If you want to own real estate but do not want to be a landlord, then real estate crowdfunding may be for you. You will be able to participate in the cash flows and capital appreciation of the project, but will not have the responsibility of day to day management. It can be a win-win for both the crowdfunder and the investor. But as this form of real estate investment gains traction, certain questions are being raised. A real estate syndication is almost always taxed as a partnership and investors are typically classified as “passive” investors. This results from the investor not being actively involved in the management of the property. The sponsor (or syndicator) is the one who is providing the management expertise and is involved in the day to day operations of the property. So what does it mean when you are a passive investor? Even though you may be getting a preferred return, you may still find that the investment is generating a tax loss as a result primarily of depreciation deductions. As a general rule, the deduction for a passive activity loss is limited in each tax year to income derived from a passive activity. However, if the syndication is generating passive income it will be taxed at the taxpayer’s marginal tax rate. But remember that this income can also be used to offset passive losses. Many investors may have cumulative passive losses relating to rental real estate that have been carried forward for years. With a syndication generating passive income, this can allow the investor to “free up” these passive losses and use them to offset the income from the syndication. Interest and dividend income is not considered passive income, so for an investor with passive losses this form of investment can offer benefits that stock and bond investments will not. So what do you do if you have passive losses that you are not able to offset against other income? If you find yourself with losses that you are currently unable to deduct as a result of passive loss limitations, there are a few strategies that you should consider. Invest in rental real estate that generates passive income. Considering the low interest rate environment these days, you may decide to invest in rental real estate that you are sure will generate net income even after considering depreciation deductions. Invest in income generating passive business activities. You could consider investing in an operating business that you have no material participation in. Assuming that the business operations generate taxable income that will be allocated to you, then you can use that income to offset the passive losses from the other activities. Increase participation in loss activities. For a crowdfunding investment this may not be possible. But depending on the investor’s involvement in the activity, it may be possible to turn the passive activity into an active activity by increasing your hours of involvement so that you may meet the material participation rules. If you can accomplish this, you may be able to bypass the passive loss rules and fully deduct any losses in the current year. Generate gains from the sale of other passive activities. Passive income will typically include gains from the sale of an interest in a passive activity or property that was used in a passive activity. The gain typically is not considered a passive activity if, at the time of disposition, the property was utilized in an activity that was not considered a passive activity in the year of sale. Decrease your involvement in active income activities. You may have a business activity that you currently materially participate in that is generating active income. Accordingly, you could consider limiting your participation (or involvement) in this activity. Understanding passive activity rules can be difficult. As you can see, there are a few ideas that you should consider if you have passive activity loss limitations. But these strategies can be complex, so make sure that you consult with a CPA or tax professional prior to implementing any of the strategies.   Tax and Legal Advice Disclaimer: AlphaFlow and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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“You only find out who is swimming naked when the tide goes out.”  This classic Warren Buffet quote quickly comes to mind as many investors tout the strong returns they’ve earned by investing in real estate crowdfunding.

Allow me to say from the start that I’m a huge believer in peer-to-peer investing. As a founder of one of the first real estate crowdfunding platforms, I’ve been in the industry a long time.  It’s incredible to look back and remember that in our earliest days we’d need 3-4 week commitments to fund a simple $100,000 single family home loan.  About a year later, our customers funded a $550,000 investment in an astonishing 34 minutes!

While we were proud and excited, it also opened our eyes to the fact that many customers had stopped doing their own diligence and were simply trusting us.  I have finance and investing at my core, so while it was encouraging as a founder, it just didn’t feel right.  Today, this leaves me still excited about P2P investing, but a bit worried that the real estate crowdfunding industry may be focused on growth at the expense of proper controls.

Investors have since taken some lumps, which has brought them to ask advice on how I look at new deals around the industry.  Lets start with what is likely the most straightforward deal: first lien debt on a single family home.  These investments are really disrupting what’s more commonly knows as hard money, which according to LendingHome, represents an opportunity of about $30 billion annually.

For those unfamiliar, allow me to quickly level-set.  Hard money loans, also sometimes called bridge loans, are most often used by those flipping houses.  They usually have terms no longer than 1 year, pay interest only, command 10-15% interest, and have a first lien on the real estate.  A common misconception is that the borrowers always have terrible credit.  In reality, developers are often willing to pay this higher cost because the speed to funding (sometimes days, if they have a pre-existing relationship with the lender) allows them to command discounts from sellers for quick cash.

Underwriting a hard money loan usually comes down to three things:

  1. Property: Many hard money lenders actually focus almost solely on this item, starting with the assumption that the deal will go bad and they’ll foreclose and still be able to recover their capital and interest. This works with more traditional hard money lending, which often limits loans to 60% LTV.  With most crowdfunding sites going to 75-80% LTV, the next two factors still carry significant weight.
  2. Track Record: Perhaps the most obvious way of evaluating whether a borrower can execute on a fix and flip plan is knowing if he has previously completed similar projects successfully.  Simply having done projects before isn’t enough. Look at similar projects: neighborhoods, price range, quality, budget, level of rehab.  These all matter, particularly as LTVs creep up.
  3. Credit Score: While credit scores seem straightforward enough, this is actually a highly debated aspect of lending today. A number of successful real estate developers experienced hardships during the 2008 financial crisis. Do you consider those, or not? That’s up to you. I’d like the sites to lay out their thinking a bit more clearly on this though.

One additional note on the third point above. Many loans have personal guarantees attached to them. Unless the guarantor has an exorbitant net worth, I don’t give much value to these myself. I worry that these can be handed out to everyone and/or applied to multiple investments on the same site (for those lawyers out there, I’m reminded of law school and how these are both unsecured and unperfected).

There are three other details I look for in particular with crowdfunding sites:

  1. Investment Structure: We’ll be digging into this more deeply with our legal team in the coming months, but in short, not all “secured” loans are created equal. I put that word in quotes because, with the entrance of Borrower Dependent Notes into the crowdfunding ecosystem, that word can mean very different things on various platforms.  I won’t name names yet, but it appears I’m not the only one who thinks there are deficiencies out there in how investors are being protected.
  2. Controls: Real estate projects are susceptible to many risks, including costs that exceed projections, a drop in local comps, and even national economic risks like unemployment and interest rate fluctuations.  A similar loan made from Wells Fargo likely includes myriad controls, like periodic reporting and loan covenants.  These often function as the canary in the coal mine, alerting the platforms (and investors) if something is wrong before things get too out of hand.  Good platforms are working on integrating these into their processes.
  3. Liquidation Plan (if any): As Warren Buffet’s quote suggests, with this rising market it’s been tough to see who has a good plan for when things go wrong.  I think we’ll learn more about this soon, but some sites have been proactive in putting together workout groups / plans.

Ultimately, these loans will always be risky, which is why you’ll earn double digit interest rates when they go well.  I still strongly believe that crowdfunding will play a large role in the future of real estate investing, and I believe we’ll need great controls and transparency in order to make that happen successfully.  Have any thoughts or questions about how you evaluate these deals? Please reach out at Ray@alphaflow.com!

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About the author:

Ray Sturm, CEORay Sturm is a leading entrepreneur in financial technology, and is currently the CEO of AlphaFlow. Prior to launching AlphaFlow, he founded RealtyShares, one of the P2P industry’s top platforms for real estate investing. His early career in finance included investment banking at Bear Stearns, restructuring at Lazard Frères and private equity at CCMP Capital.

Ray has a BBA-Finance from the University of Notre Dame and a JD/MBA from the University of Chicago.

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