By David Patch
Organizations described in sections 401(a) and 501 are generally exempt from federal income tax, except with respect to income from businesses that are unrelated to their tax-exempt purpose, known as unrelated business taxable income (UBTI).[1]
Rents from real property are specifically excluded from UBTI, making rental real estate partnerships a potentially attractive investment for many exempt entities. Otherwise excluded rental income, however, becomes taxable UBTI to the extent the property is funded with debt.[2] Given that leverage is ubiquitous in real estate investments, this presents a problem for exempt entities except in those rare situations where the real estate is entirely funded with equity.
Some types of exempt entities can avoid UBTI on debt-financed real estate investments if certain requirements are met. In order to attract such investors, many real estate funds carefully structure the terms of their operating agreements to meet these requirements and advertise their compliance in offering documents. This opens up a new source of funding for syndicated real estate investment partnerships that might otherwise have appealed mainly to taxable investors.
The types of tax-exempt entities to which these rules apply include educational organizations and their affiliated support organizations, qualified trusts under section 401 (pension, profit sharing and stock bonus plans), certain title holding companies, [3] and retirement income accounts of churches (collectively, Qualified Organizations or QOs).
In order for a QO’s investment in a real estate rental partnership to qualify for the exclusion, the partnership must meet one of the following requirements:
- All the partners of the partnership must be QOs;
- Each QO’s distributive share of each item of income, gain, loss, deduction, credit and basis of the partnership must be the same and must remain constant during the entire period the entity is a partner in the partnership; or
- Each partnership allocation must have substantial economic effect and satisfy the “fractions rule.”[4]
Partnerships in which all the partners are QO’s are rare, so the first requirement would not generally be met by a syndicated real estate fund. The second requirement is extremely restrictive and could limit the ability to structure deals in a way that will be of broad appeal. Therefore, real estate funds hoping to attract QOs as investors will generally want to meet the third test.
One requirement of this test is that the allocations provided for by the partnership agreement have substantial economic effect.[5] Among other things, partnership agreements must generally provide for liquidating distributions in accordance with positive capital accounts in order to meet this requirement. Partnership agreements frequently define liquidating distribution rights in other ways, and such an agreement would generally fail this requirement.[6] A real estate partnership hoping to attract QOs would need to ensure that its partnership agreement is drafted in a way that causes its allocations to have substantial economic effect. Virtually any partnership’s economic arrangement can be defined in this manner so meeting this requirement should not be a particular hardship, but the desire to do so must be communicated to the drafting attorney.
The more difficult requirement is that the partnership’s allocations satisfy the fractions rule. The fractions rule is met only if “the allocation of items to any partner that is a qualified organization cannot result in such partner having a share of the overall partnership income for any taxable year greater than such partner’s share of the overall partnership loss for the taxable year for which such partner’s loss share will be the smallest.”[7] Thus, for example, a QO could not generally be allocated 10 percent of the partnership’s loss in one year and 11 percent of the partnership’s income in another. This seemingly simple requirement may prove difficult to achieve in practice because most real estate funds have allocations that vary or have different classes of interests that cause allocations to change from year to year. The promoter’s interest will generally also vary depending on whether and when investment return hurdles are reached. In recognition of these common issues, the regulations provide a number of exceptions under which certain variances are ignored, including:
- Allocations reflecting a preferred return or guaranteed payments for capital computed at a commercially reasonable rate.
- Guaranteed payments to the tax-exempt member for services if reasonable in amount.
- Allocations of income made to reverse prior disproportionately large allocations of overall partnership loss or disproportionately small allocations of partnership income to a QO.
- Special allocations required by the Internal Revenue Code or regulations such as minimum gain chargebacks and qualified income offsets, as well as provisions that prevent allocations of loss to a QO if it would create a deficit capital account.
- Special allocations of certain partner-specific expenditures such as the costs of additional record-keeping and accounting incurred in connection with the transfer of a partnership interest, additional administrative costs that result from having a foreign partner or state and local taxes.
- Special allocations of certain unlikely losses, such as litigation costs or casualty losses.[8]
In addition, the regulations make the fractions rule inapplicable if (1) QOs do not collectively hold interests of greater than five percent in the capital or profits of the partnership; and (2) taxable partners own substantial interests in the partnership through which they participate in the partnership on substantially the same terms as the qualified organization partners.[9]
In 2016, regulations were proposed that would modify several of these exceptions in ways that should generally make them easier to satisfy and add additional exceptions. For example, the proposed regulations would:
- Remove a requirement in the existing regulations that preferred returns be distributed currently in favor of a requirement that unpaid amounts compound and be distributed first.
- Allow special allocations of management (and similar) fees to account for separately negotiated economic arrangements.
- Allow for special allocations intended to reverse prior special allocations of unlikely losses.
- Allow certain allocations to account for changes in ownership due to staged closings.
- Allow for changes in allocations due to unanticipated defaults on or reductions in capital contribution commitments.
- Clarify how allocations from lower-tier partnerships are taken into account.
- Add a de minimis exception for partnerships in which non-QO partners do not own in the aggregate interests of greater than five percent in capital or profits.
The proposed regulations will be effective when finalized, but partnerships may apply the rules for taxable years ending on or after November 23, 2016.
Conclusion
Syndicated real estate partnerships that fail to satisfy the fractions rule may be missing out on a valuable source of investment capital. By working closely with partnership specialists, syndicators can ensure that their funds meet the requirements for the exclusion of debt-financed income and present an attractive investment opportunity for QOs. Proposed regulations issued in 2016 will make it easier for real estate partnerships to satisfy the fractions rule, making this a great time to consider (or reconsider) taking the steps necessary to comply with the requirements.
[1] Section 501(a), section 512.
[2] Unrelated debt-financed income, Section 514.
[3] As described in section 501(c)(25).
[4] Section 514(c)(9)(B)(vi).
[5] Section 514(c)(9)(E)(i).
[6] Allocations provided by partnership agreements that do not call for liquidating distributions in accordance with positive capital accounts may meet this requirement only if they have substantial economic effect “equivalence.” To qualify, the allocations must result in ending capital accounts that reflect liquidating distribution priorities at the end of the current and all future years.
[7] Section 514(c)(9)(E)(i)(I).
[8] See generally Treas. Reg. sections 1.514(c)-2(d) though (j).
[9] Treas. Reg. section 1.514(c)-2(k)(2).
This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Summer 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com
