California Real Estate Journal
Choosing Equity Over Commission
February 13, 2006

By: Mandy Jackson

Brokers accepting interest in property must understand tax issues and ownership risks.

Some brokers are choosing to be real estate players by forgoing their commission in exchange for equity in their clients’ acquisitions.

The practice isn’t new, but with rising property values and potentially large short-term returns on opportunistic investments, it may seem more attractive today.

At the same time, brokers have to make sure buyers and sellers understand where their priorities lie while negotiations are under way. And like any investor, brokers should understand the tax consequences and know the property, the market and the partners they are pooling hard-earned capital with.

“There are a surprising number of brokers who don’t invest in real estate in general,” said Chris Runyen, senior managing director in downtown Los Angeles for the Charles Dunn Co. “If you know the market well enough, you know there are good investments for clients, and potentially for yourself if you don’t have capital to take down an entire property.”

Real estate investment trusts and institutional investors would not look to brokers to fund a piece of their transactions because they draw from large pools of financial resources. However, smaller private investors sometimes need extra cash to make a deal work.

“If it’s not penciling the way they need it to or something needs to be fixed, they might be able to wash that out with the broker investing their commission,” Runyen said.

Careful Deal Structuring

When a broker accepts interest in the real estate in lieu of commission from a transaction, the deal must be structured carefully.

“For brokers, it’s a way of investing in real estate. For owners, it’s a way not to pay commissions immediately,” said Yunna Barats, a principal at the accounting and business consulting firm RBZ LLP in Los Angeles. “There’s a big difference in tax consequences depending on how you structure the transaction.”

If it appears that the broker asked for his commission to be invested in the real estate transaction, the money is taxed by the Internal Revenue Service as if he received cash and then invested it in the partnership. The structure of the deal must be documented carefully to avoid a later conflict with the IRS.

Usually the investor asks the broker to forgo his commission for a small percentage interest in the property, rather than the broker initiating the arrangement.

“A lot of brokers are willing to do it because values are going up, or they believe you can add value. They think there’s an upside to this deal,” Barats said.

Ed Indvik, president of Lee & Associates’ central Los Angeles office, agreed that it is mostly entrepreneurial private investors who ask brokers to forgo their commission, but more of them are doing it.
“We like it. It helps a broker build his wealth,” he said. “We think it makes a broker a better broker. He starts seeing a building from his client’s perspective.”

While Lee & Associates encourages its sales agents to take advantage of such arrangements, it is important to establish early on where the broker’s loyalties lie.

Indvik said brokers must make the appropriate disclosures so it is clear that their investment in the property won’t compromise their fiduciary responsibility to the client.

“If the client says he doesn’t want the broker to put money into the property he’s selling, then the broker won’t do it,” Indvik said. “Brokers will do what’s in the best interest of their client because that’s their bread and butter in the long term.”

It’s important to have a smooth transaction because the buyer and seller both could be clients on future transactions. If the broker is representing the buyer and the seller, he must still work diligently for both parties, regardless of his interest in the property.

“You don’t want the seller to think you negotiated a lower price,” Runyen said.

The broker also has to make sure his employer gets its share of what would have been the broker’s commission.

“We like to do it for a lot of reasons,” said Kevin Kaseff, a managing partner at Titan Real Estate Investment Group in Los Angeles.

Titan is a national real estate investment firm that buys stable and value-added office, industrial, retail and multifamily properties.

“One of the biggest things we do in finding our transactions in a difficult market is that we do off-market transactions,” Kaseff said. “One of the things that brings brokers back to us time and time again is that they know as a private company we have the opportunity to offer outside investors the chance to work with us.”

The broker’s commission amounts to a small enough investment in Titan’s transactions that it will not make or break the deal. It does give the firm some reassurance if the broker believes in the property enough to roll his commission into the transaction. However, Kaseff said it is still the exception rather than the rule.

“Most fund, REITs and institutional players can’t bring in other venture partners. The private investor could, but most don’t like to do that. We’re not the only ones, but you have to have a group that has some flexibility,” he said.

Profit Breakdown

Brokers can take a profit interest or a capital interest in the partnership that buys the property, or both.

“The difference is your liquidation rights,” Barats said. “If you and I are partners, you’re a money partner and I’m an idea partner. You contribute $1 million and [as a broker] I contribute my services. You get 95 percent interest in this partnership and I get 5 percent.”

If the broker has only a profit interest in the property, he gets 5 percent of the profits whether it comes through rental income or through a sale. If the real estate transaction does not go through and initial contributions are returned to the investors, the broker is not entitled to anything, including a commission.
When the broker receives a capital interest his rights to distributions are sealed. So if the broker has a 5 percent interest in the partnership and the deal does not go through, he is still entitled to 5 percent of the investor’s $1 million contribution to the transaction -- $50,000 -- even though no profits were generated.

In May 2005, the IRS same out with proposed regulations that eliminate the distinction between profit interest and capital interest,” Barats said.

The proposed regulations have not been made law yet.

“How they’re going to do this is very unclear. It is very hard to determine the value of the profit interest received,” Barats said. “If the partnership in which a broker holds a profit interest bought raw land and is planning to build on it, a broker may not see returns for five, six or seven years. Whereas, if a partnership acquired a fully leased building to IBM for 50 years, you’ll see returns a lot sooner.”

Without the new regulation, if a broker’s profit interest agreement is structured right, he or she should not be taxed on the initial transaction until income is received from the partnership. Receipt of capital interest is taxable immediately.

“In essence, the investors never really pay the commission,” Barats said. “If there’s a large transaction and there are millions of dollars in the transaction, they can buy that much more property.”

Ryan Cinelli, vice president at Los Angeles-based First American Properties, has given up commissions in exchange for positions mostly in apartment buildings, often acquired in 1031 tax-deferred exchanges.

“We would do it with the intention of, in the hot market of the last four or five years, working with them in buildings that needed renovations, had under-market rents, or had condo-conversion potential,” Cinelli said. “It would expand the range of properties we could look at. Also, it shows the client my belief in the project.”

Cinelli has invested in enough properties with his clients that he now has the capital to acquire assets on his own or hold a much larger stake in the investments.

There are always disadvantages to investing with partners because there are more people involved in the decision-making process, especially when a problem arises or a loan must be refinanced. Because of that relationship, it is important to understand the reputation and the financial capacity of the partners investing in the property.

“Those are always things you have to understand as an investor. It separates a novice from a better investor,” Cinelli said.

The broker’s commission may not be the only cash he is asked to commit to the property once his new partners close escrow.

“There may be cash calls at times to repair things,” Runyen said. “It just depends on the property and what kind of unknowns might pop up later on.”

Brokers generally have very little control over operation of the real estate when they accept equity in a property. The managing member of the limited partnership holds the decision-making authority.

Kaseff said Titan will ask brokers for additional cash after the deal closes if the property has unforeseen expenses. If they elect to invest more money to fix roofs or repair electrical problems, it ups their stake in the asset.

“If they have to bring in additional capital, they would be treated like all the other partners and they would have to put in their fair share,” Kaseff said.