“What is the potential exposure to Unrelated Business Taxable Income (UBTI) from my fund's investments?” Most fund sponsors and managers are asked this question by potential and existing investors. Specifically, tax-exempt entities such as IRAs, foundations, pension plans, and university endowments make up a group of investors that consider this question during the investment due diligence process. Therefore, fund sponsors need to understand why UBTI is a concern, the relevance of UBTI in equity and fixed income investments by real estate private equity funds, and mitigation strategies to reduce or eliminate UBTI.
Why is UBTI a concern?
Tax-exempt organizations generally are not subject to taxation. However, they may be subject to taxation on UBTI, which is generally defined as gross income derived from an unrelated trade or business regularly carried on by a tax-exempt organization, less deductions directly related to the conduct of that trade or business. A taxable trade or business is a trade or business that is not effectively related to the charitable, educational, or other purpose upon which the organization's tax-exempt status is based.
UBTI directly impacts the investment income of tax-exempt investors because such organizations are subject to UBTI tax. UBTI is generally taxed at corporate tax rates (a maximum federal rate of 21% for the 2023 tax year), except for UBTI generated by organizations that would otherwise be taxed as trusts. Such tax-exempt trusts are taxed on UBTI at trust tax rates (a maximum federal rate of 37% for the 2023 tax year).
UBTI may give rise to tax liability at the federal level, as discussed above. UBTI allocated and distributed to various states may also give rise to state filing and tax liability. Real estate private equity funds that invest in real estate in various states may impose such liability.
How UBTI impacts real estate private equity funds
Income from an unrelated trade or business is generally taxable, subject to the exclusion of some income categories and related deductions. However, debt income is considered UBTI even if it is generally excluded from UBTI. The common exclusions related to real estate equity and debt investments and debt umbrella investments are as follows:
Investing in Real Estate Equity
Real estate rentals and related deductions are generally not included in the computation of UBTI. In addition, gains on the sale of real estate are generally excluded, unless the gains and losses arise from assets considered inventory or assets held primarily for sale in the ordinary course of a trade or business. Thus, income from the development and sale of condominiums is taxable as UBTI.
Investing in Real Estate Debt
Interest income and related deductions generally are not included in the computation of UBTI. Note that the interest exclusion also applies if the fund is deemed to be conducting a lending trade or business. Although a trade or business conducted by a tax-exempt organization is generally subject to UBTI, interest income, along with its associated expenses, is specifically excluded. Thus, portfolio interest, such as interest from bank accounts, is excluded, as is interest arising from the fund's lending business on real estate mortgages.
Debt Proceeds
Debt income is income derived from assets for which there is an acquisition liability at any time during the tax year. Debt income includes income that is normally excluded from UBTI, such as rent and interest, and gain or loss on the disposition of such assets. Acquisition liabilities include liabilities incurred in acquiring or improving such assets, or liabilities incurred after such time but that were reasonably foreseeable at the time of acquisition or improvement.
The amount of UBTI generated by an asset is proportional to the amount of debt on the asset. The calculation of income considered to be UBTI is the product of the asset's income multiplied by a fraction, where the numerator is the average acquired debt (the average amount of debt outstanding during the tax year) and the denominator is the average adjusted basis of the debt-financed assets. In the case of a disposition of an asset, the debt used in the numerator is the highest amount of debt outstanding during the past 12 months.
Debt Proceeds – Real Estate Equity
For real estate private equity funds investing in real estate equity, debt income is typically a concern since most properties are acquired with debt. A quick way to determine the amount of UBTI is to consider the loan-to-value ratio (LTV) of the property. A property with an LTV of 65% will typically generate income, of which 65% is considered UBTI. However, this calculation is typically not precise and can be wildly inaccurate because outstanding debt can change throughout the year and adjustments such as depreciation change the adjusted basis of the property.
Subscription lines of credit are a common short-term financing tool used by many real estate private equity funds. Such financing should be carefully analyzed to ensure additional UBTI is not inadvertently generated.
Debt Proceeds – Real Estate Debt
UBTI may also arise when a real estate private equity fund invests in debt. When a debt investment is funded with an investor's capital and other liabilities, a percentage of the resulting interest income and related deductions will generally be considered UBTI to the tax-exempt investor.
Mitigation Strategies to Reduce or Eliminate UBTI Exposure
Previously, tax-exempt entities with UBTI could offset losses from individual UBTI activities against income from other UBTI activities. Thus, only the net amount of UBTI was taxable. The Tax Cuts and Jobs Act of 2017 (TCJA) included provisions requiring UBTI to be calculated separately for each trade or business. As a result, the offsets previously allowed were eliminated and losses cannot be used to offset income, potentially resulting in additional tax liability.
Due to the various effects of UBTI discussed above, tax-exempt organizations typically attempt to mitigate the impact of UBTI, and fund sponsors should be aware of the various options available to reduce or eliminate UBTI.
Following the fraction rule
Qualifying organizations do not have to consider indebtedness associated with the acquisition of real estate, and therefore debt income, as UBTI if such indebtedness is incurred against real estate. Qualifying organizations are educational institutions, such as university endowments, certain pension trusts, and certain church retirement plans. However, this exclusion does not apply to investments made through partnerships, such as real estate private equity funds, unless the partnership meets certain requirements, including complying with the fractional rules. This compliance test, the fractional rules, analyzes partnership allocations to ensure that income is not directed to tax-exempt partners and losses are not directed to taxable partners.
Corporate Saboteurs
A C corporation blocker can be included in a fund structure to hold investments that generate UBTI. The effect of this structure is that the UBTI is blocked by the C corporation and only dividends that are not subject to UBTI flow through to the tax-exempt organization.
Note that such blockers are still taxed on UBTI (more specifically, all taxable income, not just UBTI) at the blocker level, so tax-exempt investors making their fund investments through a standard C corporation may be worse off, as they will be taxed on all income from the fund, not just the UBTI that would otherwise be taxable. As a result, when a C corporation blocker is structured for tax-exempt investors, the blocker may be funded not only with equity, but with both equity and shareholder debt, to create a “leveraged blocker” to mitigate some of the tax.
Interest expense incurred on the debt may absorb a portion of the company's otherwise taxable income. Note that various interest expense limitation provisions may apply, which may limit the tax benefits of such structures and therefore require a thorough analysis. Similarly, additional compliance and structuring costs may also be incurred.
Real Estate Investment Trusts (REITs)
REITs can also reduce UBTI exposure. Similar to C corporation blockers, REITs are formed to hold investments that generate UBTI. In contrast to C corporations, REITs are generally not subject to tax themselves because they allow the deduction of dividends paid to shareholders. REIT dividends paid to shareholders, including tax-exempt corporations, are not subject to UBTI. However, careful analysis must be done when a foreign corporation invests in a real estate debt fund to ensure that portfolio interest, which would not normally be subject to nonresident withholding, is not converted into REIT dividends, which would normally be subject to withholding.
Use of Cash or Segregation of UBTI Investments
Another option to avoid UBTI is to avoid debt financing if the income is excluded from UBTI. Purchasing investments with cash should reduce and possibly eliminate the impact of UBTI, because rent and interest are generally excluded. However, fund sponsors frequently use leverage to increase purchasing power, so this option may be limited or not suitable at all.
When debt financing is required, fund sponsors can structure a fund with multiple investment entities. One option is for the UBTI generating investments to be held by the REIT and other investments to be held directly through the fund partnership. For example, a fund with a qualifying entity for fractional rule compliance may have certain investments that are not subject to fractional rule compliance. Sale-leaseback transactions are generally not permitted by the fractional rules but still generate UBTI for the qualifying entity. These investments can be held in the REIT and other fractional rule compliant investments held through the main fund partnership.
Tax Considerations for UBTI
Fund sponsors and managers should be aware of the parameters that potential investors consider when making an investment. Taxation of UBTI could significantly alter investment returns in tax-exempt organizations and prohibit investment in certain real estate private equity funds. For example, a 10% return in a tax-exempt organization may appear at first glance to be a viable investment.
However, if such income is subject to UBTI, the gains would be reduced by up to 37% (for a tax-exempt entity taxed as a trust) resulting in a net gain of 6.3%.State taxes on such UBTI may further reduce investment income.
Fund sponsors and managers should carefully consider their UBTI exposure and consult with their legal and tax advisors to maintain the fund's characteristics that are most attractive to investors.