Some people prefer the traditional, the tangible. But for everyone else, the prospect and benefits of tokenizing real estate is intriguing.
What is Tokenization?
Tokenization is the process through which an ownership interest in a real estate asset(s) is represented in the form of a blockchain-based token. It is an example of the growing use of fintech (financial technology) to provide for the democratization of assets among a larger pool of potential investors.
A token for real estate is the equivalent of an NFT for a work of art. However, while an NFT represents a nonfungible token, real estate tokens can be considered fungible tokens. One real estate investment may be represented by 1,000 or more tokens, each representing a fraction of the overall investment.
The token can represent a variety of different real estate investments — from a portion of a real estate deed to an equity interest in a legal entity or ownership of collateralized debt.
Lifecycle of a Real Estate Token
Tokenizing real estate generally consists of the following steps:
Creating the Legal Documentation
The legal documents for tokenized real estate are similar to those required for a traditional real estate investment. However, various disclosures and provisions must be adapted to reflect the tokenization.
Minting the Token
Minting refers to the process of creating the token and confirming the information on the blockchain. The resulting real estate token is a digital form of proof of ownership.
Programming the Token
Through smart contracts, tokens can be programmed to make rent distributions to token holders and enforce compliance requirements.
Making the Capital Contribution
Investors contribute capital to the real estate venture using traditional methods or cryptocurrency. The tokens represent the investors' shares in the venture.
Trading and Collateralizing
Investors can trade tokens on secondary markets, as long as they comply with regulatory requirements. Tokens can also be used as collateral.
Distributing Returns on the Investment
The underlying real estate venture can distribute returns to investors using various methods such as dollars, cryptocurrency, and wire transfers.
Advantages of Tokenized Real Estate
Tokenized real estate investments provide investors with several key advantages. Tokens are more liquid than the underlying real estate assets and offer fractionalized shares. Real estate owners and funds have more efficient access to capital and new pools of investors. The nature of blockchain provides transparency, traceability, and proof of ownership. Smart contracts also standardize processes and enhance administrative efficiency.
Risks of Tokenized Real Estate
The general risks of owning any real estate asset apply to tokenized real estate. These risks include tenant vacancies, market fluctuation, and repair and maintenance costs. Other risks include the opportunity for fraud, the competence of the issuer, and the inherent risks of new technology. Given the new and evolving nature of tokenized real estate, there are also uncertainties regarding future regulation.
The Regulatory Environment
Real estate tokens are generally treated as securities subject to registration with the SEC. However, there are exemptions, including:
506(c) under Regulation D
Investors must meet income or net worth requirements to participate. There are no limits on the amount of funds that can be raised, and investors can generally transfer their interests after one year.
Regulation S
Offers and sales outside the United States are generally exempt from registration requirements.
It's important to consult with an experienced securities attorney before proceeding with any tokenized real estate investment.
Taxation of Tokenized Real Estate
The taxation of tokenized real estate depends on the type of investment. For an equity interest in an LLC, the ownership and tax reporting are based on the number of tokens owned.
The net rental income allocated to each member of the LLC is generally equal to the rents received from the tenant(s), less operating costs and depreciation, multiplied by the ownership percentage.
There are additional tax complications to consider, such as IRS Schedule K-1 and state tax requirements.
Sale of a Tokenized Interest
The emergence of liquid secondary markets for tokenized assets allows for more frequent buying and selling. The tax consequences of selling a partnership interest depend on the holding period and may include unrecaptured 1250 gain.
Calculating the gain on the sale of the partnership interest is based on the sales price on the secondary market and the partner's tax basis.
Real estate tokenization is a rapidly developing ownership option. While it offers potential benefits, there are still uncertainties and complexities to navigate in the regulatory and tax environments.
Caption: Example 1 - Taxation of tokenized real estate
Caption: Sale of a tokenized interest - Example 2