Direct Investments
An investment that is not one of the three traditional asset types (stocks, bonds and cash) is considered an alternative investment. Examples include real estate investment trusts, equipment leasing programs, managed futures, and oil or gas programs. For certain investors, alternative investments can have distinct advantages over traditional investments. One common theme to alternative investments is that they are often hoped to have modest correlations with traditional investments and so to increase the diversification of investor's portfolios.
Some of the key advantages to alternative investments include independence from market volatility, increased diversification, tax benefits, and potential for higher returns. Drawbacks to consider typically include lack of liquidity, infrequent valuation, and reduced transparency.
Through an analysis of your existing portfolio, your goals, your risk profile, and your liquidity needs, the advisors at LJCooper can help you make a smart decision about whether alternative investments should play a role in your overall portfolio.
Real Estate Investment Trust (REIT)
REITs are corporate entities that buy, sell, finance, and manage real estate and real estate related instruments, like mortgages and real estate backed notes. REITs have been around for decades. The first REITs offered to investors were very basic, buying and holding real estate assets such as office buildings or retail centers. Investors were able to own multiple properties for a minimal investment amount and received rental income in the form of dividends paid out by the REIT Corporation.
REITs have come along way from its early beginnings. Today investors can choose from a wide and diverse variety of real estate offerings, in addition they can choose between public traded REITs offered through the stock exchange or public non-traded and private Reg. D investments.
REIT Investment Classifications:
Public Traded – A real estate entity that has registered with the Securities and Exchange Commission (SEC) and offers to the investing public shares of stock through an exchange such as the New York Stock Exchange (NYSE). The REIT Company may have procured the underlying real estate through a public or private capital raise and is looking to provide some additional funding or liquidity through the offering of shares to the investing public.
Shares of public traded REITs are bought and sold on a daily basis by the investing public and are considered a liquid asset, even though real estate in itself is not a liquid asset. The shares traded on the open market are priced based on bid and ask pricing as dictated by supply and demand of shares held by investors. In addition to public traded shares offered on the various market exchanges, it is possible to purchase multiple public traded REITs through mutual funds and exchange traded funds (ETFs).
Public Non-Traded – A real estate entity that has registered with the SEC and offers shares of stock to investors directly from the company, instead of through a stock exchange. Non-traded REITs are identical to Public Traded REITs in every respect with a few notable exceptions; share price and dividend are fixed by the REITs management, and shares are considered illiquid.
The investor must be willing to hold the non-traded REIT for a specified amount of time typically 7-10 years. REIT management will begin to consider options for a liquidity event prior to the projected 7-10 year holding period. There are several liquidity event options: Sell-off individual holdings, merge with another REIT, list shares on a public exchange, or a complete liquidation of all assets to another entity.
In order to offset the illiquid nature of non-traded REIT shares, many of these companies provide a share redemption program on a pre-determined percentage of outstanding shares or at the discretion of company’s management team.
Private Offering (Regulation D) – Private or Reg. D offerings are not registered with the SEC and can only accept accredited investors* into the program. While companies using a Reg. D exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what’s known as a "Form D" after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s executive officers and stock promoters, and includes the date of the first shares sold, but contains little other information about the company.
Reg. D offerings are non-public and have limited investor participation due to the size allowed by the accredited investor exemption which requires a total offering price of less than $5,000,000. These types of offerings also require that the sponsor cannot solicit or advertise shares to the public, which is why they are considered “private” offerings.
For more information on Regulation D go to www.sec.gov/answers/regd.htm
*Accredited Investor See information and requirements listed below or click on the link provided
Source: NAREIT
*Accredited Investor – a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase; a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
The following is the complete list of entities that can qualify as an accredited investor.
The federal securities laws define the term accredited investor in Rule 501 of Regulation D as:
- A bank, insurance company, registered investment company, business development company, or small business investment company;
- An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- A charitable organization, corporation, or partnership with assets exceeding $5 million;
- A director, executive officer, or general partner of the company selling the securities;
- A business in which all the equity owners are accredited investors;
- A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
- A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
- A trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.
If you would like more information about Real Estate Investment Trusts (REITs), please contact us by either emailing our advisory team at (advisor@ljcooper.com) or calling our office, (877-405-4015 or 801-221-2939).
Before considering any investment you should consult with your financial or tax advisor.
Capital Gains – Dealing with Appreciated Assets
Over the years LJCooper has been involved with the recognition and handling of capital gains tax consequences associated with the sale and/or liquidation of appreciated assets. These assets range in variety from basic real estate to stocks, mutual funds and businesses. Each of the aforementioned assets has a different way of being recognized and properly dealt with. A variety of programs have been used over the years to defer capital gains tax on appreciated assets, but it seems every year the options are being eliminated.
Commonly investors understand that when they sell land or real estate they may have a capital gains tax issue, if the value of the real estate has increased in value from the date they originally purchased it. The following is one recognized way to control and defer the capital gains tax associated with the sale and/or liquidation of real estate. There are other programs that can be used and if you would like to learn more about other capital gains deferral options we invite you to schedule a meeting with our expert advisory team.
1031 Exchange -- Exchange of property held for productive use or investment
No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. Source; IRC Title 26 §1031
Who qualifies for the Section 1031 exchange? Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.
How does a 1031 Exchange work? A person or entity sells real estate. In order to affect an exchange for the purposes of deferring capital gains tax or mortgage debt the seller is required to enlist the services of a qualified intermediary (QI) to escrow the funds and supervise the actual exchange process. The seller must identify replacement property within a 45 day window and the property must be a like-kind nature. Meaning you can’t exchange land for stocks, but you can exchange land, a real property, for a building if the land was used in the conduct of some business purpose.
Once the replacement property is identified the exchanger (seller) has 180 days from the date of sale to complete the exchange (purchase) of the indentified property. It is very important to follow the rules set forth by IRC code 1031 as there is no leeway for missed dates and if not followed exactly could trigger tax consequences. Click on link Short Video about 1031 Exchange
Day 1
Sale of Property, An accommodator or Qualified Intermediary (QI) sets up escrow and provides the seller with an identification document
Day 45
Up to three separate properties can be identified and must be submitted on the 45th day to the QI. Failure to properly identify replacement properties’ within the 45 days will result in tax consequences. It is possible to identify more than three properties but the guidelines are very strict. Consult your tax professional or a QI. QI’s can be found through most Title companies. The person that is exchanging their property through 1031 can list additional properties, but must adhere to very strict guidelines for listing more than 3 replacement properties. Click on link Identification Rules
Day 180
Once replacement property has been identified, the exchanger must complete the transactions acquiring the replacement property by the 180th day from sale date. Failure to meet this deadline results in tax consequences.
Securitized 1031 Exchange – Considered an investment by the Securities and Exchange Commission (SEC). This type of replacement property is offered through a securities licensed representative or advisor. The registered representative or advisor must hold a series 7, general securities representative license or the Series 22, the Direct Participation Programs Limited Representative securities License. The DPP Registered Representative can participate in the purchase and sale of certain direct participation programs. FINRA offers investors the ability to check the status of any licensed representative or advisor through the following link. Finra.org
1031 exchanges from a securitized perspective or exchanges which involve a securitized offering come in two primary forms.
1. Tenant-In-Common (TIC) A form of Real Estate ownership where 2 or more entities own an undivided share in the property.
2. Delaware Statutory Trust (DST) Is an unincorporated association which is created by a governing instrument ("trust agreement") under which either (a) property is held, managed, administered, invested and/or operated, or (b) business or professional activities for profit are carried on by a trustee or trustees for the benefit of a person who is entitled to a beneficial interest in the trust property. A Delaware statutory trust has a separate legal existence and can conduct business in its own name. See IRS Revenue Ruling 2004-86 for more information on DSTs.
Understanding Capitalization Rate (Cap Rate)
This section will help the investor understand what factors to consider prior to placing funds into an investment, such as how to determine cap rate, cash on cash return, property values and other key terms related to real estate investing.
Key Terminology for Capitalization Rate section:
Debt Service – The annual cost of the interest portion of mortgage payments made on the property loan. The higher the interest rate the higher the debt service. If the loan is an interest only loan then the entire payment would be considered debt service.
Net Operating Income (NOI) – Projected income for a property after vacancy losses, operating expenses and any collection accounts are deducted. NOI does not include debt service payments, tenant improvements, capital expenditures or leasing costs.
Cash-on-cash Return – This return shows the annual percentage of return that investors receive from the property based on their equity investment into the property. The formula for Cash-on-cash return is illustrated in Formula C.
Capitalization Rate or Cap Rate – A rate of return used to derive the capital value of an income stream.
Formula (A) for property value:
Property Value = Annual Inome / Capitalization Rate
Example Formula A:
$125,000 annual income / 8.5% Cap Rate = $1,470,588 Property Value
Formula (B) for Cap Rate:
Cap Rate = Net Operating Income / Purchase Price
Example Formula B:
$125,000 Net Operating Income / $1,500,000 Purchase Price = 8.33% Cap Rate
It is important to understand that Cap Rate is not cash on cash return of your investment amount. Typically the cash on cash or return on investment is lower than the Cap rate.
For an investor to receive an 8.5% ROI the cap rate would have to be higher. The higher the cap rate the better the potential cash on cash return. Higher cap rates are also indicative of better loan terms and favorable purchase price. Lower cap rates denote tighter market competition for available property and/or less favorable lending rates.
Formula (C) for cash on cash return:
Cash on Cash Return= (NOI – debt service- capital expenditures – leasing costs) / Equity amount of the property’s purchase price
Example Formula C:
$125,000 - $60,182 - $10,000 - $5000 = $49,818
$49,818 / $750,000 Equity Portion of purchase price = 6.64% Cash on Cash return
This projected first year calculation assumes a loan amount of $750,000 financed at 5% over 20 years with $10,000 for capital expenditures and $5,000 for leasing costs*. Subsequent years can also be projected but may not accurately reflect real cap rates due to changes in local economies and unforeseen expenses.
* Leasing costs can include commissions to agent, concessions to attract new tenants, and/or sales and marketing materials.
Management plays the key role in reducing capital expenditures and leasing cost. The longer lease terms that can be contracted, the fewer leasing cost are incurred. In addition, consistent property maintenance and account oversight can provide an added value to cap rates and cash on cash return to the investor.
1033. Involuntary conversions
Though a 1033 is not regularly utilized it is important to understand. The most common use of this code for exchange purposes has been when municipal, State or Federal agencies have required the use of certain lands related to expansions, services or legislative mandates where private citizens are required to sell their property. The code allows for other mitigating circumstances that require the forced liquidation of real and in some cases personal property, but in general it is an imminent domain issue. (click to see IRC 1033 Full Definition)
(The following is the complete explanation of 1033 from the Internal Revenue Code Section 1033. This information will be accessible as a pdf through a link on the 1033 brief description on the Direct Investment page)
1033 Involuntary Conversions
(a) General rule
If property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof) is compulsorily or involuntarily converted—
(1) Conversion into similar property
Into property similar or related in service or use to the property so converted, no gain shall be recognized.
(2) Conversion into money
Into money or into property not similar or related in service or use to the converted property, the gain (if any) shall be recognized except to the extent hereinafter provided in this paragraph:
(A) Nonrecognition of gain
If the taxpayer during the period specified in subparagraph (B), for the purpose of replacing the property so converted, purchases other property similar or related in service or use to the property so converted, or purchases stock in the acquisition of control of a corporation owning such other property, at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized upon such conversion (regardless of whether such amount is received in one or more taxable years) exceeds the cost of such other property or such stock. Such election shall be made at such time and in such manner as the Secretary may by regulations prescribe. For purposes of this paragraph—
(i) no property or stock acquired before the disposition of the converted property shall be considered to have been acquired for the purpose of replacing such converted property unless held by the taxpayer on the date of such disposition; and
(ii) the taxpayer shall be considered to have purchased property or stock only if, but for the provisions of subsection (b) of this section, the unadjusted basis of such property or stock would be its cost within the meaning of section 1012.
(B) Period within which property must be replaced
The period referred to in subparagraph (A) shall be the period beginning with the date of the disposition of the converted property, or the earliest date of the threat or imminence of requisition or condemnation of the converted property, whichever is the earlier, and ending—
(i) 2 years after the close of the first taxable year in which any part of the gain upon the conversion is realized, or
(ii) subject to such terms and conditions as may be specified by the Secretary, at the close of such later date as the Secretary may designate on application by the taxpayer. Such application shall be made at such time