Is Fractional Real Estate a Good Investment?
April 11, 2022
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Have you always wanted to buy a vacation home but didn't have the capital to buy it yourself? Maybe you thought about real estate investing but know you couldn't do it yourself. Fractional real estate investing makes investing in real estate much more affordable and feasible for the everyday investor.
Here's what you must know about fractional ownership companies and owning real estate with other investors.
What Is Fractional Real Estate?
Fractional ownership of real estate means you own a part of the property, not the entire thing. Therefore, you don't have direct ownership of the property like you would if you were the sole owner but instead have shared ownership.
It's not a timeshare where you own units of time. Instead, you own a percentage of the property and hold title in your name along with any other owners' names. You can own both personal and commercial properties in fractional ownership, and when the property is sold, you earn a part of the capital gains (if applicable).
For residential properties, as a fractional owner, you have access to the property based on the agreement created with you, the other owners, and the property management company. Each property manager has different rules regarding fractional real estate investments, so always read the fine print.
You could have fractional ownership of just about any luxury asset, but vacation homes, luxury jets, and boats are the most common examples.
If you own commercial properties as a fractional owner, you don't get time in the property but instead, have rights to a portion of the rent collected. You don't have to manage the property - a property management company does that for you. What you get is passive income from investing with others in a commercial property.
How Do You Make Money With Fractional Real Estate?
To make money with fractional real estate investing, you must invest in commercial real estate or rental properties. With these investments, you earn a fraction of the rental income earned on the property.
Each property pays its shareholders at different intervals, though, so make sure to read the fine print. For example, you could receive rent monthly (most common), but there's a chance you may be paid weekly or quarterly too.
Fractional Real Estate Pros
- You can buy higher-value properties
If you don't have a lot of money to invest but would love to join other real estate investors in the real estate market, fractional investing can be the way to do it. You need much less capital but can call yourself a real estate investor with fractional ownership.
- You may earn passive income
With fractional ownership of commercial properties, you don't have to do the work to maintain the property. Instead, a property management company handles the job. All you have to do is choose the property and invest your money. The property manager handles the rest.
- The home won't sit unused
If you invest in residential real estate, such as a vacation home, as a fractional owner, you don't have to worry about the home sitting unused. With multiple fractional owners, the home will get more consistent use. This may help the home's value and longevity overall since the utilities will be used more regularly.
- You aren't responsible for the home's maintenance yourself
When you own real estate with other investors, you are all equally responsible for the home's decisions, maintenance, and repairs. Even if you pay a property management company to handle the work, there are still decisions to make that can be burdensome to one owner, but easier with multiple owners.
Fractional Real Estate Cons
- It can be hard to sell
It's hard enough to sell an investment property or vacation property yourself, but it can be even more stressful when there are multiple owners, each with different ideas or goals in mind. If you want to cash in your fractional shares of the property, you might be met with some resistance. It's important always to read the fine print of your agreement to know how long you're tied into the investment.
- Getting everyone to agree can be impossible
If you invest in a fractional property, you aren't the only one making decisions. It could be something as minor as what color to paint the walls or as important as when you should replace the roof. Fractional ownership companies usually have procedures to manage these types of decisions, but be prepared for some pushback if someone doesn't agree with you.
- You're stuck with one property
If you invest in one vacation property, your money is tied up in that property versus a timeshare where you could switch up where you spend your allotted time. You might get lucky enough to be part of a property management company that offers the option to exchange your time in other properties, but it's rare.
Fractional Ownership vs Timeshares vs REITs
A timeshare is somewhat related to fractional ownership, but there are some significant differences. As the name suggests, owners of a timeshare have their 'allotted time' to use the real estate properties. Rather than having their name on the deed, they have the right to a certain amount of time each year to use the property.
You usually have a certain number of years to use the timeshare, and you can pass it down to your beneficiaries when you die. Most timeshares have an upfront payment plus annual maintenance fees. But, at the end of your agreement, you have nothing. You don't earn equity or have an ownership interest in the property.
REITs or real estate investment trusts are shares you buy from a real estate company that invests in commercial real estate. Unlike fractional ownership, you don't have a say in what properties the company invests in, but you get paid dividends from the rental income earned from the real estate properties owned by the fund.
Fractional ownership can be residential real estate or commercial real estate. If it's residential, you have the right to use the property, as do the other fractional owners. If it's a commercial property, you have a right to the income brought in from rent and equity in the property.
Dividing Fractional Ownership Usage Rights
The usage rights can be one of the most challenging factors with fractional ownership. The number of owners, the type of property, and whether it will be a rental property or not will determine the complexity of the agreement.
To determine usage rights, it helps to decide how often most owners would want to visit the property and during what time of year.
In a traditional agreement, each fractional investor has a usage assignment or time they can use the property each year. The agreement can get as detailed as naming the months or weeks each owner can use it or state the amount of time each fractional owner can use it and let them work it out.
Some property management companies use a fee-based usage schedule, but this isn't as common. With this method, you pay a usage fee when you use the property. The money goes toward the operational costs of owning the investment property, but it gets complicated when there are many owners.
Fractional Real Estate FAQ
How Are Fractional Vacation Homes Managed?
Determining the management structure of a fractional investment can be complicated. There are typically four areas to focus on - usage, finances, cleaning, and repairs.
If you only have a few owners, splitting up usage may not be as complicated as it sounds. You each take a certain month of the year or weeks that you want, and the other times are up for grabs. If there are a lot of real estate investors in on the property, though, it can get complicated or even frustrating as you try to determine who gets which weeks.
Accounting, cleaning, and repair management are hands-on tasks that are often best left to a property manager. A neutral third party that can manage the property, collect funds from everyone as required, and keeps up with the property's cleanliness and repairs helps to keep everyone on the same page and honest while providing investors with passive income.
Even if you invest in a vacation home, it's still a real estate investment. While you enjoy the property, chances are it will appreciate over time, and each investor will earn capital appreciation that could be subject to capital gains tax when the property is sold.
Can You Get a Mortgage for Fractional Ownership?
Securing mortgage financing for a fractional real estate investment might be more complicated than you think. Most big banks don't do it, but smaller private banks may offer the option. You'll have to do your due diligence, find a bank that offers it, and see if you qualify based on your qualifying factors.
Why Would the Owners of a Vacation Home or Resort Property Consider Selling a Fractional Interest?
Sometimes buying into a fractional investment property feels like the right thing to do, but it becomes less pleasurable over time. Investors either find that they need to recapture their capital, or they just don't use the property like they thought they would.
Many owners would rather sell their shares to someone that would use the property and use the money they get back for alternative investments that might appreciate more or provide them with regular income.
What Legal Restrictions Apply to Fractional Ownership?
Like any real estate investment, there are federal and state laws you must follow. Fractional ownership laws vary by area, so it's important to research the area you plan to invest in. Some areas even prohibit real estate investing under the fractional method.
Are Payments on a Fractional Ownership Vacation Home Tax Deductible?
The tax treatment of vacation homeownership depends on how you own the property. Is it strictly a vacation home, or do you rent it part of the year? If you use it as a rental property, is it full-time, or do you split the time between collecting rents for usage of the home and using the property for personal use?
If you own the property strictly for rental purposes, you may be able to treat the ownership as a business and write off your expenses as they pertain to running the property, as well as things like mortgage interest and other costs.
But, if you use the property for personal use at any time of the year, you'll have to split the deductions based on the time the property is rented on the real estate market and when you use it for personal reasons. Any personal use allows you to deduct the mortgage interest because it's a second home, but you cannot deduct expenses incurred running the property during that time. You may, however, deduct those expenses during the time it's for rent. Always check with your tax advisor on the tax treatment of fractional properties before investing, though.
How Will I Be Taxed When the Fractional Vacation Home Is Sold, or I Sell My Share?
When the owners decide to sell the property, you'll likely earn capital appreciation subject to taxation. Unfortunately, since it's not your primary residence, you can't exclude any portion of the capital gains. Still, if you as a group held the property for a long time (over 12 months), you can pay long-term capital gains taxes, which are lower than your ordinary income tax rate.
Key Takeaways: Is Fractional Real Estate a Good Investment?
Fractional real estate can be a good investment, just like many other investment opportunities you might have. Whether it's good right now depends on the real estate sector, how much you pay, and the property's potential.
There's a risk for loss like any investment, so keep that in mind and always diversify your portfolio to set yourself up for success should anything happen to the property, its value, and your expected capital gains. Learn more by signing up and visiting our blog.
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