Fractional Ownership: Education is Key to Enjoying its Value
Fractionalized ownership is a method of owning and investing in real estate for those without deep pockets or the financial support of an institutional lender. Although it is an ownership structure that has been around for a long time, it has recently gained popularity and garnered attention because such owners obtain actual ownership rights in the property at a more affordable price. As with any growing trend, people often are unfamiliar with the concept of fractionalized ownership, confuse it with other methods of ownership and investing, and resist the idea because it differs from the norm. This article will clarify what fractionalized ownership is, what it is not, how it compares to other methods of ownership and investing, and how to overcome certain issues related to investing in real estate with fractionalized ownership.
Overview of Fractionalized Ownership
Fractionalized ownership means owning a portion of an asset instead of owning the entire asset. This is often useful for acquiring ownership interest(s) in assets that otherwise would not be affordable or cost‑effective when purchasing the entirety of such asset. It is not uncommon for private planes to be owned in this manner. A person or business can purchase a certain share of ownership in a plane which allows them to use the plane part‑time, but only pay for its proportionate share of the costs to maintain and fly the plane. This concept also applies to owning and investing in real estate. Instead of needing a large sum of cash to purchase an entire property and then being solely responsible for maintenance and related costs, fractionalized ownership is a way of investing in real estate with a lower cost of entry and shared responsibility among all owners.
How Does Fractionalized Ownership of Real Estate Work?
Typically, a special purpose vehicle, such as a limited liability company (LLC), is created by a sponsor or investment company with a minimum cost of entry. Each fractional investor pays the cost of entry representing a percentage of ownership in the investment property. Investors may purchase as many additional shares as desired. Each investor shares the rights to the property’s value and income, as well as the cost of maintenance, taxes, and other assessments, proportional to its percentage share of ownership. This allows each investor to be deeded as an equitable title owner of the investment property and avoid needing a large sum of cash, or potentially a loan, to purchase the property.
Fractionalized Ownership vs. Timeshares
Fractionalized ownership can be confused with timeshares because both involve multiple parties sharing rights to the same piece of property. While that is true, fractionalized ownership and timeshares are not the same because there are multiple differences between the two. First, both come with rights to use the property, but fractionalized ownership includes a true ownership interest in the property (i.e., timeshares include only the rights to use the property). This is a large reason why timeshares are typically part of a hotel or resort and owners have standard, pre‑determined time slots for when they can use the property. Fractionalized ownership properties are often residences in sought-after second home communities and allow for more flexible scheduling between the owners.
Fractionalized Ownership vs. REITs
While fractionalized ownership is similar to a real estate investment trust (REIT), there are key differences. A REIT investment is buying a security in the company that owns the investment property. Fractionalized ownership is owning a share of the physical property itself. This means REIT investments may be publicly or privately traded by its property management team, whereas a fractional owner has the right to gift or sell its share(s) in the property at its own discretion. Similarly, fractionalized ownership provides an investor with more freedom to choose what type of property it wants to invest in, compared to REITs which tend to focus on particular types of property (e.g., shopping malls, storage facilities) as determined by the property management team.
Pros and Cons of Fractionalized Ownership of Real Estate
No investment strategy is perfect for everyone, but fractionalized ownership may be a more accessible means of investing in real estate. Consider the following when determining whether fractionalized ownership is appropriate for future real estate investments:
1) Lower Cost of Entry: Generally, the cost of entry is lower for fractional ownership than other real estate investments. A fractional investor can purchase as many shares as it desires while avoiding the limitations of required credit scores or having a large sum of cash. This often allows fractional investors to invest in properties of higher quality and/or more profitable locations that may otherwise be reserved for accredited investors or those with deeper pockets.
2) Diversification: No matter the amount of funds an investor has available, fractionalized ownership allows an investor to develop a more diversified portfolio. Fractionalized ownership provides more flexibility when choosing how much to invest in a single property and what type(s) of property to invest in. This is especially helpful for an investor looking to gain experience and learn about different markets.
3) Passive Income: Solely owning real estate comes with the headache of managing and maintaining the property. Fractionalized ownership typically involves a property management company that handles the overall management of the investment property, such as maintenance, repairs, accounting, advertising and legal requirements. Therefore, a fractional owner isn’t required to expend time or energy on such matters and truly enjoys passive income from rent collections and capital appreciation.
4) Tax Advantages: A fractional owner typically gets the same tax benefits as a traditional real estate owner, granted these benefits are proportional to the fractional owner’s share(s) in the investment property.
5) Liquidity: Fractionalized ownership is still seen as a long‑term investment but is usually easier to sell. A fractional owner can often sell his/her shares in less time than the owner of an entire property.
1) Fees: Fractional investors should expect additional charges from the LLC for administrative and startup costs. These charges likely will fluctuate depending on the LLC and/or the work required for the property.
2) Earning Potential: If a fractional investment pays out dividends, it could be irregular depending on the investment property’s needs. While passive income is desirable, it is always important to consider whether it’s worth forgoing the value that could be obtained through other investment options.
3) Legal Restrictions: Fractionalized ownership of real estate is not allowed in all areas. This may limit, or even eliminate, investment opportunities in an investor’s desired market.
4) Liquidity: Unlike trading stocks, transferring shares of fractionalized ownership may be subject to contractual time limitations imposed by the LLC.
Getting Started with Fractionalized Ownership
Like any investment strategy, it is always best to evaluate the possible risks in order to make a well‑informed decision. With fractionalized ownership, not only are typical real estate documents involved, but also corporate documents by which owners buy their respective interest in the property. With the rise in popularity of fractionalized ownership has also come an increase in resistance by municipal zoning boards and neighboring property owners opposed to allowing properties in their area to have multiple owners. With purchase documents and corporate formation documents to prepare, tax implications to understand, and zoning laws to navigate, suffice it to say that it always pays dividends to seek legal advice for any type of real estate investment.
Fractionalized ownership is a long‑tested and modern method for a group of people to invest in real estate and own a second residence. For individuals who understand the process and how to overcome any potential issues, fractionalized ownership can be a more accessible way to invest in real estate.
This DarrowEverett Insight should not be construed as legal advice or a legal opinion on any specific facts or circumstances. This Insight is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. We are working diligently to remain well informed and up to date on information and advisements as they become available. As such, please reach out to us if you need help addressing any of the issues discussed in this Insight, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.
Unless expressly provided, this Insight does not constitute written tax advice as described in 31 C.F.R. §10, et seq. and is not intended or written by us to be used and/or relied on as written tax advice for any purpose including, without limitation, the marketing of any transaction addressed herein. Any U.S. federal tax advice rendered by DarrowEverett LLP shall be conspicuously labeled as such, shall include a discussion of all relevant facts and circumstances, as well as of any representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) upon which we rely, applicable to transactions discussed therein in compliance with 31 C.F.R. §10.37, shall relate the applicable law and authorities to the facts, and shall set forth any applicable limits on the use of such advice.
 Although not a topic of this article, fractionalized ownership through an LLC or other vehicle may trigger applicable security laws and regulations.