Can you imagine trying to send out 45,000 K1 forms?

With an ERIT, the situation differs. You get a 1099 for the amount of dividends and distributions you receive for the prior year instead of a K1. This helps to streamline your process and saves you both time and sanity. Every January, you run your Excel of what dividends were sent out. Then you send it to your accountant and request that they send those 1099s by the end of the month. That’s the end of your involvement with investors in that regard. You must still file a tax return for the REIT, but now it’s on your timeframe and has nothing to do with the investors.

There’s another benefit to going this route, too. Your investors get a 20% deduction on whatever they receive through the REIT. So, some tax benefits are going to the investors, too.

 

Delving Deeper into the Penguins

It’s time to turn our attention back to the penguins mentioned previously.

REITs must have 100 or more investors each year after the first taxable year. That means doing a Reg D 506B or 506C will be more challenging because you must hit that 100 within the first year of operations. If you do, you’ll retain the REIT election. Most of your investors also need to be accredited. That’s a challenge because only 10% to 15% of the population is accredited in the first place.

This is another reason that you’re asking for higher minimum investments. You need more investors. Hitting that number for a REIT in the first year through Reg D can be difficult, so making the minimum investment $500 or $1,000 lowers the bar a bit. It’s less of a concern if you’re going through Reg CF or Regulation A.

We talked about private firms and how they can help you find accredited investors in exchange for a fee. They often make promises to the effect of “We’ll deliver 95 investors for $1,000 per person who invests”.

These are just some of the reasons it is more beneficial to go with a Regulation A deal. In addition, Regulation A offerings can be structured and positioned in such a way that they meet all the terms of a REIT.

 

Reg D vs. Reg A REITs

It’s not uncommon to have Reg D and Reg A REITs. However, you can also combine them depending on your specific goals and obtain benefits. As mentioned, a REIT requires a 1099. Based on the dividends an investor earns. This can be a big turn-off for accredited investors in a Regulation D offering because the depreciation was a primary reason for their investment decision. However, with a Reg A REIT, you’re dealing with unaccredited investors and the situation is very different.

Unaccredited investors are probably putting $1,000, $10,000, or $20,000 into a deal, rather than $50,000, $100,000, or $200,000. Because they’re not accredited, they simply don’t care as much about the passer of losses, and they can’t make use of depreciation the way accredited investors can.

One option is to do a general Regulation A fund to bring in unaccredited investors, while still doing individual Reg D partnership taxation offerings so that bigger accredited investors get the benefits they expect.

The way this works is surprisingly simple. You just have syndication going along with a REIT getting capitalized. In these cases, the REIT is often more of a blind pool with the syndication, that particular asset investment is more of a Reg D. It doesn’t matter because the Reg D is structured as a 506 C, so it’s 100% accredited and you can advertise it online.

In essence, you have a two-sided strategy. One allows you to market your offering and reach lots of unaccredited investors. The other side allows you to bring in accredited investors who have more funds and who want different results from their partnership with you. Then they come together through a tenancy in common arrangement or a joint venture arrangement to buy the property.

Ownership is divided between the two funding sources just based on the amount of investment money. And, because you’re going the series LLC route, you can still have different terms, fees, and benefits, all coming into the same property.

 

Can a REIT Have Nonaccredited Investors?

Yes, you can. In fact, nonaccredited investors may find them more favorable because they’re not concerned about losing depreciation. They’re taking the standard deduction on their taxes, which means they need to itemize a lot. REITs are good for that.

The accredited vs. unaccredited investor discussion is more centered around securities law, including Reg D, Reg A, and reg CF. REIT taxation versus partnership taxation doesn’t touch on that. It’s more about tax reporting and how it works with the IRS.

 

How Much Real Estate Do You Need in a REIT?

Percentage-wise, 75% of the assets in the REIT must be real estate. Because we’re dealing with percentages here, a single-family home that’s renting but has 101 shareholders could be enough. Real estate must be a key component of the business, which makes franchises and carwashes key examples. They’re both business models that need land on which to operate.

 

What Objections Would an Investor Have to a REIT?

Why would an investor prefer being a non-managing member of an LLC over being a shareholder in a REIT? The biggest difference between these two positions is taxation. Maintaining the REIT classification and its benefits has more requirements. There is no clear-cut answer to which is better, either. It will differ depending on an individual’s specific needs and goals. And again, smaller, unaccredited investors tend not to care about depreciation, plus there’s the fact that the automatic 20% deduction can be more favorable with smaller deductions, which means that REITs may be more attractive to unaccredited investors. You also need to consider tax-free retirement accounts. REITs can be excellent hedges against devaluation, like the crash of 2008.

 

Do Series LLCs Apply If You’re Looking to Buy Businesses But Don’t Want Specific Opportunities?

On a series-by-series basis, you can change the target and the terms. You’re not required to do the same thing repeatedly. For instance, you don’t have to only buy carwashes with an offering. You choose based on a series-by-series rollout, which creates a very flexible platform that can accommodate virtually any type of deal. For instance, series one might be a carwash, while series two might be a laundromat.

 

Can You Use a Series Model in California?

Yes, you can use series LLCs in California, but it depends on where you form the entity. If you’re doing business in California, you may still need to file as a foreign entity doing business in the state, which subjects you to California law. However, you can still rely on the series LLC setup where it’s legal to organize. However, note that states that don’t recognize series LLCs will treat these as separate businesses. Massachusetts is a good example of this. That can mean multiple registrations in a single state. It’s also important to realize that the assets purchased through a series LLC do not have to be in the state where the series LLC originated.

 

Must You Have a Target Entity Business Before You Can Raise Funds?

You do not need a target entity business before you can start raising funds with most offering options. However, if you’re following the syndication model, understand that syndications have a target business or asset for which they’re raising money. You cannot start with a blank slate if you’re going the series LLC route. You must have your first series with your first asset identified to move forward.

 

Is the CF REIT/Series LLC Offering a Good Choice for a First-Time Syndicator?

It comes down to what you’re targeting to acquire for your business plan. Suppose you’re interested in multi-million-dollar businesses. In that case, Reg CF may not be the best vehicle. However, if you’re trying to raise $300,000 for an asset or investing in smaller collectibles, then it might work well because $5 million goes a long way when acquiring businesses.

 

In Conclusion

REITs are not new, but they do make interesting options when it comes to series LLCs and your ability to attract different types of investors. That’s particularly true if you want to invest in brick-and-mortar business models that require real estate, like franchises and carwashes. However, they can also be used for an incredibly wide range of other needs so long as you meet the requirements to be considered a REIT.

Not sure how to structure your deal? Interested in learning more about how Reg A stacks up against Reg D or Reg CF? Contact us to schedule a free consultation.

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