Passive Income Considerations for Real Estate Private Equity Debt Funds
October 24, 2022
By Michael Torhan, CPA
The tax implications of a real estate private equity fund structure are commonly analyzed in the planning and formation phase of a new fund. A large portion of a sponsor’s concern at this stage of the process is whether sufficient capital will be raised from investors. Therefore, the favorability, or lack thereof, of a fund structure’s tax attributes is clearly important for how well a new fund will be received by investors. This is particularly important for fund managers of real estate private equity debt funds. Whereas depreciation has the ability to generate losses in equity funds, debt funds generally produce income from the outset. Fund managers need to understand what type of income a fund will generate as well as ensure proper reporting to investors.
Background on Interest Income
Interest income is normally portfolio income to a taxpayer which cannot be offset by losses from other passive activities. However, funds that are considered to be in a trade or business of lending money generate ordinary business income for investors. This ordinary business income may be considered passive income for investors that do not materially participate in the business.
Nonshelterable Passive Activities (“NOPAs”)
The passive activity loss rules under the tax code generally prohibit taxpayers from offsetting portfolio type income (i.e., interest and dividends) and active income (i.e., businesses with materially participation) against passive losses (i.e., activities where a taxpayer does not materially participate). Because of these rules, certain tax shelter strategies were considered abusive by Congress because taxpayers tried to create passive income to offset passive losses. Congress enacted a set of complex rules for certain of these activities called NOPAs.
Equity-Financed Lending Activities
Equity-financed lending activities are included as a NOPA under Treasury Regulation § 1.469-2T(f)(4). These activities are defined to include a trade or business of lending money where a substantial amount of funding for the business is derived from equity. The bright-line test included states that any trade or business of lending activity where 20% or more of the interest-bearing assets are financed by equity, rather than debt, becomes subject to the rule. The rule causes a recharacterization of a certain percentage of income for a taxpayer from passive to nonpassive which cannot be offset with passive losses.
If an activity falls under this rule, the amount of income that is recharacterized is based on a complex calculation that essentially apportions a taxpayer’s net interest income between equity financing and debt financing. The amount allocated to equity financing (but limited to a taxpayer’s total net passive income from the activity) is treated as nonpassive. The regulation contains an anti-abuse provision that states that liabilities incurred principally for the purpose of increasing the amount of debt financing are ignored for the test.
Tax Planning for Fund Managers
Due to the negative impact of this treatment as well as the additional complexity in tax compliance, fund managers should consider various options when structuring debt funds. Carefully structuring a fund to ensure that equity financing does not fail the test has the ability of providing passive income treatment for investors. However, the larger amount of debt financing may increase the risk profile of the fund which may be not acceptable by the fund manager and/or investors.
The testing and reporting requirements under the recharacterization rule can also be avoided if a debt fund is structured with a REIT. Since all income and expenses are incurred at the REIT level, the rule is irrelevant to investors because the income they receive consists solely of dividend income.
It should be noted that REIT dividend income is also portfolio income which is not eligible to be offset with passive losses. However, in addition to the reduction in compliance complexity, there is also a significant tax benefit that may not be available to debt funds in partnership form under the 2017 Tax Cuts and Jobs Act. The 20% qualifying business income deduction allowed for certain trades or businesses will generally not apply for debt funds in partnership form because of requirements for sufficient wages and depreciable basis in a business. But, the 20% deduction for REIT dividends ignores these wage and depreciable basis requirements. This benefit as well as other benefits of REITs for real estate private equity funds are discussed in a separate article.