Key Takeaways
- • EisnerAmper's Q4 2019 newsletter outlines accounting and tax considerations for private equity funds investing in real estate, targeting fund managers and their investors.
- • Investment company status under ASC 946 determines whether real estate is reported at fair value (investment company) or depreciated cost (operating company), a classification that is not always clear and requires judgment.
- • UBTI exposure arises when real estate is acquired with financing or when financing for improvements is anticipated, affecting tax-exempt investors.
- • Structuring a fund as a REIT can attract tax-exempt and foreign investors and reduce multi-state filing burdens, but requires strict ongoing compliance to preserve REIT status.
- • Under IRC Sec. 199A, introduced by the TCJA, the 20% pass-through deduction may be limited or unavailable when income-producing properties are sold late in the taxable year, so disposition timing matters.
Summary
EisnerAmper's Q4 2019 publication addresses the considerations facing private equity funds that invest in real estate. Successful real estate operators and developers have increasingly launched such funds to raise capital from high net worth individuals, institutions and tax-exempt entities. The article notes that prospective investors typically request historical performance data, including track records, financial metrics and internal rates of return, and advises that investors verify such performance with a reliable source before committing capital.
On the accounting side, the firm points to Accounting Standards Codification Topic 946 as the guidance for determining whether a fund qualifies as an investment company. Qualification depends on criteria such as pooling investor funds, providing investment management services and investing solely for capital appreciation, investment income, or both. An investment company should maintain its stated strategy, including its exit plan. The article cautions that a value-add strategy involving physical improvements may not qualify, and that managers who generate significant cash flows and are heavily involved in day-to-day operations may resemble an operating company. The distinction determines presentation: an operating company carries real estate at depreciated cost and reports rental income and operating expenses, while an investment company reports real estate at fair value with changes recognized as unrealized gains and losses.
Tax considerations highlighted include unrelated business taxable income (UBTI), REIT structuring and property disposition timing. Real estate rental income and gains are generally exempt from UBTI, but acquisitions financed with debt, or properties where improvements financed by debt are anticipated, may generate UBTI. The article notes that a REIT can attract both tax-exempt and foreign investors because rental income converted to dividends is not UBTI and does not create effectively connected income. It adds that the Tax Cuts and Jobs Act of 2017 made the REIT structure more attractive by offering U.S. investors a 20% deduction, and by limiting state filing obligations to the investor's state of residence, though maintaining REIT status requires careful monitoring.
Finally, the article warns that under IRC Sec. 199A, a property must be held in a qualified trade or business at year-end to support the deduction, so late-year dispositions could reduce or eliminate it. Managers should weigh whether to postpone a sale to the following tax year. EisnerAmper concludes that fund managers should consult their accountants and attorneys throughout the fund's life to understand the implications of structuring decisions.
On the accounting side, the firm points to Accounting Standards Codification Topic 946 as the guidance for determining whether a fund qualifies as an investment company. Qualification depends on criteria such as pooling investor funds, providing investment management services and investing solely for capital appreciation, investment income, or both. An investment company should maintain its stated strategy, including its exit plan. The article cautions that a value-add strategy involving physical improvements may not qualify, and that managers who generate significant cash flows and are heavily involved in day-to-day operations may resemble an operating company. The distinction determines presentation: an operating company carries real estate at depreciated cost and reports rental income and operating expenses, while an investment company reports real estate at fair value with changes recognized as unrealized gains and losses.
Tax considerations highlighted include unrelated business taxable income (UBTI), REIT structuring and property disposition timing. Real estate rental income and gains are generally exempt from UBTI, but acquisitions financed with debt, or properties where improvements financed by debt are anticipated, may generate UBTI. The article notes that a REIT can attract both tax-exempt and foreign investors because rental income converted to dividends is not UBTI and does not create effectively connected income. It adds that the Tax Cuts and Jobs Act of 2017 made the REIT structure more attractive by offering U.S. investors a 20% deduction, and by limiting state filing obligations to the investor's state of residence, though maintaining REIT status requires careful monitoring.
Finally, the article warns that under IRC Sec. 199A, a property must be held in a qualified trade or business at year-end to support the deduction, so late-year dispositions could reduce or eliminate it. Managers should weigh whether to postpone a sale to the following tax year. EisnerAmper concludes that fund managers should consult their accountants and attorneys throughout the fund's life to understand the implications of structuring decisions.
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