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.
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.
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. 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 month period.
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. 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. 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. Therefore, only the net amount of UBTI would be subject to taxation. 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.
As of the date of this publication, final guidance has not yet been released regarding how organizations will determine if they have more than one unrelated trade or business for this purpose or how they will specifically identify separate unrelated trades or businesses to comply with this new requirement.
From Technology and Risk Management to Specialty Audit Services and more, Richey May Advisory has the solutions you need to find and focus on your competitive advantage. When creating and structuring a prospective alternative investment vehicle or family of entities, it is important to consider the tax impact that both tax-exempt and foreign investors may have on your fund. At Richey May, we provide resources to help determine the impact of these investors, as there are certain tax rules to navigate to provide the most tax efficient result for all investors.
Unrelated business taxable income, effectively connected income, withholding agent responsibilities, and proper U. It is the product of those entities engaging in taxable activities, that are not substantially related to the purpose of the organization in which they are invested. Income from investment activities carried on within an alternative investment fund interest, dividends and capital gains is generally not taxable to tax-exempt entities. However, there are instances in which UBTI are generated by investing in an alternative investment fund.
Several common activities can trigger UBTI in a fund. Funds that have tax-exempt investors need to be aware of these triggers:. There are ways to mitigate UBTI from within certain fund structures. Various offshore blockers can be employed in certain cases to block the UBTI from flowing to tax-exempt investors.
Alternatively, tax-exempt investors could be placed into a side pocket within the existing fund away from the UBTI generating investments. The account custodian normally prepares this form, with certain exceptions. Trade or Business and is taxable to foreign investors in U. In fact, there may be no tax savings on LLC operating income that would be UBTI, just the convenience to tax-exempt and foreign investors of avoiding filing tax returns and reporting the income directly.
Blocker entities allow the fund to invest in a corporate entity the blocker that, in turn, typically invests in a single operating LLC. As with the feeder, the blocker captures and pays U. The blocker's after-tax income is then paid out to the fund. Unlike the feeder, the blocker can be set up at the time of a proposed investment in an LLC. There are a number of structuring issues with blockers, and finding the optimal structure in a particular case will involve tradeoffs.
For example, if the fund makes its entire investment in an LLC through a blocker entity, all of the fund's partners, including taxable partners, will bear a share of the tax paid by the blocker on the LLC's income. If, however, the LLC is unlikely to generate significant current income, the blocker's tax will be relevant only upon a disposition of the LLC.
Accordingly, it is important to structure an LLC investment through a blocker so as to optimize after-tax returns from a future liquidity event. In a liquidity event, taxable individual investors, including the principals of the general partner, will prefer capital gain treatment or even better, a tax-free exchange.
It may be necessary to use another entity, in addition to the blocker, to avoid subjecting the general partner's carried interest in the investment to U. None of the above structures are perfect solutions, and some of the structures are more appropriate where a fund expects only a limited exposure to income that would be UBTI. Nonetheless, more companies are now organized as LLCs, and funds are investigating ways to address the tax issues.
Toggle navigation. Use of Debt or Options Some private equity funds have structured their investments in LLCs as convertible debt or options or debt with warrants , rather than as a present equity interest.
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