UBTI Exposure from Equity and Debt Investments by Real Estate Private Equity Funds

Published: Jun 14, 2024
By: Michael Torhan
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“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 by potential and existing investors. Specifically, tax-exempt entities such as IRAs, foundations, pension plans, and university endowments comprise a group of investors considering this question during their investment due diligence process. Accordingly, fund sponsors must understand 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 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 a direct impact on investment returns for tax-exempt investors because such organizations are subject to tax on UBTI. UBTI is generally taxed at corporate rates (federal rate of 21% for the 2023 tax year), other than UBTI generated by entities that would be taxable as trusts if they were not exempt. Such exempt trusts are subject to tax on UBTI at trust rates (top federal rate of 37% for the 2023 tax year).

UBTI can create a tax liability at the federal level, as discussed above. UBTI that is allocated and apportioned to various states can also 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, several categories of income and related deductions are excluded. However, even if generally excluded from UBTI, 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

Rents from real property and the related deductions are generally exempt from inclusion in the computation of UBTI. Furthermore, the gain from selling real property is also generally excluded. However, gains and losses are not excluded if they are generated from property 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

Interest income and the related deductions are generally exempt from inclusion in the computation of UBTI. Note that this exclusion for interest applies even where a fund is considered 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 lending business through real estate mortgages.

Debt-Financed Income

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 that 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 that 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 the property will change due to adjustments such as depreciation.

Subscription lines of credit are a common short-term financing tool used by many real estate private equity funds. Such financing must be carefully analyzed to ensure additional UBTI is not inadvertently generated.

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 and 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 various UBTI consequences discussed above, tax-exempt organizations commonly look to mitigate UBTI exposure. Fund sponsors should know 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 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, the fractions rule, analyzes the allocations of the partnership to ensure income is not directed toward tax-exempt partners while losses are directed toward taxable partners.

Corporate Blockers

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.

Note that such blockers are still taxed on the UBTI (more specifically not just the UBTI but all the taxable income) at the blocker level and therefore a tax-exempt investor holding a fund investment through a standard C corporation may be in a worse off situation since it will be subject to tax on all of its income from the fund rather than just the UBTI it would have otherwise been taxed on. As a result, when C corporation blockers are structured for tax-exempt investors, the blockers are sometimes funded with both equity and shareholder debt, rather than just equity, to create “leveraged blockers” in an attempt to mitigate some of the tax.

The interest expense generated on the debt may absorb some of the income that would have otherwise been taxable inside the corporation. Note that various interest expense limitation provisions may apply which may limit the tax benefits of such structures and therefore a full analysis would be needed. Likewise, additional compliance and structuring costs may result as well.

Real Estate Investment Trusts (“REITs”)

REITs can also mitigate UBTI exposure. Like C corporation blockers, REITs are formed to hold investments producing 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 invest 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.

Using Cash or Separating UBTI Investments

Another option for avoiding UBTI is simply avoiding using 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 that are not eligible for fractions rule compliance. A sale-leaseback transaction is generally not allowed under the fractions rule and would still generate UBTI for 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.

UBTI Tax Considerations

Fund sponsors and managers need to be mindful of the parameters potential investors consider when making investments. The tax on UBTI could significantly alter investment returns to tax-exempt organizations, making investments in a particular real estate private equity fund 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.

Fund sponsors and managers must carefully consider UBTI exposure and consult with their legal and tax advisors to maintain the most attractive fund characteristics for investors. 

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Michael Torhan

Michael Torhan is a Tax Partner in the Real Estate Services Group. He provides tax compliance and consulting services to clients in the real estate, hospitality, and financial services sectors.

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