For many Americans the dream of owning a second home or investment property is just that, a dream. Dramatic increases in property values paired with recent interest rate hikes have made it more difficult than ever to make that dream a reality. These factors have caused not only families, but also investors, to find creative alternatives to accomplish their goal of acquiring properties. This article discusses one such approach known as ‘fractional equity ownership.’ For the purposes of this article, the term “equity” refers to ownership of an entity and not the difference between the value of a given property and the underlying debt.
So, what does the ‘fractional equity ownership’ approach entail? This structure and the order in which the different steps occur varies from client to client depending on their specific needs. However, the general steps for a fractional equity ownership structure are as follows:
- Form an entity for the purpose of purchasing the subject property. This step will likely include the drafting of organizational documents that detail how the entity will function. A seasoned business law attorney should assist throughout the drafting process as the entity’s governing documents will flesh out crucial concepts such as how and when the owners of the entity can utilize the property. The owners of the entity may already know their various ownership percentages or could make that determination post-acquisition.
- Purchase the property through your newly created entity. This purchase will function in a similar fashion to a traditional real estate transaction. The primary difference being that the newly formed entity is purchasing the property and not the individual owners of the entity. In addition to consulting a transactional real estate attorney, the owners of the entity should consider retaining an experienced real estate broker to assist in the acquisition.
- If the entity ownership percentages were not established at formation, sell, transfer, or otherwise convey an ownership interest in the entity that now owns the property. This is where the fractional concept comes into play and different individuals buy or sell an interest in the underlying entity owning the property. Once the ownership structure is established, each owner of the entity owns a fractional interest in the entity that owns the property.
There are several benefits to owning a property via fractional equity ownership. One such advantage is the fact that the cost of purchasing the property can be spread out across the other owners of the entity. Another advantage is increased liability protection. In this structure, the entity owns the property, which may allow the members to remain insulated from potential liabilities associated with owning a property in their individual capacity. There are other benefits to this structure, but as with most things in life this approach carries several potential drawbacks as well. Below is a brief discussion on some of the potential pitfalls associated with the fractional equity ownership structure.
One potential pitfall that is often overlooked in this arrangement are transfer taxes. In Colorado, some towns have imposed a tax on all transfers where real property is conveyed. Purchasing, selling, or otherwise conveying a fractional interest in real estate through an entity could qualify as a transfer that would require payment of real estate transfer taxes (“RETT”). The laws regarding RETT vary throughout Colorado and whether RETT would apply to a specific situation is a fact intensive question. You should consult a licensed Colorado attorney to determine whether RETT will apply to your transaction.
Due on Transfer/Sale.
Another potential pitfall that could cause an issue under this structure relates to debt on the property. If the entity borrowed money to purchase the property, then the lender most likely recorded a deed of trust in the applicable County real property records that probably includes a due on sale or due on transfer clause. The language varies in these clauses, but the sale of an ownership interest could trigger one of these clauses giving the lender the right to call any outstanding amounts due and payable immediately. Therefore, you should consult an attorney to weigh the risks of potentially triggering one of these clauses.
Sale of Unregistered Securities.
The final major pitfall that comes up in this type of arrangement relates to securities laws. You may not think that buying or selling a fractional interest in real property through an entity implicates securities laws, but in many cases, you would be mistaken. Overlooking this point could lead to the sale of an unregistered security and a dispute with the Securities and Exchange Commission. Whether or not a fractional sale of real estate through an entity is deemed the sale of a security is extremely fact intensive and turns on complex multi-factored tests. You should consult an attorney with experience in securities laws to evaluate whether your specific situation runs afoul of any such laws or regulations.
Employing the fractional equity ownership approach may allow a client to accomplish their goal of owning a second home or investment property. However, it also carries a myriad of risks and the potential for missteps. It is always better to consult an attorney at the outset to ensure that your transaction is properly structured versus reaching out once you are amid a dispute. Therefore, if you are thinking about utilizing this structure contact an attorney to advise you throughout the process.
The team at FJGG possesses a wealth of knowledge and experience regarding the different areas of law involved in fractional equity ownership of real estate in Colorado making them an ideal match for clients wishing to explore this type of arrangement. Please contact Blake Gabriel for more information on fractional equity ownership of Colorado real estate.
The information provided herein is not intended to provide legal advice to the reader. Fractional equity ownership of real estate is a complex legal matter requiring knowledge not only of real estate, but also business law and securities law.