Community Real Estate Investment Vehicles: Structure and Governance

PathLight attorneys have extensive history structuring community investment vehicles and funds, with partner Brian Beckon authoring the legal chapter for NC3’s guide on community investment funds at the start of this growing trend. Since then, we’ve partnered with many organizations to structure community investment real estate projects, some actualized and even more being planned.

Below are the key considerations and decision points for structuring a community owned real estate vehicle or a diversified community investment fund (with real estate as its core holding):

Determine the community-focused goal: charity or for-profit?

Is it important to the mission of the vehicle that individual community members have direct legal ownership? If so, then a for-profit entity where community members hold equity is a good fit. If the organization will serve only disinvested neighborhoods, the vehicle may be able to organize as a charity. This would open up the possibility of charitable donations as well as investment notes as paths for capital raising, and some states have a securities law exemption for charities, making capital raising compliance easier. Charities are usually organized as non-profit corporations and don’t have shares or shareholders, so they are not a good fit if direct community ownership is the goal. 

If the goal is direct ownership by community members, the next step is:

For-profit legal entity choice

This choice is primarily driven by tax considerations, costs and convenience.

Real estate investment groups often use a limited liability company (LLC) as the legal entity for a real estate fund, because LLCs are “flow-through” entities. This means that an LLC does not pay tax on its income; instead, all income and loss is attributed to the equity holders (called members instead of shareholders) of the LLC for tax purposes. All net income and losses “flow through” to the members. 

Corporations, on the other hand,  pay corporate income tax on net income at the entity level. When a shareholder receives dividends, those dividends come from a corporation’s after-tax income. When a member of an LLC receives a cash distribution from the LLC, that income was not taxed first, so for the same amount of net income, an LLC taxed as a partnership will generally be able to pass along more to the owners (this is a generalization about tax considerations and each situation needs to be analyzed individually). This difference can be very significant if real property is sold at a gain.

However, tax returns for members of LLCs can be complicated and generally cost more to prepare. Each member (whether a community investor, angel or institutional investor) receives a form K-1, and this makes the investor’s tax return more complicated. If there are tens to hundreds of community investors, receipt of a K-1 would be an unwelcome surprise for many. A form K-1 may make a tax return significantly harder to do yourself, even with tax prep software, to the point that receiving a K-1 could mean that the investor can no longer easily use the IRS’s free e-filing system and may need to hire a tax professional.

This is a dilemma. If a member’s share of net income is nominal, which may be the case early in a fund’s existence,  but it costs more than a nominal amount to have an accountant prepare a K-1 for numerous community investors and the K-1 complicates tax filings for community investors, is it worth it to choose a pass-through tax status?

With a few wealthy owners of a real estate investment group, the potential tax savings are so great that the extra time and energy to deal with partnership tax returns is worthwhile. However, in a community-owned vehicle, as the number of co-owners goes up and the investment dollar amount per person is relatively low, the inconvenience of partnership taxation starts to outweigh any benefit, and corporate tax treatment may become more attractive. Some examples follow.

Small projects: A group of neighbors coming together to buy real estate could use just one entity. Generally, small groups choose an LLC model. However, if they prefer to avoid partnership tax returns and form K-1s, they could use a corporation. Some real estate cooperatives choose to structure this way.

Optimizing for large projects: A legal structure that uses both an LLC and a corporation may be a good choice when large funders, charities and community investors are all planned stakeholders. The LLC, as a pass-through entity, may be attractive for impact investors who want to maximize after-tax returns, and likely already have their taxes professionally prepared. An L3C, a special version of an LLC that is designed to accept larger charitable investments, could be used if foundations will be making program-related investments. A corporation could be used to accept investment from community members, and the corporation could also be the right entity for a charity to invest in directly, if the charity wants a corporate blocker to separate the community investment vehicle from its own economic activities on its tax return. The LLC and the corporation in this picture would be affiliates. They both co-own one or more subsidiary LLCs that hold title to each of the properties being purchased by the community investment vehicle. Note that this is just one possible legal structure, and the best structure will depend on the circumstances.

Note too that a corporation may qualify for Real Estate Investment Trust (REIT) tax status and could elect that status once it qualifies. REITs, although corporations, receive pass-through tax status as to dividend payments (the dividends are not taxed at the corporate level before being paid to investors). We generally see that start-up community investment vehicles are not ready to make this election during their organizational phase, but it is something to keep in mind as a potential future step.

Governance

For-profit community investment vehicles generally want democratic governance by community members, much like a cooperative model. Here is a general description of this structure:

Quick primer on equity in general:

Ownership of a corporation is represented by shares of stock. Ownership of an LLC is represented by membership interests. For ease of this discussion, we will use the term stock to mean either corporate stock or membership interests. Generally, LLC membership classes can be structured to mimic the rights and privileges of classes of stock in a corporation.

Shares of stock can be split into different classes with different rights, as described in corporate formation documents. Common stock generally has all of the default rights, including the right to one vote per share, and the right to all income and gain left after preferential payment rights are satisfied. If there is no description of the stock in the articles, all of the shares will be common stock. 

Preferred stock is a general term for stock that has some benefit over common, to incentivize investment. Preferred stock generally has priority payment rights.

Community-focused framework for equity classes

In a cooperative, preferred stock is generally non-voting, because voting is a personal right of members, and each member has one vote regardless of the amount of money invested. In general, corporations can and sometimes do assign voting rights to preferred stock holders but do not have to do so. Community investment vehicles usually want governance to be democratic, with one vote per person, more similar to a cooperative. A democratic approach recognizes that all community members are affected by use of the community-owned property as local residents or business owners, therefore all members should have a say in how the property is used.

Any corporation or LLC can adopt a one member one vote capital structure by setting the the cost of one share of common stock at a dollar amount that is appropriate as an entry point in that community. The cost of one voting share would be the minimum cost to participate. Each common share has one vote, and each community member can be limited to purchasing one and only one share. 

Preferred shares in this model have some economic incentive but no voting rights. Typically a class of preferred shares has a target dividend that is in the board of directors’ discretion to declare or not, but that target dividend would need to be paid before common stock gets any dividend. Preferred shareholders would also have the right to receive their investment back first in the event of dissolution.

Here’s a summary of a straightforward capital structure for a community investment vehicle:

• common stock:
  • low to moderate share price (think $5-$500)
  • 1 share per person = 1 vote per person
  • after preferred dividend, remaining cash can go to common shareholders
  • In the event of sale/dissolution, preferred shares get declared dividends and a pre-determined share of the gain, and common stockholders get everything else.
• preferred stock:
  • higher price per share / higher minimum investment, e.g. $1,000-$10,000 per share
  • target (not guaranteed) dividend of 3-5%, target dividend is paid before common stock receives a dividend in that year
  • gets dividends and reasonable, but capped growth, in the event of sale/dissolution, common stock gets the remainder.

For organizers that want a simple structure and fewer decisions to make, the group may decide that the only local residents can hold voting stock (and thus they are the only ones to elect the board). The preferred stock could be open to anyone, residents and nonresidents, subject to limitations of applicable securities law.

For a larger project with a non-profit sponsor, the founding group may consider adding special voting or governance rights for the non-profit to guard against mission drift. For example, the non-profit sponsor may have the right to appoint a certain number of directors.

Capital raising and other compliance considerations

In addition to the structure and governance decisions discussed above, those planning a community investment vehicle also have to stay within an appropriate exemption to the Investment Company Act.

Finally, organizers of a community investment vehicle will need to utilize one or more capital raising exemption strategies to bring investors into the fund. 

Ready to discuss community investment vehicles? Schedule a consultation.