UBTI Exposure from Equity and Debt Investments by Real Estate Private Equity Funds
October 24, 2022
By Michael Torhan, CPA
“What is the fund’s potential exposure to unrelated business taxable income (“UBTI”) from its investments?” Most fund sponsors and managers have been approached with this question from potential, and existing, investors. Specifically, tax-exempt entities such as IRAs, foundations, pension plans and university endowments comprise a group of investors that consider this question during their investment due diligence process. Accordingly, it is essential that fund sponsors have an understanding of the reasons why UBTI is a concern, the relevance of UBTI for equity and debt investments by real estate private equity funds and the mitigating strategies to reduce or eliminate UBTI.
Why UBTI is a concern
Tax-exempt organizations are generally not subject to tax. However, they may be subject to tax on UBTI. UBTI is generally defined as the gross income derived from any unrelated trade or business that is regularly conducted by an exempt organization less the deductions directly connected with carrying on such trade or business. The trade or business that becomes subject to tax is one that is not substantially related to the charitable, educational, or other purpose that is the basis of the entity’s exempt status.
UBTI has two direct impacts on tax-exempt investors.
- Organizations are subject to tax on UBTI. Other than UBTI generated by entities which would be taxable as trusts if they were not exempt, UBTI is taxed at corporate rates (21% for the 2021 tax year). Exempt trusts are subject to tax on UBTI at trust rates (top rate of 37% for the 2021 tax year).
- An entity’s tax-exempt status could be at jeopardy if the IRS determines that the organization has excessive income from unrelated businesses. There is no specific percentage that is defined as excessive and such a determination would depend on the relevant facts and circumstances.
UBTI not only can create a tax liability at the federal level as discussed in item 1 above, but UBTI which is allocated and apportioned to various states can create state filing and tax liability obligations. A real estate private equity fund that invests in properties in various states may trigger such obligations.
UBTI impact on real estate private equity funds
Although income from unrelated trades or businesses is generally taxable, there are several categories of income, and related deductions, which are excluded. However, even if generally excluded from UBTI, income that is considered debt-financed income will be considered UBTI. The general exclusions as they relate to real estate equity and debt investments as well as the debt-financed catchall are listed below.
Investments in Real Estate Equity – in General
Rents from real property, and the related deductions, are generally exempt from inclusion in the computation of UBTI. Furthermore, the gain from the sale of real property is also generally excluded. However, gains and losses are not excluded if they are generated from property that is considered inventory or property held primarily for sale in the ordinary course of a trade or business. Therefore, income from the development and sale of condominiums is taxable as UBTI.
Investments in Real Estate Debt – in General
Interest income, and the related deductions, are generally exempt from inclusion in the computation of UBTI. It is important to note that this exclusion for interest applies even where a fund is considered to be in the trade or business of lending. Although a trade or business carried on by a tax-exempt entity is generally subject to UBTI, interest income is specifically excluded along with the expenses attributable to it. Therefore, portfolio interest such as interest from bank accounts is excluded as well as interest generated through a fund’s business of lending through real estate mortgages.
Debt-financed income is income generated by assets for which there is acquisition indebtedness at any time during the tax year. Debt-financed income includes income which would otherwise be excluded from UBTI, such as rents and interest as well as gains and losses from the disposition of such assets. Acquisition indebtedness includes debt which was incurred when acquiring or improving such assets, or which was incurred after such time but was reasonably foreseeable at the time of acquisition or improvement.
The amount of UBTI generated by an asset is proportionate to the amount of debt on the asset. The calculation of income considered UBTI is the product obtained from multiplying the asset’s income by a fraction, the numerator of which is the average acquisition indebtedness (average amount of debt outstanding during the tax year) and the denominator of which is the average adjusted basis of the debt-financed asset. In the case of a disposition of an asset, the debt used for the numerator is the highest amount of outstanding debt during the preceding 12-month period.
Debt-Financed Income – Real Estate Equity
For real estate private equity funds investing in real estate equity, debt-financed income is generally a concern because most properties are acquired with debt. A quick method of determining the amount of UBTI is considering the loan-to-value percentage (“LTV”) of the property. A property with a 65%
LTV will generally produce income, 65% of which is considered UBTI. However, this computation will generally not be exact, and possibly materially incorrect, since outstanding debt may change during the year and the adjusted basis of property will change due to adjustments such as depreciation.
A common short-term financing tool used by many real estate private equity funds is the use of subscription lines of credit. Such financing needs to be carefully analyzed to ensure additional UBTI is not inadvertently generated. More information on this issue can be found here.
Debt-Financed Income – Real Estate Debt
Real estate private equity funds investing in debt may also produce UBTI. If debt investments are financed with investor equity as well as other debt, a percentage of the resulting interest income, and related deductions, will generally be considered UBTI to tax-exempt investors.
Mitigating strategies to reduce or eliminate UBTI exposure
Historically, tax-exempt entities with UBTI have offset losses from individual UBTI activities against income from other UBTI activities. Therefore, only the net amount of UBTI would be subject to taxation. The 2017 Tax Cuts and Jobs Act (“TCJA”) included a provision that requires UBTI to be calculated separately for each trade or business. Therefore, the netting previously allowed has been discontinued, and this may result in additional tax liabilities due to the inability to use losses to offset income.
Due to the two UBTI consequences discussed earlier, tax on UBTI and tax-exempt status concerns, as well as the new limitation on netting, tax-exempt organizations commonly look to mitigate UBTI exposure. Fund sponsors should therefore be aware of the various options for reducing or eliminating UBTI.
Fractions Rule Compliance
Qualified organizations are not required to consider acquisition indebtedness, and therefore debt-financed income as UBTI, when such debt is incurred for real property. Qualified organizations are defined as educational organizations including university endowments, certain pension trusts, and certain church retirement plans. However, this exclusion does not apply to investments through partnerships, such as real estate private equity funds, unless certain requirements are met, one of which is that the partnership is fractions rule compliant. This compliance test analyzes the allocations of the partnership to ensure income is not directed toward tax-exempt partners while losses are directed toward taxable partners. View more discussions of the fractions rule.
C corporation blockers can be included in fund structures to hold UBTI producing investments. The effect of this structure is that UBTI will be blocked by the C corporation with only dividends, which are not subject to UBTI, flowing to tax-exempt organizations. While this may allow organizations to mitigate the risk of losing tax-exempt status, the blocker is still taxed on the UBTI. Additional compliance and structuring costs may result as well.
Real Estate Investment Trusts (“REITs”)
REITs can also mitigate UBTI exposure. Similar to C corporation blockers, REITs are formed to hold investments that produce UBTI. In contrast to C corporations, REITs are generally not subject to tax themselves because
REITs are allowed to deduct dividends paid to shareholders. REIT dividends paid to shareholders, including tax-exempt entities, are not subject to UBTI. However, careful analysis must be undertaken when foreign entities are also investors in real estate debt funds. This is to ensure that what otherwise would be portfolio interest, which is generally not subject to nonresident tax withholding, is not converted to REIT dividends, which are generally subject to withholding. An in-depth review of the benefits of REITs for real estate private equity funds can be found here.
Using Cash or Separating UBTI Investments
An additional option for avoiding UBTI is simply avoiding the use of debt financing when income would otherwise be excluded from UBTI. Since rents and interest are generally excluded, purchasing investments with cash should reduce and even eliminate UBTI impacts. However, fund sponsors frequently use leverage to increase purchasing power; this option may be limited or totally unsuitable.
If debt financing is necessary, fund sponsors may structure funds with multiple investment entities. One option would be for UBTI producing investments to be held by REITs whereas other investments would be held directly through the fund partnership. For example, a fund with a qualified organization for fractions rule compliance may have certain investments which are not eligible for fractions rule compliance. A sale-leaseback transaction is generally not allowed under the fractions rule and would still generate UBTI to a qualified organization. These investments could be held in a REIT, while all other fractions rule compliant investments could be held through the main fund partnership.
Fund sponsors and managers need to be mindful of the parameters that potential investors need to consider when making investments. The tax on UBTI could significantly alter investment returns to tax-exempt organizations, which may cause investments into a particular real estate private equity fund to be prohibitive. For example, a 10% return for a tax-exempt entity may at first glance appear to be a viable investment. If such income is subject to UBTI however, the return may be reduced by as much as 37% (in the case of exempt entities taxed as trusts) for a net return of 6.3%. State taxes on such UBTI could reduce the investment return even further. Therefore, fund sponsors and managers need to carefully consider UBTI exposure and consult with their legal and tax advisors to maintain the most attractive fund characteristics for investors.