Posted by Susanne Wolfe and Mariaelena Tejada
Tax-exempt organizations — including pension funds, endowments, foundations and individual retirement accounts (IRAs) — play a significant role in the real estate investment landscape. While these investors benefit from broad exemptions from U.S. federal income tax, certain types of income can still result in unexpected tax exposure.
A key tax consideration for these investors is unrelated business taxable income (UBTI). As tax-exempt capital continues to play a significant role in institutional real estate investment, fund sponsors and investors must carefully evaluate how investment structures may affect UBTI exposure.
UBTI is income earned by a tax-exempt organization from activities that are not related to its exempt purpose. When UBTI exceeds $1,000 in a tax year, the organization is required to file Form 990-T and may be subject to federal income tax. For tax-exempt real estate investors, UBTI matters because it can:
Importantly, UBTI can arise even from investments that appear passive. In real estate, the use of leverage is often the key factor that converts otherwise exempt income into taxable income.
For tax-exempt investors participating in real estate funds, understanding when UBTI may arise is critical. Although passive income — such as interest, dividends and rents from real property — is generally excluded from UBTI, real estate investments frequently involve debt financing. When a property is acquired or improved using debt, a portion of the income attributable to that property may be treated as debt-financed income, which is classified as UBTI for tax-exempt investors. This can include the rental income and gain on the sale attributable to the property. The portion treated as UBTI is generally determined based on the ratio of average acquisition indebtedness to the property’s adjusted basis during the tax year.
In addition to debt-financed income, UBTI may also arise when a partnership conducts an active trade or business. In those situations, the income generated from the activity is generally treated as UBTI in its entirety for tax-exempt partners. This issue commonly arises in the real estate industry, particularly where investments involve operational assets such as hotels, golf courses, certain senior housing operations or other actively managed properties.
Because of these rules, the asset class and investment strategy can have a significant impact on UBTI exposure and overall fund design. Certain asset classes inherently create greater UBTI exposure. For example:
Ultimately, the nature of the asset class, whether leveraged real estate, passive credit, operating infrastructure or public equities, drives the tax outcomes for investors. In turn, those outcomes influence the optimal fund architecture, including the use of feeder funds, blocker entities, REIT structures and the choice between corporate or partnership entities. For many real estate funds, the goal is to design a structure that efficiently accommodates both tax-exempt and foreign investors while remaining aligned with the fund’s underlying investment strategy and return objectives.
Real estate investments are commonly structured through partnerships that include both taxable and tax-exempt investors. Because UBTI and related tax attributes are determined at the partnership level, decisions regarding leverage, operations and depreciation affect all partners.
Because UBTI exposure can arise from multiple sources, including leverage, operating activities and structural limitations, fund sponsors and investors often consider planning strategies early in the investment process. While UBTI cannot always be eliminated, careful planning can help manage exposure for tax-exempt investors. Common strategies include evaluating the use of blocker entities, managing leverage levels and assessing the operational intensity of an investment. However, certain structural constraints can limit the planning options available.
In particular, some tax-exempt investors, including pension plans and other qualified organizations, must comply with the fractions rule to avoid UBTI on debt-financed income. The fractions rule restricts how partnership allocations may be structured, limiting the ability to disproportionately allocate income or losses to tax-exempt partners.
These restrictions can significantly limit the use of promote or carried interest arrangements commonly found in real estate partnerships. As a result, structuring investments that comply with the fractions rule can be complex and may reduce flexibility for both sponsors and investors. Because of these limitations, many tax-exempt investors seek structures that avoid partnership level UBTI altogether.
As tax-exempt investors cannot isolate themselves from partnership level tax decisions, understanding investor composition and deal structure early in the transaction lifecycle is critical. In practice, funds investing in highly leveraged real estate or operating businesses may rely on structural solutions, such as blocker entities, REIT structures or tiered partnership arrangements, to manage or reduce UBTI exposure.
Because of these challenges, many real estate fund sponsors explore structural solutions that can help mitigate UBTI exposure for tax-exempt investors. One of the most common approaches for managing UBTI exposure in real estate investments is through the use of REIT structures. Investing through a REIT can help insulate tax-exempt investors from partnership-level UBTI while preserving access to real estate returns.
REIT structures are often attractive to tax-exempt investors for several reasons:
As a result, private REIT structures are commonly used in real estate funds designed to accommodate tax-exempt investors and help mitigate potential UBTI exposure.
However, special rules apply to pension-held REITs. A REIT is considered pension-held if it is owned more than 50% in value by qualified pension trusts. This occurs when one or more qualified pension trusts each own more than 10% in value of the REIT, or when a single qualified trust owns more than 25% in value. In these situations, tax-exempt pension trusts that own more than 10% in value of the REIT may be required to treat a portion of the dividends received as UBTI. While these circumstances are relatively limited, they require careful structuring and ongoing monitoring, particularly for funds with significant pension plan participation.
Another issue that may arise in real estate structures involving tax-exempt investors is tax-exempt use property. Under certain circumstances — such as when property is leased to or otherwise used by a tax-exempt entity, including through certain disqualified lease arrangements — the property may be treated as tax-exempt use property under the tax rules. In some cases, this treatment can arise not only when property is directly leased to a tax-exempt entity, but also when the property is considered used by a tax-exempt entity through certain indirect ownership or leasing structures. As a result, a portion of the property may be treated as tax-exempt use property even though the partnership or entity owning the property is itself taxable.
When property is classified as tax-exempt use property, the applicable portion must be depreciated using the Alternative Depreciation System (ADS), which can affect the timing of depreciation deductions. This generally results in:
UBTI considerations are not limited to federal tax. State and local conformity to federal UBTI rules varies, and real estate investments often create filing obligations in multiple jurisdictions. Tax-exempt investors may face additional compliance burdens depending on where properties are located and how income is characterized at the state level.
Recent legislation has significantly increased IRS funding for oversight of tax-exempt organizations. While the underlying UBTI rules have not changed, the likelihood of enforcement has increased. Investors should expect:
As tax-exempt capital continues to represent a meaningful portion of institutional real estate investment, understanding how UBTI arises, and how structures such as blockers and REITs can mitigate that exposure, remains an important consideration in fund design.
Contact Susanne Wolfe or a member of your service team to discuss this topic further.
In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.