What Is Fractional Ownership and How Does it Work?

There are many ways to invest in real estate. For example, your first purchase might be the home you live in, and after that, a typical initial foray into investing is a residence to rent out to someone else. If you want to own the entirety of a property yourself, a fractional investment may not be the path to achieve that goal. However, for some investors, fractional investments can help them move toward their desired objectives.

What Is a Fractional Investment?

First, it’s important to note that a timeshare is not a fractional investment, and not eligible for a 1031 exchange. With a fractional investment, the group of people who buy a property each have an ownership interest in that property. The structure allows the costs and any profits to be allocated among the owners according to their ownership share. With a timeshare, the buyer only buys the right to use the property for a specific amount of time each year and does not own any portion of the asset. A timeshare is not an investment; it is for personal use.

Two common forms of fractional real estate investments are a Tenant-in-Common investment structure (TIC) and a Delaware Statutory Trust.

How Does a Tenant-in-Common Investment Work?

Each co-owner holds an undivided, fractional interest in the property with a TIC agreement. The shares can vary in size and percentage. The owners pay expenses and receive income based on their ownership share. For example, suppose a TIC has twenty investors, and each one has the same percentage of ownership. In that scenario, they would be responsible for the same allocation of expenses and earnings. In contrast, if the distribution of ownership is divided unequally, the disposition of costs and profits tracks the percentage of ownership allocation.

What Rules Does a TIC Have to Follow?

•       A TIC can have no more than 35 co-owners.
•       All owners must agree on major decisions.
•       Each owner has the right to sell, give away, trade, or leave their portion as an inheritance to anyone without the approval of the other owners.

How Do You Invest in a DST?

Unlike TIC investments, where the co-owners are not required to be accredited investors, DSTs are only available to those who hold that status. The Securities and Exchange Commission requires that for some investments to protect unsophisticated investors from risks that might need more detailed financial knowledge to understand.

Also, unlike a TIC arrangement, DSTs can have unlimited investors, known as beneficiaries. The sponsor (trustee) plans the strategy and opens the trust for investors to purchase their interest in the fund. One important note is that the DST may not accept any additional investors or raise funds after the initial offering period. One clear advantage to the trust shareholders is that their personal assets are excluded from liability, even though they are deemed to have direct property ownership equal to their fraction of the trust. Each one also has the same tax benefits that come from direct ownership.

Can I Use a 1031 Exchange With These Fractional Ownership Investments?

In most cases, DST and TIC investments are eligible for entry and exit via a 1031 exchange transaction. Always consult your financial or tax advisor for details concerning your circumstances.