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Direct participation program (or direct participation plan or direct investment, abbreviated DPP) is a financial security that enables investors to participate in a business venture’s cash flow and taxation benefits. The term originates from the Securities Act of 1933 and NASD Rule 2810, which addresses the regulation of compensation, fees and expenses in public offerings of DPPs.

Direct participation programs are most commonly formed to invest in real estate, energy, futures & options, and equipment leasing projects. A DPP is often organized as a limited partnership or limited liability company, structures that enable the income and losses of the entity to flow-through to the underlying taxpayer on a pre-tax basis. As such, the DPP pays no tax at the corporate level. An investor’s stake in the DPP is quantified in units and may be referred to as their interest. A non-listed real estate investment trust enjoys a special tax-free status if its distribution of income is sufficient, and as such may be organized as a corporation without being subject to double taxation.

Broker/dealers often market DPP securities and are paid commissions for their role in distribution and administrative functions.

DPP securities are generally not traded publicly, so the value of a DPP product is determined by the performance of the underlying assets rather than by the public markets. DPP products are generally illiquid for their duration, although some limited secondary markets may exist. There may be substantial fees and costs associated with DPP securities. Refer to the prospectus for specific details.

Under the current test, an individual qualifies as an “accredited investor” if he or she has at least $200,000 in annual income in each of the two most recent years (or $300,000 jointly for married couples), with an expectation of meeting that threshold again in the current year, or $1 million in net worth without taking into account the primary residence. The exclusion of the net worth of the primary residence was a relatively recent change brought about with the enactment of the Dodd-Frank Act. For a more detailed explanation of the Accredited Investor rules, please see the SEC website link:

http://www.ecfr.gov/cgi-bin/retrieveECFR?gp=&SID=8edfd12967d69c024485029d968ee737&r=SECTION&n=17y3.0.1.1.12.0.46.176

Regulation D establishes three exemptions from Securities Act registration.

Rule 504

• Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period.
• Issuer cannot be a blank check company and nor subject to Exchange Act reporting requirements.
• In general issuers may not use public solicitation or advertising to market the securities and purchasers receive “restricted” securities, meaning that they may not sell the securities without registration or an applicable exemption.
• However, issuers can use this exemption for a public offering of your securities and investors will receive freely tradable securities under the following circumstances:

The offering can be sold exclusively in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors; The securities may be registered and sold in a state that requires registration and disclosure delivery and also sell in a state without those requirements, so long as the disclosure documents mandated by the state in which the securities are registered are delivered to all purchasers; or, the securities can be sold exclusively according to state law exemptions that permit general solicitation and advertising, so long as they are sold only to “accredited investors,” a term we describe in more detail below in connection with Rule 505 and Rule 506 offerings. Even if there is a private sale where there are no specific disclosure delivery requirements, the offerer should take care to provide sufficient information to investors to avoid violating the antifraud provisions of the securities laws. This means that any information provided to investors must be free from false or misleading statements. Similarly, information should not be excluded if the omission would be false or misleading to investors.

Rule 505

• Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period.
• Under this exemption, you may sell to an unlimited number of “accredited investors” and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions.
• Purchasers must buy for investment only, and not for resale.
• The issued securities are “restricted.” Consequently, investors must be informed that they may not sell for at least a year without registering the transaction.
• May not use general solicitation or advertising to sell the securities.

Rule 506

• Rule 506 provides an exemption as follows:
• The company that is raising money can raise an unlimited amount of money.
• The company cannot market the securities to the general public.
  • Note: This piece of the legislation is subject to change as a result of the JOBS act that passed Congress in April, 2012. The Securities and Exchange Commission (the regulatory body for securities) is currently deciding on final rules.
• The securities that are sold are “restricted” so they cannot be resold during the first year
• The company must sell the securities to “accredited investors” and up to 35 “non-accredited” investors so long as they are sophisticated. Sophisticated investors in this sense means they have the requisite business and financial knowledge to make them capable of understanding the risks associated with the investment.
  • When securities are sold to non-accredited investors, there are additional regulations and disclosures that are required.

A Form D must be filed in every state where there is an investor.

Passive Real Estate Equity Investment Structures

Many passive real estate equity are structured through “direct participation” investment vehicles like limited partnerships or limited liability companies. These structures not only give investors the benefits of passive investing, they also allow for the “pass-through” of depreciation, interest expense, and other deductions that that can reduce the investor’s taxable income. They represent a great investment alternative for investors who aren’t in a position to spend all their time searching for, and then managing, appropriate investment properties.
Investors will usually invest alongside a professional real estate company — often called a “sponsor” or “operator” — that will find a viable project and perform the related management tasks once the property has been acquired. Such companies typically need other investors to provide some (or most) of the capital required for any single opportunity — and these investors will then share in some of the project’s benefits (and risks).
Although limited partnerships are sometimes used, many real estate investments are structured using limited liability companies. These entities not only provide limited liability to the investors (and usually the sponsor), they also allow for the “pass-through” of tax deductions that derive from the ownership of real estate.
The structuring issues then come down to how to divide the financial benefits of the project among the investors and the sponsor. (Investors also want to know that a sponsor contributes at least 5-10% of the equity capital for the project, so that it has sufficient “skin in the game” that its interests are aligned with the investors.) For investors, a partial risk/benefit analysis might include the following:

The negotiations involved in resolving these issues vary with each transaction, depending on the anticipated risks and benefits involved in the particular project. Over time, however, some common patterns have emerged for many transaction:

Investors:

• Provide the vast majority of the capital (usually 80-95%)
• Receive a “preferred return” on their investment (often 5-10%)
• Receive a share of the remaining cash flow and profits (typically 50-80%)
• Receive the bulk of the tax benefits, such as depreciation and interest deductions

Sponsor:

• Provides a small portion of the capital (usually 5-20%)
• Receives the same preferred return as investors on its own invested capital
• Receives a “promote” share of the remaining cash flow and profits
• May receive fees relating to property acquisition, loan financing and management
• Receives some share of the tax benefits

Investors putting cash into a project also generally receive some “preference” in the return of that money before any “sweat equity” gets compensated. The preferred return, often in the 6-10% range, means that the investors will receive that amount before the sponsor gets paid any “promote” share of distributable cash flow. The preferred return is not a guaranteed dividend, however; sometimes the preferred return is not paid out because the property cash flows don’t allow it (for example, where the property is still under development). In such cases, the preferred return typically continues to accrue, and any unpaid amounts are ultimately recouped by the investor when the property is sold.

Real estate investment opportunities can be structured in many different ways; for example, pools of real estate properties can be owned through real estate investment trusts (REITs). The use of pass-through entities (like LLCs), however, can make real estate investing much more attractive; those structures allow passive investors to take advantage of many of the tax advantages of real estate ownership in a way that REITs do not.

Any type of property, whether it’s commercial or residential, can be a good investment opportunity. Commercial properties typically often offer more financial reward than residential properties, such as rental apartments or single-family homes, but there also can be more risks. Understanding the full pros and cons of investing in commercial properties is important so that investors make the investment decision given their risk tolerance and level of knowledge.

Commercial properties may refer to:

• retail buildings
• office buildings
• warehouses
• industrial buildings
• apartment buildings
• “mixed use” buildings, where the property may have a mix, such as retail, office and apartments.

A commission or sales charge applied at the time of the initial purchase for an investment. It is deducted from the investment amount and, as a result, it lowers the size of the investment. Front-end loads are paid to investment intermediaries (financial planners, brokers, investment advisors) as sales commissions and related marketing costs.

Investment Distribution Rate

Cash on Cash – Cash-on-cash (sometimes called the equity dividend rate) is one of the most common return formats used in the real estate industry. It is a ratio (usually converted to a percentage) that is derived by dividing cash flow (before tax) by the amount of equity initially invested.

The cash flow figure equals the net operating income of the property – the gross rental income less the usual operating expenses – minus the debt service on any mortgages to which the property is (or will be) subject. That number is then divided by the equity investment in order to get a measure of the “return on equity,” or cash-on-cash return. A simple example might be as follows:

The cash-on-cash figure doesn’t take into account any income tax effects, resale implications (including changes in property value), future cash flows, or reductions in loan principal. It does, however, give a good feel for the immediate and ongoing periodic return that a cash flow investor can expect. Investors are cautioned that it is possible to have losses instead of cash flow in any investment and that an investor’s entire equity investment could be lost.
The cash-on-cash figure can also show the effects of leverage – using a mortgage loan to finance part of the property’s purchase price. Let’s assume now that in the above example $800,000 of the total purchase price is financed by a mortgage loan – so that the investor is only paying $200,000 cash for the same property. Although this will result in debt repayment expenses (interest and, oftentimes, principal amortization), the much lesser equity investment required often makes this additional expense worthwhile. Let’s look at the same property with leverage in place, assuming an 8% interest-only loan:

The cash-on-cash return would thus more than double if this mortgage loan were to be used to finance the greater part of the property’s purchase price. Loans bring with them risks, of course – any decrease in the property’s projected net operating income will be borne entirely by the owner, since the bank must be paid back in any event. Yet this cash-on-cash return analysis shows how leverage can also greatly increase the return on equity, and thus the proportionate cash flow returns to the investor, if the interest rate on the loan offers favorable financial leverage to the person making the equity investment.

There are other measures that may be needed to decide whether an investment should be purchased; investors need to consider income taxes, riskiness, whether more or less money should be borrowed, and possible alternative means of financing. A potential real estate investment requires a sophisticated level of in-depth analysis. The cash-on-cash return measure remains a basic and important yardstick, however, in indicating whether an investment might be a good one.

Potential investors should note that while utilizing leverage can have positive effects on the investor’s return on investment, it can also potentially have a negative impact on the investment and accelerate or compound potential losses.

Internal Rate of Return – IRR – The simple “cash-on-cash” return figure uses a property’s cash flow numbers to give a simple look at the desirability of an investment. In addition to not taking into account any appreciation of a property, however, it also doesn’t incorporate a key second element in measuring return on investment, time. Investors are interested not only in how much money they will receive, but when they will receive it. The internal rate of return figure (“IRR”) incorporates the “time value of money” and thus provides a fuller analysis of return on investment.

The key idea underlying the time value of money is the “present value” concept. This is simply the idea that a dollar today is worth more than a dollar tomorrow. This is true for three reasons:

• Inflation – because prices rise, future dollars are generally worth less than present dollars.
• Opportunity cost – a dollar in hand today could be invested to earn interest; if a dollar is not received until a year from now, the interest that could have been earned must be foregone.
• Risk – if a dollar is to be received in the future, there is always some possibility that the dollar will not in fact be repaid.

The value of future money must thus be “discounted,” a concept that is related to the idea of compound interest. The value of a future dollar is linked to how a present dollar earns interest – and that includes the idea that interest in later periods is paid on both that initial dollar and the interest earned on earlier periods. This is the “compound interest” that is earned by money in a bank savings account, for example. In the finance world, this compounding of interest is calculated as follows:

The calculation of investment yield, or IRR, is a variant on this formula, and can be viewed simply as compound interest in reverse – that is, compound interest worked backwards in time, or “discounting.” It states a rate of return on investment that is a function of the present value of both the property’s future cash flows and the expected gains to be made from its ultimate sale. Since all of these monies will be gained at different times in the future, an IRR calculation is needed to relate the combined present value of each of those various income sources to the value of the initial investment. One drawback of the IRR calculation is that it assumes that earlier cash flows will be reinvested at the same rate of return, which is usually a bit unrealistic. Nevertheless, the IRR figure is a relatively good indicator of a project’s overall rate of return.

Computers and calculators make the computation of IRR quite easy. One must assign expected cash flow figures to each year (with any projected gain on sale assigned to the final year), and make clear how many years the project is to last — and modern spreadsheet programs can immediately calculate the IRR of the project. These programs also permit an investor to use different sets of assumptions and projections in analyzing the investment.

That functionality is important, since the IRR is necessarily based on a set of projections and assumptions. For example, since the IRR is computed based on the amount actually invested, it will generally increase significantly for those projects that are partially financed with debt. The various other risks inherent in a project must also be evaluated, and different sets of assumptions utilized, before settling on a set of cash flow and sales figures that are the key to calculating the IRR. These other steps are part of the due diligence to be undertaken on a project — and here, there is still no computerized substitute for thoughtful human analysis of the various risk factors that might affect an investment’s outcome.

Crowdfunding is one of the new buzzwords to hit the financial services industry and it is now being applied to real estate. Through crowdfunding, investors can pool money together and buy shares of real property like apartment buildings, office buildings and retail centers. Rather than buying the entire property and dealing with the hassles of tenants, toilets and trash, individuals investing through crowdfunding can pool their capital with others to invest in larger properties than they could individually and have the benefit of professional management so they do not deal with any of the day-to-day management of the property.

The tax benefits of real estate investing are attractive, but until recently many investors had difficulty participating in commercial real estate syndications that could fully take advantage of those tax benefits.

The tax benefits of direct real estate ownership are substantial and not generally available to investors in real estate investment trusts (REITs), who do not receive all the tax attributes associated with the actual ownership of real estate. Real estate investments made through a limited partnership (LP) or limited liability company (LLC) structure can be more attractive than REITs for several reasons, but at least some of the appeal lies in the inability of REITs to fully take advantage of the various tax shelter benefits available through the LP or LLC structure.

Depreciation. The primary tax feature of equity real estate investing is the role of the depreciation deduction, which has long played a major part in the popularity of real estate direct participation programs involving LPs or LLCs. This is because well-located and well-maintained real property often has a useful life longer than the depreciation recovery periods allowed by law. The depreciation deductions thus effectively create a tax shelter for a property that likely still has a useful life following the investment period. More accurately, the deductions create a tax deferral, since the tax basis of the property is reduced by the amount of the depreciation deductions, increasing the gain (or decreasing the loss) recognized at the time of sale. It should be noted that some or all of this additional gain may be recaptured in the form of ordinary income, as opposed to capital gain.

A particular advantage of the depreciation rules is that the basis for depreciation write-offs is the full cost of the asset. Rarely is real estate purchased for all cash; usually, the major portion of its cost is financed through a mortgage loan or other type of debt financing. The owner, however, gets a full depreciation deduction whether or not he pays all cash for the property, and whether or not he makes any sort of personal guarantee on a financing loan. The reasoning for not limiting the depreciation deduction to an owner’s equity stake is that eventually the owner will have to amortize the debt obligation to complete his investment in the property. In practice, however, mortgages usually amortize at a slow pace during the early years of ownership, and many investments are limited to 5-10 year hold periods. Generally, then, even when depreciation deductions are compared with loan repayments, the deductions may generate more current tax savings than the outlays allocated to principal repayment on the loan.

Loan Interest. A further major tax benefit is the deductibility by the real estate operating entity of mortgage interest expense to shelter the current income from that property. Rental properties purchased using mortgage or other financing can have the associated interest expense deducted from the rental income of that property for purposes of calculating the operating entity’s taxable income.

Investors in a real estate LP or LLC usually hope that the pass-through entity will have sufficient depreciation, interest expense, and other deductions to shelter the cash flow from the property and keep that distribution of cash nontaxable (or at least tax-deferred). These shelters can permit the entity’s partners (or members) to receive a return similar to a tax-exempt bond – only real estate returns have historically been substantially higher. Investors may ultimately have to have some of this tax benefit “recaptured” upon a sale or other disposition of the property, but in the meantime they have substantially tax-free use of the distributed cash.

Investors also often hope that the LLC will generate excess deductions and thus net operating losses (NOLs) to offset income they have earned from other passive investments. To fully utilize these, investors must take into account the “passive loss rules” (which generally provide that losses generated by an activity characterized as a passive activity can only shelter income from other activities characterized as passive activities, and cannot offset non-passive income) and the “at risk” rules (which generally limit an investor’s ability to utilize losses generated by an activity in a given year to the amount for which the investor is considered “at risk” with respect to such activity) in evaluating the current tax savings to be recognized from a real estate investment. If the depreciation deduction, interest expense and other items result in a net loss, such losses are subject to those passive loss rules.

Along with existing cash flow and the potential for appreciation in a property, then, equity real estate investments made through pass-through vehicles like LLCs can take full advantage of the depreciation and interest expense deductions that are some of the most valuable characteristics of direct real estate investing. These tax benefits are substantial and not generally available to investors in REITs — and we’ll analyze some of those differences more thoroughly in an upcoming article.

DRSI does not advise on any personal income tax requirements or issues. Use of any information from this section is for general information only and does not represent personal tax advice either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.

The sale or exchange of business or investment property normally generates a taxable gain or loss – but under certain conditions, a taxpayer can delay the reporting of gain. A “1031 like-kind” exchange refers to one such instance – an exchange of property held for either investment or for productive use in a trade or business for property of like kind. One of the most common situations involving like-kind exchanges is the exchange of real estate held for business or investment.

The like-kind exchange tax rules are governed by Section 1031 of the Internal Revenue Code (hence the reference to “1031” exchanges). These rules derive largely from a “continuity of investment” theory; that current taxation is improper because the taxpayer’s capital is still tied up in the same basic kind of investment, which might also mean that the taxpayer may not have enough liquid assets to pay a tax anyway.

Such tax deferrals are clearly valuable; one investment property may be traded for another and the underlying investment amount could conceivably continue to grow, tax-deferred, for many years. This deferral of income tax liabilities can be of great help as an investor considers how to reposition or rebalance his portfolio.

The popularity of 1031 exchange programs has increased recently. Many persons who might be ready to sell long-held investment property may have a very low tax basis in the property. Moreover, this basis may have been reduced even further by many years of depreciation deductions. In cases like these, those who would like to sell would normally be faced with significant federal and state income taxes due upon such a sale.

A properly structured 1031 exchange can solve the income tax problem by providing tax deferral for those taxpayers who want to sell their low-basis investment property but do not want to pay punitive federal and state income taxes. However, to qualify for this Section 1031 tax deferral, taxpayers must make a new real estate investment. This “replacement property” can take the form of another “whole” replacement property or a fractionalized property, such as a tenant-in-common (TIC) form of ownership or an interest in a Delaware Statutory Trust.

In order to qualify for tax deferral, the following primary conditions must be met:

• The property being exchanged, and the new property being received, must be held for rental, investment, or be used in a trade or business;
• The property must be exchanged rather than sold;
• The property received must be of like kind to the property transferred;
• The exchange does not have to be simultaneous, but the replacement property must be identified within 45 days, and actually received within 180 days (or sooner, if that year’s tax return is coming due), after the transfer of the relinquished property

There are many finer points, however. One rules is that a person cannot have access to, or control over, the funds while the exchange is in process, so the taxpayer may identify a qualified intermediary with whom the funds are entrusted in order to avoid this problem.

Taxpayers may identify more than one property for replacement, but they must meet one of three important criteria:

• The 3-property rule allows a taxpayer to specify up to three potential replacement properties
• The 200% rule allows a taxpayer to specify more than three properties so long as their aggregate value is not more than 200% of the relinquished property
• The 95% rule allows a taxpayer to specify any number of properties so long as he acquires properties before the end of the exchange period with a total fair market value equal to 95% or more of the replacement properties identified.

A 1031 exchange provides taxpayers the opportunity to defer taxes due upon the transfer of a property, and as such these transactions are valuable wealth-building tools. The rules are flexible and demanding at the same time; taxpayers can identify several possible replacement properties and can exchange for properties of greater value, but deadlines and other rules are strictly enforced. A 1031 exchange can be an important tool for tax deferral, but taxpayers must be armed with some background knowledge and the help of a skilled accommodator or other intermediary.

DRSI does not advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.

Member of SIPC, which protects securities customers of its members up to $500,000 (including $250,000 for claims for cash). Explanatory brochure available upon request or at www.sipc.org.

Investors can think of cash flow investing the same way they think about dividends with stocks. At some interval, whether it is monthly, quarterly, semi-annually or annually, investors will receive regular cash distributions from their investment. The investor is buying a portion, or all, of an asset that can be leased or otherwise used to generate income.

With real estate investing, cash flow is the result of proceeds from rent payments. Let’s take a multi-family apartment building as an example. Say the property has 50 units and each unit rents for $1,000 per month. If we assume an expense ratio of 40%, the net income per month on that property is $30,000. While it is always a good idea to keep some portion of that net income in reserves, the remainder of the income is available for distribution, in this example, $28,500.

HERE IS A SAMPLE SIMPLIFIED CASH FLOW STATEMENT:

Real estate is just one type of cash flow investment. Other examples include investing in ATM machines or laundromats – purchasing any asset that provides regular income.

Although cash flow investing is a great strategy for the right investor, there is always the possibility that the investment will not cash flow (for example, there could be unforeseen vacancy that reduces your rental income below total expenses, among other possibilities). Performing proper due diligence and fully understanding the possible outcomes will help investors determine the right investments for them.

Real estate syndication can be an effective way for investors to pool their financial and intellectual resources to invest in properties and projects much bigger than they could afford or manage on their own. Although real estate syndication has been around for decades, until recently and before the advent of crowdfunding, syndicated investments were difficult for individual investors to access. Real estate crowdfunding gives access to the financial fundamentals of a deal and makes it easy for accredited investors to purchase shares without using the old model of country-club small talk and caddy fees.

Real Estate Syndication Principles

How, exactly, does a syndicated deal work? Real estate syndication is a simple transaction between a Sponsor and a group of investors. You know how when two guys open up a bar together, one has more money to invest and the other has a lot of experience working in and managing bars? The guy with the bar experience (the Sponsor) finds a bar to open and arranges everything, while the other guy (the investor) simply invests his money. The guy with the bar experience naturally runs the bar, and, as a result, gets a paycheck for his work. Both get a share of the profits based on time and money invested.

The basics of real estate syndication aren’t all that different from two guys opening a bar together. As the manager and operator of the deal, the Sponsor invests the sweat equity, including scouting out the property, raising funds and acquiring and managing the investment property’s day-to-day operations, while the investors provide most of the financial equity. The Sponsor is usually responsible for investing anywhere from 5-20% of the total required equity capital, while investors put in between 80-95% of the total.

Syndications are simple to set up and come with built-in protections for all parties. They’re usually structured as a Limited Liability Company or a Limited Partnership with the Sponsor participating as the General Partner or Manager and the investors participating as limited partners or passive members. The rights of the Sponsor and Investors, including rights to distributions, voting rights, and the Sponsor’s rights to fees for managing the investment, are set forth in the LLC Operating Agreement or LP Partnership Agreement.

Real Estate Syndication Profits

How can investors make money when participating in a real estate syndication? Rental income and property appreciation. Rental income from a syndicated property is distributed to investors from the Sponsor on a monthly or quarterly basis according to preset terms. A property’s value usually appreciates over time, so investors can net higher rents and earn larger profits when the property is sold.

When and how does everyone get paid? Payment depends upon the time the investment needs to mature; some types of syndications are over within 6-12 months while others can take 7-10 years. Everyone who invests receives some share of the profits. Also, at the deal’s beginning, the Sponsor may earn an average acquisition fee of 1% (although it can be anywhere from .5 to 2% depending upon the transaction). Before a Sponsor shares in the profits for their work as manager and promoter, all investors receive what is called a ‘preferred return.’ The preferred return is a benchmark payment distributed to all investors that is usually about 5-10% annually of the initial money invested.

Real estate syndications are structured so that the sponsor is motivated to help ensure the investment performs well for everyone. Let’s look at an example of a preferred return. If you’re a passive investor who invests 50k in a deal with a 10% preferred return, you could take home $5k each year once the property earns enough money to make payouts possible. After each investor receives a preferred return, the remaining money is distributed between the Sponsor and the investors based on the syndication’s profit split structure. If, for example, the profit split structure is 70/30 — investors net 70% of the profits after receiving their preferred returns and the sponsor nets 30% after the preferred return — here’s an example: after everyone receives their preferred return in a 70/30 deal, and there is $1 million remaining, the investors would receive $700k and the Sponsor would receive $300k.