Tax Implications of Real Estate Private Equity Fund Subscription Lines
A commonly used strategy in real estate private equity funds is the use of a line of credit to finance acquisitions of properties as a funding bridge between contract signing and when capital is ultimately called and received from investors. Therefore, it is important for fund sponsors and investors to consider the possibility of tax implications resulting from this practice.
Institutional investors, including tax-exempt entities, have increasingly become a common group of investors in real estate private equity funds. Tax-exempt entities are generally not subject to income tax. However, when they earn or receive income that is considered Unrelated Business Taxable Income (UBTI), they do become subject to tax on this UBTI (subject to certain exceptions for qualified organizations which are beyond the scope of this article). A careful understanding is therefore needed of what activities may generate UBTI.
Income is considered UBTI under two general circumstances. First, 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. Rents from real property are generally exempt from this definition. Second, income that is generated from debt-financed property, including rental income, is subject to UBTI tax. Since rents from real property are generally exempt from the definition of UBTI, the impact of subscription lines used for property acquisitions must be considered under the second circumstance. Real estate funds with tax-exempt investors need to carefully consider the risks involved with subscription lines to evaluate whether the ultimate income will be characterized as UBTI.
In order for debt-financed income to be considered UBTI, the debt must be “acquisition indebtedness” which is defined as 1) debt incurred in acquiring or improving property, 2) debt incurred before acquisition or improvement of property if such debt would not have been incurred but for such acquisition or improvement, and 3) debt incurred after acquisition or improvement if such debt would not have been incurred but for such acquisition or improvement and such debt was reasonably foreseeable when the property was acquired or improved.
As it relates to subscription lines, the primary question becomes whether the line of credit is considered acquisition indebtedness. Real estate funds that utilize these lines generally do so because they do not maintain significant cash reserves which, with low investment returns, would hurt investor return calculations. However, they need quick access to capital to acquire properties. The lines of credit are only outstanding for short periods of time because investors ultimately contribute capital for the investments.
There is no specific exemption in the tax law which excludes such short-term debt from being considered acquisition indebtedness. However, the mechanics of the UBTI calculations dictate an annual calculation based on the average amount of acquisition indebtedness during the year. Therefore, if the line of credit is repaid in a short amount of time, the impact of the line of credit may be minimal in generating UBTI. Furthermore, UBTI calculations for income from the disposition of property do not consider any debt repaid more than one year prior to disposition, and therefore lines of credit will generally not impact the ultimate UBTI from property sales.
Nevertheless, the possibility of lines of credit causing some UBTI must be considered and analyzed. There are several private letter rulings and a revenue ruling which address situations with short-term debt and its ultimate inclusion or exclusion as acquisition indebtedness. In these rulings, the IRS has generally followed the approach that where debt is transitory, not used to circumvent debt-financed income limitations, and incurred solely for the administrative convenience of the tax-exempt entity, it would not be considered acquisition indebtedness. However, it should be noted that a clear link is not available between the facts of these rulings and the activities of a real estate private equity fund.
In summary, the use of lines of credit in real estate private equity funds should be evaluated when tax-exempt entities are included as investors. Fund liquidity and cash reserves, and their impact on investor returns, must be balanced with potential tax implications to certain investors. As discussed, due to the mechanics of debt-financed income calculations, the ultimate impact if subscription lines are included as acquisition indebtedness may be limited. However, with significant asset values and the required financing needed to acquire them, some tax liability may nevertheless be present and fund sponsors and investors must be cognizant. Careful planning with legal and tax advisors is recommended to avoid any unintended consequences.