Q4 2019 - Considerations for a Private Equity Fund Investing in Real Estate
December 11, 2019
Successful real estate operators and developers have the knowledge, experience and insight to acquire, develop, and manage real estate investments. These owners and operators have launched private equity funds looking to attract and raise capital from investors, namely high net worth individuals, institutions, and tax-exempt entities. While performing their due diligence, these investors will generally request results and returns of historical performance to properly evaluate the manager. A fund manager can present their track record including acquisition and development deals, as well as relevant financial metrics and internal rate of return. Making this as well as the fund strategy available for review provides potential investors with the information needed to make educated and informed investment decisions -- however, investors should remain skeptical and ensure that the performance has been verified by a reliable source.
Fund formation and structuring can have many compliance and reporting implications. Accounting Standards Codification Topic 946 provides guidance to determine whether an entity qualifies as an investment company. In order to be considered an investment company, the fund must meet certain specified criteria, such as obtaining funds from investors, providing investment management services, and investing solely for returns of capital appreciation, investment income or both in addition to others. An investment company should follow and maintain its investment strategy, including exit plan, while seeking capital appreciation on its real estate investments. It is also important to understand the governing documents to consider the expectations of the investors. A value-add strategy including making physical alterations and improvements, thus improving quality of life for its tenants, may not qualify as an investment company. Further, managers that generate significant cash flows from their real estate investments and that are heavily involved in the day-to-day management may be more in line with an operating company. The reporting determination may not always be clear and obvious, and judgment should be applied to recognize all facts and circumstances. This distinction between an operating company and an investment company will dictate the presentation of the financial statements. An operating company reports real estate at depreciated cost and reflects the operations of the property, including rental income and operating expenses. In contrast, an investment company would report the investment in real estate at fair value, with changes in the fair value presented as unrealized gains and losses. Fund managers should ensure that their investment strategy and reporting presentation align with investor expectations.
There are numerous tax considerations for private equity funds investing in real estate. A sample of considerations to be aware of are unrelated business taxable income (“UBTI”), the use of real estate investment trusts (“REIT”), and timing of property dispositions.
Fund managers need to consider the UBTI exposure for their existing and potential investors. Generally, tax-exempt entities are not subject to tax, but may incur tax liability if income is generated from an unrelated trade or business. Further, the IRS may question the tax-exempt status of an organization engaging in a considerable amount of unrelated activities. Investments in real estate, including rental income and gains on disposition, are generally exempt from UBTI. However, an entity may also be subject to UBTI if a property is acquired using proceeds from financing, or if the property anticipates financing for improvements in the foreseeable future. A real estate debt fund that provides financing for real property is generally exempt from UBTI, but financing may create UBTI similar to funds investing in real property.
Structuring the Fund as a REIT
There are important tax considerations that fund managers need to be aware of while structuring a fund. A REIT can be an advantageous structure looking to attract both tax-exempt and foreign investors, but adheres to strict guidelines in order to maintain its tax-beneficial status. A REIT converts real estate rental income into dividends and, as a result, this income is not taxable as UBTI to a tax-exempt organization and does not produce “effectively connected income” for a foreign investor. Additionally, U.S. investors generally favored a partnership structure as opposed to a REIT in order to take advantage of pass-through losses until the enactment of the Tax Cuts and Jobs Act (the “TCJA”) in 2017. The TCJA now provides U.S. investors with new tax incentives under a REIT structure including eligibility for a 20% deduction with no wage or property-basis limitations. Further, U.S. investors in a partnership generally need to file a tax return for each state where the fund holds real estate, whereas a REIT structure would reduce this time-consuming and costly activity by reporting dividends, which are generally only taxable in each investor’s resident state. It is critical that the fund manager properly structures and monitors activity to maintain REIT status, thus eliminating significant interest and penalties.
Fund managers need to plan properly and analyze the tax impacts of real estate dispositions. IRC Sec. 199A was introduced under the TCJA, which provides taxpayers with a deduction up to 20% of their qualified business income from pass-through entities. In order to qualify for the deduction in a given year, a property must be held by, and available for use in, a qualified trade or business at the close of the taxable year. For fund managers who dispose of properties during the year, the deduction could be limited or even entirely unavailable. The fund manager should evaluate the impact on the deduction when disposing of income-producing properties late in the taxable year to determine whether it is the appropriate time for disposition or if there is a tax benefit to postpone until the following year.
Forming and managing a real estate private equity fund provides potential accounting and tax benefits and as well as implications. Fund managers should consult with their trusted accountants and attorneys throughout the fund’s existence to ensure that they fully understand the implications of their structuring decisions.
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- Considerations for a Private Equity Fund Investing in Real Estate
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- Hedge Fund Accounting Update
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