Understanding the Fractions Rule for Real Estate Private Equity Funds
October 17, 2018
By Michael Torhan, CPA
Tax-exempt investors (“TEIs”), such as university endowments and pension plans, are a significant source of capital for real estate private equity funds. As a result, fund managers, both those that currently have TEIs as well as those seeking to attract TEIs, must be cognizant of tax impacts that certain types of real estate income may have on these investors.
Because of their tax-exempt status, TEIs have certain tax-related requirements in regard to the structure of real estate private equity funds that they invest in. Certain types of income that a TEI earns may trigger a tax liability. Tax on one type of such income, unrelated business taxable income (“UBTI”) from partnership investments, may not apply, however, for certain TEIs when a partnership complies with the fractions rule. Therefore, fund sponsors need to be knowledgeable on this topic since TEIs will expect consideration of this in the fund raising and structuring process.
Background on UBTI in Real Estate Private Equity Funds
While generally not subject to tax, TEIs that earn UBTI will be subject to tax unless certain exceptions apply. Income from a trade or business that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization's exemption is considered UBTI. Passive investment income such as interest, dividends, and rents from real property are generally exempt from this definition of UBTI.
UBTI also includes income (i.e., rental income) from debt-financed property Due to the nature of real estate private equity funds (i.e., real estate is generally financed with debt), a significant portion of income has the possibility of being characterized as UBTI. However, an exception to the classification of debt-financed income as UBTI exists for certain qualified organizations (“QOs”).
UBTI Exception for Debt-Financed Income Earned by QOs
Debt-financed income earned by QOs will not be considered UBTI if certain requirements are met. QOs include the following:
- Educational organizations including university endowments
- Certain pension trusts
- Certain church retirement plans
Due to the common practice in real estate private equity funds where real estate is acquired through joint ventures and other partnerships, one of the requirements for the UBTI exception is of particular importance and must be considered by real estate private equity funds that have QOs as investors:
- All of the partners of a partnership must be QOs,
- Each income or loss allocation to a partner which is a QO must be a “qualified allocation” (i.e., generally a fixed pro-rata percentage that does not change throughout the life of the partnership), or
- Such partnership must be compliant with the fractions rule.
Since real estate private equity funds generally consist of a wide variety of investors, not just QOs, the first option is generally not applicable. Likewise, since real estate private equity funds generally include a promote/carry for the general partner, option two will not be available. Therefore, compliance with the fractions rule will be required if a QO seeks to avoid characterization of debt-financed income as UBTI.
Understanding the Fractions Rule
The fractions rule consists of the following requirements:
- A QO cannot be allocated a percentage share of overall partnership income for any partnership taxable year greater than the QO’s fractions rule percentage.
- A QO’s fractions rule percentage is its percentage share of overall partnership loss for the partnership taxable year in which its percentage share of overall partnership loss will be the smallest.
- Partnership allocations must have substantial economic effect.
Example - The fractions rule mandates that if a QO will only be allocated 30% of a partnership’s losses in the taxable year it has the lowest loss allocation (by percentage), it should never be allocated more than 30% of the partnership’s income in a taxable year.
The general premise behind the fractions rule is to prevent tax avoidance by limiting the transfer of tax benefits from tax-exempt partners to taxable partners, whether by directing income to tax-exempt partners (which generally pay no tax) or by directing losses to taxable partners (which can offset taxable income).
A partnership must satisfy the fractions rule both on a prospective basis and on an actual basis for each taxable year of the partnership, beginning with the first taxable year of the partnership in which the partnership holds debt-financed property and has a QO as a partner. However, if there is a partnership agreement change which violates the fractions rule, the violation will only cause the exception to not apply in the year of change and subsequent taxable years.
Coordination of Real Estate Private Equity Fund Agreements with the Fractions Rule
At first glance, operating agreements for real estate private equity funds appear to satisfy the fractions rule due to their economic structure. Preferred returns generally accrue to limited partners until a certain hurdle is met: at which time the general partner receives a promote.
Example - If a QO’s percentage of losses in initial years is 15%, the percentage of income when a 20% promote applies would only be 12%. The 12% of income allocations would not exceed the QO’s fractions rule percentage of 15%, and the fractions rule would be satisfied.
However, this simple example does not account for several exceptions and limitations imposed by the fractions rule. Several common real estate private equity fund provisions and attributes have the possibility of causing violations. While a detailed discussion of each of these is beyond the scope of this article, preferred returns, management fees, and subsequent closings are important to note in the context of real estate private equity Funds.
- Preferred returns
- At first glance, preferred returns that are solely payable to QOs before distributions to other partners would appear to cause a violation of the fractions rule. This is because income allocations would be allocated entirely (100%) to the QO in initial years.
- Example - A QO that receives all distributions (and therefore income allocations) until it achieves a 10% preferred return, with subsequent distributions (and income allocations) split 50% to QO and 50% to other investors, would appear to violate the fractions rule. 100% of income allocations in initial years would be made to the QO whereas the maximum allocation of losses would be 50%.
- However, income tax regulations provide that a reasonable preferred return for capital is disregarded in computing overall partnership income or loss for purposes of the fractions rule.1 Furthermore, prior to the proposed regulations, only distributed preferred returns were disregarded (i.e., accrued preferred returns would not be eligible).2 The proposed regulations removed this limitation.
- Management fees
- Since many real estate private equity funds charge varying management fees to partners, these disproportionate expense allocations could cause the fractions rule to fail. Under the proposed regulations, however, management fees were added to the list of partner specific expenses that are ignored for the fractions rule, provided that the fees do not exceed 2% of the partner’s capital commitments.
- Subsequent closings
- Subsequent closings are common for new funds as additional capital is committed by existing and new investors. As additional closings occur, it is common for operating agreements to treat new investors as having been invested as of day one. Two consequences of these closings are that partner interests are recalculated based on new commitment percentages and income/loss allocations may be disproportionately made to adjust capital accounts to the revised commitment percentages.
- Under the proposed regulations, changes in partnership allocations due to subsequent closings will be taken into account only in determining whether the partnership satisfies the fractions rule in the year of the change and subsequent years, and the resulting disproportionate allocations to adjust the partners' capital accounts will be disregarded for the fractions rule if 1) such changes and disproportionate allocations are not inconsistent with the general purpose of the fractions rule (i.e., not abusive in nature) and 2) certain requirements are met.
- One such requirement is that the subsequent closings would need to occur within 18 months after partnership formation. Since real estate private equity funds commonly have subsequent closings past 18 months after formation, this is a potential concern for compliance under the fractions rule.
Other Considerations for Fractions Rule Compliance
The fractions rule must carefully be considered with other partnership activity such as transfers of partner interests, tiered partnerships, and partner defaults. It should also be noted that certain de minimis exceptions exist which cause the fractions rule to be disregarded in limited situations.
One other consideration is the requirement that partnership allocations have substantial economic effect in order for the fractions rule to be applicable. The concept of substantial economic effect generally requires a partnership to liquidate in accordance with positive capital accounts. Most real estate private equity funds include liquidation provisions that follow cash distributions. Profit and loss allocations are then targeted to get capital accounts to equal what they would be in a hypothetical liquidation. Since targeted allocations are not specifically included in the definition of substantial economic effect, a careful analysis should be performed by fund sponsors, and their tax and legal advisors, to ensure that partnership allocations have substantial economic effect to meet compliance with the fractions rule.
Fund sponsors need to understand and consider the implications of the fractions rule when they form and structure real estate private equity funds as well as when they look to attract TEIs. UBTI is a significant consideration for many TEIs, especially in the real estate industry where debt-financed property has the capability of generating UBTI. The activities of the partnership must be carefully analyzed, at formation and on an ongoing basis, to ensure that the requirements and limitations imposed by the regulations are adhered to. Professional advice is highly recommended due to the prospective nature of the analysis that is required.
2 “Proposed regulations” refer to proposed regulations under Prop. Reg. § 1.514(c)-2. They are proposed to apply to taxable years ending on or after the date final regulations are published in the Federal Register, but they may be applied by a partnership and its partners for taxable years ending on or after November 23, 2016.