All Forum Posts by: Kurt Granroth

Thanks for the explanation, @Brian Burke - that was exactly what I was looking for.

Indeed, my example was unrealistic in several aspects but I did so to try and reduce the number of variables in play and to ensure that my primary question wasn't hidden in the noise.

Your explanation of the psychology behind the difference makes a lot of sense. I've heard something along a similar vein when talking about the promote share split percentages. That is, a 80/20 split would benefit the LP far more than a 60/40 split... but in the latter case, one could argue that the sponsor would be working much harder to maximize profits than it would in the first case. In a "rising tide raises all ships" scenario, it's possible that the LP could still make more money in the latter case even though the actual percentage aren't as good as the former.

Thanks!

Most private placement deals I see have a LP/Sponsor waterfall that incorporates a Preferred Return, whereby the LP gets a stated rate of return before the Sponsor gets any money.

The Preferred Return can be based either on the Initial Capital Contribution or it can be based on the Unreturned / Unrecovered Capital. In the former case, the per annum distributions paid out is the same if there is a refinance or other Return of Capital event prior to sale. In the latter case, the per annum distributions will be reduced if there is any Return of Capital event.

Let's look at some numbers to explore this difference.

Say I invest $100,000 in a deal with a 7% Preferred Return after which there is a 70/30 split between LPs and Sponsors. In this case, the deal lasts for five years; a refinance at the beginning of Year 3 returns all capital to LPs; and it sells for 50% profit at the end of Year 5. It also doesn't generate Distributable Cash until Year 3 and does so at 9% for the next three years. By having the refinance/Return of Capital event in the same year as the first Distributable Cash, it should make no difference if this is European or American style waterfall.

Let's look at this from two perspectives. In the first, the Preferred Return is based on Initial Capital Contribution. In the second, the Preferred Return is based on the Unreturned Capital Contribution.

7% x Initial Capital
LP
Year 1: $7,000 (7% Preferred Rate)
Year 2: $7,000 (7% Preferred Rate)
Year 3: $108,400 (Initial Capital + 7% Preferred Rate + 70% Share of 2%)
Year 4: $8,400 (7% Preferred Rate + 70% Share of 2%)
Year 5: $43,400 (70% Share of Sale + 7% Preferred Rate + 70% Share of 2%)
Total: $174,200 (1.74x, 14.8% CoC)

Sponsor
Year 1: $0
Year 2: $0
Year 3: $600 (30% Share of 2%)
Year 4: $600 (30% Share of 2%)
Year 5: $15,600 (30% Share of Sale + 30% Share of 2%)
Total: $16,800

7% x Unreturned Capital
LP
Year 1: $7,000 (7% Preferred Rate)
Year 2: $7,000 (7% Preferred Rate)
Year 3: $106,300 (Initial Capital + 70% Share of 9%)
Year 4: $6,300 (70% Share of 9%)
Year 5: $41,300 (70% Share of Sale + 70% Share of 9%)
Total: $167,900 (1.68x, 13.6% CoC)

Sponsor
Year 1: $0
Year 2: $0
Year 3: $2,700 (30% Share of 9%)
Year 4: $2,700 (30% Share of 9%)
Year 5: $17,700 (30% Share of Sale + 30% Share of 9%)
Total: $23,100

If these calculations are all roughly accurate, then basing the Preferred Return on Unreturned Capital has a clear upside for the Sponsor at the tune of 38% more cash over the five years. All that cash comes from the LP, who makes $6,300 less.

It certainly seems like this is 100% skewed in favor of the Sponsor at the expense of the LP, based on my understanding. Am I missing something, though? Why shouldn't I, as an LP, treat Unreturned Capital Preferred Returns as a notable red mark against the deal?

Okay, it's been three years since I originally posted this and at the time it was all theory and no practice. I now have three years of following this ladder in practice and so it's time for a checkpoint.

Here are my results from the past three years:

Yeah, I'm missing my target by a notable amount. It's a mix of changing market conditions and just practical effects vs theoretical.

In no particular order:

1. The listed "preferred rate" these days is more commonly 7% than 8
2. But even then, that rate is only applicable retroactively after the deal completes. Precisely one of my deals (BAM Multi Fund) hit the preferred rate in the first two years -- most are notably less the first year.
3. Those CoC numbers aren't annualized, which they should be to be accurate since none of the deals happened at the beginning of the year and, in fact, all were initiated between June and October of each year. Still, even annualized, only one deal hit the preferred rate at all.
4. 2020 has $50k less invested than predicted since I was furloughed and we were keeping our cash close to the vest as a "just in case"
5. 2020 didn't do as poorly as I would have expected, though. I mean, they were all low (except one - yep, BAM Multi Fund for the win) but not as low as I thought they'd be.

I am back to work and we have a healthy liquid funds buffer built up so the goal is to invest $150k this year to catch up in the 5 year plan. It'll be very interesting to see when the first sale will be and how it'll impact all this.

Okay, here's some more on what I found out while researching what my K-1 actually means.

Line 20 represents the Section 199A items.  These are brand new for this year -- so much so that quite a few resources online still claim that not enough is known about them.  Newer ones are more clear.

They are used when calculating the Qualified Business Deduction (QBD).  The QBD is also new for this year.  It's a 20% deduction on income earned by a qualified business.  That came into play for me because I have a YouTube channel and earned $2k at it.  That means I have a small business (even pay self-employment taxes) and so I was able to deduct 20% of that $2k.  So the question is if passive investing in a syndication is considered a "qualified business."

As far as I can tell, the answer is no.  I would need to be far more involved than any passive investor can possibly be in order for me to claim it.  Heck, it looks like even being an active landlord renting out homes that you own is still not active enough to be considered "qualified".

Thus, while it is true that Section 199A is used to calculate the QBD, it simply will never apply to me in this context, so the entirety of Line 20 is informational but pointless to me.

Originally posted by @Charles LeMaire:

Normally as an overview assuming you are passive and this is your first deal, you put it the $50, they distribute say 5% per year for the 5 year hold ($2.5K/year * 5 years = $10K), you are still receiving a return of capital (no taxes on your money).  At the end of the hold they sell it and you double the investment (your share of the sale is $100K).  They send (it often takes several checks to close it down) you the $100K.  Your capital account (basis) was $40, so you get to pay cap gain on $160K (really there were some actual expenses that modify this a bit, but think big picture).  If you are a mover and shaker, you get to pay 20% + the 3.8%.  Smaller fish, 15%.  Maybe you can get away with 0% tax.

 

Thank you for this reply -- I'm still parsing out the ramifications in my mind.

In the above, am I right in that you are referring to the "outside basis" or "tax capital" rather than the ongoing "tax basis"?  If that, then the outside basis is calculated by reducing the initial capital with any distributions, thus my ending outside basis would be $40K in your example.  A sale that doubled my investment would result in $100K returned to me, which would include my initial $50K.  At this point, only $50K is taxable since half is the return of my investment.  But, since $10K was already returned to me, it's really $60K that is taxable since they're sending me $100K and not "$50K more than my initial investment".  The distributions, then, are more "tax deferred" rather than "tax free".

Is that $60K actually taxed as capital gains?  I thought all proceeds from these investments are taxed as income...

Did I read that right?

Originally posted by @Eamonn McElroy:

@Kurt Granroth

Asking CPAs to educate you 3 weeks before a major statutory deadline might be an uphill battle...

You are confused on several things above.  I'd encourage you to google and read about the following:

• Tax capital vs tax basis
• How to calculate tax capital and tax basis
• What happens when losses exceed tax basis
• The passive activity loss rules and how they relate to calculating taxable loss or income annually for passive activities
• The new 20% passthrough deduction and items of QBI

 Yeah, the date doesn't matter a lot to me directly at the moment since this particular K-1 results in no taxes for this year.  It's the long term view that I'm looking for... so if it takes a year to nail down all the details, then that works for me!

Based on your suggestions of further topics to google, here's what I found.

Tax capital is what you start out with and what matters when the property is sold.  I believe it's referred to as "outside capital".  Tax basis, then, is an ongoing amount that affects what is taxed, primarily.  Tax capital and basis start out the same at the beginning.

Tax basis is calculated by starting with the last year's basis ($0 for the first year), then add on any capital added during the year ($50,000 for my first year), then add or subtract any income from Part III Line 2 (-$30,690) and finally subtract any cash distributions or withdrawals (-$1,841).  The result is my tax basis == $17,469.  Not yet 100% certain how to calculate the capital or "outside basis".

A positive tax basis appears to mean that cash distributions are tax free and all of a loss may be used for that year.  The basis cannot be reduced below 0.  Any portion of a cash distribution that would lower the basis below 0 is instead treated as capital or income and is taxed accordingly.  Any portion of a loss that would lower the basis below 0 is not available for use the current year but may be carried over for future years.  That latter bit is subtle.  I'm guessing that it comes into play if you have multiple passive investments?  Like maybe you have one investment with income of $60,000 and another with a loss of $60,000... but the tax basis starts at $30,000 and so subtracting that loss brings it below 0 and thus only $30,000 of the loss may be applied to the $60,000 in profit.  If there is only one passive investment, then it doesn't seem like the "below zero" matters at all for the loss since you're going to carry all of it over regardless?

Don't yet know much about the 20% passthrough and deductions and QBI.

I just got my first K-1 from a multi-family syndication and want to understand it.  This is the actual K-1 with real numbers and only personally identifying elements have been removed.  I'm going to describe what I think I understand and then followup with questions.  I am super green when it comes to this, though, so don't assume for a second that I actually know what I think I know -- I value any and all corrections!

Starting with section J, describing my share of the profit, loss, and capital.  They are all 0.2059%.  As far as I can tell, these are strictly informational and have absolutely no impact on taxes whatsoever.

Next up, there's section K, where I see a Qualified nonrecourse financing value of $81,639.  This is my share of the debt (loan) on this apartment.  Being that's it's "qualified nonrecourse", I will never be personally responsible for that debt.  This is not a taxable amount... but I've seen a couple references that this might be used when factoring the tax basis?  The use of this field is mostly a mystery to me.

Section L is very important in that it's directly referencing the "tax basis".  Since the tax basis plays a huge role in determining what is taxable and what is not, it's very important to know what this is.  Here's how I am interpreting it.

This is my first year, so my tax basis is either my beginning account ($0) or my initial capital ($50,000).  The tax basis for next year(?) is my existing basis plus or minus the net income (-$30,690) and minus any distributions ($1,841).  That leaves me with a tax basis for 2019 of $17,469.

In Part III, we see in line 2 that my share of the income is -$30,691.  That's $1 less than the amount in the tax basis calculation, so maybe it includes the $1 interest income (line 5) but interest isn't part of the tax basis?  Since it is a loss, I can use it as a deduction against future earnings.  It can ONLY be used against passive earnings and not against any of my earned income or other capital gains.  It's not clear to me if it can only be used against this specific property or if it can be used against any passive income (another syndication, perhaps).  Since I have no positive earnings, I can carry this over into future years, indefinitely.  Is the amount that I can use in a year limited by my tax basis, maybe?

Line 2 is the primary "taxable" amount shown on the K-1.

Line 5 is interest -- that's akin to a 1099-INT.

Line 19 is the cash distributions I received over the year. Distributions ($1,841 in this case) are not directly taxable and won't flow down to my 1040.  However, the distribution is directly used when calculating the tax basis and the tax basis does have a huge say in how much of the income is taxable, so it may be considered indirectly taxable?

Line 20 refers to Section 199A items.  Are these informational?  Maybe used for calculating a "qualified business deduction", but not now because there was no profit.  I don't know for certain how they come into play.

A refers to the $1 in interest.

Z is the actual income coming from the property (essentially just Line 2)

AA has $484 of "W-2 Wages".  Huh?  No idea where this is used.

AB has $103,328 of an "Unadjusted Basis".  I have no clue how this is calculated or how it is used.

Okay, that's it for this year.  Since my income is negative, there's nothing to tax and so it has no material impact on my taxes this year (other than the $1 in interest).  I will save off the $17,469 as a tax basis and carry over $30,691 to use in future years.

So now it's 2020 and I get my 2019 K-1.  In this hypothetical future, I see my first profit of $20,000 in Line 2 and I have distributions in Line 19 of $4,000.  I am now going to wave my hands around and proclaim things -- please challenge anything that is not completely true!

My tax basis for 2019 is $17,469 so I subtract that from my $20,000 profit to leave $2,531 of taxable (ordinary) income.  However, I still have the carryover from the 2018 and so I deduct $2,531 from $30,691 leaving me with $28,160 to carry forward.  My taxable amount is still $0.

I calculate my new tax basis with a starting value of $17,469 + $0 additional capital + $20,000 in income - $4,000 in distributions, leaving me with a new basis of $33,469.

Now it's 2021 and I get my 2020 K-1.  My profit this year on Line 2 is $50,000 and I get $5,000 in Line 19 distributions.  I subtract the $33,469 tax basis to get $16,531 of taxable income.  I use up more of my carried over loss from 2018 leaving me with $0 in taxable income and still $11,629 in loss for future years.

My new tax basis is $33,469 + $0 + $50,000 - $5,000 = $78,469

After three years, I've received $10,841 in payments without paying any taxes at all and with my current tax basis and remaining loss, I'd need to receive $90,098 in income in year four to have any taxable income.

Some or much of this is undoubtedly wrong.  I'd appreciate knowing where and how! 

Originally posted by @Michael Bishop:

@Kurt Granroth & @Shannon C., you've talked about aspects of offerings that you don't like and that turn you away from them; how about some aspects that you do like, in terms of being in line with your ethical and moral values? What specifically do you look for or like to see that a Sponsor is doing to give back to the community and add value to tenants?

The reality of this entire style of investing is that opportunities to invest in syndications that fully match my ideals are essentially unicorns.  Instead, it's more practical to find the investments that don't appear to be doing direct harm.

BUT... it is funny that you ask this because something incredibly close to my ideal did just pop up recently and I find myself having to really hold the line on evaluating the opportunity on a financial basis when the concept behind them is so attractive!

This opportunity is a "social impact fund" developed by a group that "[...] is a vertically integrated, minority and women-owned workforce and affordable housing investment firm" with an overall goal to to "build community and enrich lives through serving as a vehicle for social impact, environmental sustainability, and financial alpha — generating attractive risk-adjusted returns for all stakeholders" and for their investment objectives to include "[...] create, renovate, and preserve workforce and affordable housing in high growth markets throughout the US that have demonstrated the ability to outperform jobs, real wage growth, population growth, renter household formation; and exhibit a supply/demand imbalance"

Well, there you go.  I don't yet know all the details on just how they accomplish that, but the words on paper are almost exactly what I'm looking for.

Originally posted by @Scott Mac:

I know this man who went from rags to unbelievable riches, and has similar feelings about many things.

Here is how he handles it. Rather than try to fight the way things work (everything has downsides and you can't protect people from every possible harm that may come there way), use "the system" to make a profit for yourself, and give back where you feel it will do the most good (and there is never enough, there never will be).

Scott, thank you for the very thoughtful post!  The concept of "giving back" as, at the very least, a balm against the potential ethical wounds inflicted while making the money is one I've struggled with over the years, well outside the confines of just real estate.

There is a long history of the wealthy donating substantial sums (in absolute terms, if not percentage) to help the less fortunate.  The current adherents of "philanthrocapitalism" have brought this to almost an art form.

I'm far from a philosopher and so my own thinking on the topic is scattered and inconsistent.  I tend to lean heavily towards the idea that I'm more okay with charitable giving if it's "paying back" versus the potentially rationalizing affect of "evening the score"

That is, the money I've earned is relatively innocuous (with reasonable constraints), coming from those that benefited from our relationship as much as I did.  So when I donate to causes that matter to me, it's doing so at least in part to "pay back" the ethical debt incurred by getting to where I am with the help of so many others.  I was once dirt poor and depended on help from others -- now that I am capable of doing the helping, I am glad to do so.  This feels right to me.

But there's another way of looking at the wealthy's charitable giving and that's those that earned their money largely on the backs of others that can scarce afford it.  Now they view their giving as a way of "evening the score", by helping those that they stepped on on the way up.  In my mind, that's just rationalization and could be a case of lacking the self awareness necessary to really see ones place in the grand scheme of things.

It's precisely that latter case that prompted the thought processes that led to this thread.  If I end up thinking that my investments in various syndications overall more "caused misery" than "sparked joy", then I would feel like I was just rationalizing away my actions if I then just increased my charitable giving to compensate.

Heh... like I said, though, I'm definitely no philosopher!

@Lance Langenhoven - Honestly, I have mostly passed over the cap rate on all the deals I have looked at because -- without exception -- those rates were nearly identical.  That is to say, every deal I've seen has a cap rate between 5% and 6%, depending mostly on long the planned hold is for.

A cap rate of 10% for an apartment syndication today may well exist... but if so, those deals are well out of my league and their sponsors certainly aren't showing them to me!