June 29, 2022

Tokenization Has Created a New World Order for Global Real Estate Markets

Asset Tokenization is Changing Real Estate Investors' Options

By Steven Baum, Partner, Assurance Services & Michael Greenwald, Partner, Tax & Business Services

Tokenization Has Created a New World Order for Global Real Estate Markets Real Estate

Seasoned real estate investors and tenants have different roles in the global real estate market but they often have a shared concern: how to keep real estate transactions secure as they become digitized.

It is likely that the democratization of global real estate markets has finally arrived with the advent of the metaverse and, by default, asset tokenization (“tokenization”). Real Estate Investment Trusts (“REITs”) were supposed to provide any investor the chance to own a fractional interest in large-scale, diversified portfolios of income-producing real estate by owning shares of a tradeable security. Tokenization takes that concept several steps further.

A blockchain is, in the most simplistic terms, the record-keeping and storage technology behind some of the crypto-financial networks (i.e., Bitcoin, Ethereum). The process of tokenizing property involves the act of representing property rights in the blockchain ledger via a crypto-token (or, digital assets that are built on another crypto-currency’s blockchain). It allows investors to break assets into smaller units of ownership, thereby paving the way for small to mid-sized investors to purchase part of a property and diversify their holdings rather than tie up their assets in a single property. Since tokens can be pegged to a particular property, the value of a single token can increase in value as the property appreciates and gains value — and by default, decrease as the property value depreciates in value.

The tokens are fungible, which means that after the initial issuance they can be traded in a secondary market. In fact, a larger secondary market is in development wherein lenders and investors will be able to buy and sell existing mortgages or mortgage-backed securities to facilitate the trade of tokens with users in their respective networks. In the meantime, in order to trade tokens, an investor would have to be assisted by the issuer.

Real estate tokenization, and blockchain technology generally, will enable investments in digital tokens supported by real-world assets and securities. It could solve liquidity issues that arise with having many parties involved in the normal course of a transaction. Specifically, it could cut out the middleman and permit ownership to be transferred directly from investor to investor.

Tokenization could also help track apartment rentals and even manage maintenance requests, which are among many aspects of real estate that will be revolutionized by blockchain technology.

As exciting as blockchain technology advances are for token issuers and investors alike, there are legal, tax, and reporting implications to be considered:

Token ownership

Tokens can represent direct ownership via a portion of a deed, equity interest in a legal entity, ownership of the collateralized debt, etc. In fact, real estate tokens may qualify as securities under state and federal law. Token ownership rules will require changes in state law. From the onset, token issuers must decide what kind of ownership of the underlying asset will the token represent, which can affect the kind of reporting that will be needed to satisfy regulators and government agencies. It is critical for investors to use outside consulting to structure the business in the most tax efficient way possible. Using blockchain technology to exchange tokens may have the potential to substantially lower transaction costs associated with real estate. REIT funds may serve a comparable role while often requiring high upfront fees and minimum investments. Tokens would lead buyers and sellers of real estate to have substantially lower transaction costs as they eliminate the traditional closing cost charges.

Receipt and classification of rental income

Some of the tax considerations for token holders include how they receive rental income and how receiving rental income will be classified. Are they receiving cash disbursements or stable coin payments such as US Dollar Coin (“USDC”), a type of token backed by real-world assets? Will they pay tax on capital gains when selling property tokens at a gain? Would it be classified as income from real estate or dividend income?

Location of the properties

As previously stated, the low barrier to entry to ownership can allow for investment in multiple properties, but this also means investors can have a filing obligation in all jurisdictions where the properties are located. Furthermore, if the platform/token is accessible to international investors, these investors may be subject to withholding on income or gains realized from their investment (unless they are eligible for certain tax treaty benefits in their resident country).

Blockchain and tokenization are still relatively new in terms of serving as a legacy financial vehicle on the road to property ownership, and you need a guide who knows the way. Your Marcum LLP advisor can get you there and keep you updated on changes in both the real and virtual worlds.