New fractions rule guidance for real estate funds
TAX ALERT |
A long-awaited and highly-anticipated guidance project concerning the so-called ‘fractions rule’ under section 514(c)(9)(E) has at last resulted in proposed regulations. At its core, the fractions rule aims to prevent the shifting of losses to taxable entities (or the shifting of income to tax-exempt entities) when they co-invest in real estate assets through partnership structures.
For real estate funds with qualified tax-exempt investors (e.g., pension plans and college endowments), the fractions rule has long-served as a popular tax structuring technique by helping to mitigate the qualified tax-exempt investor’s exposure to the unrelated business income tax (UBIT). In order for a qualified tax-exempt organization to recognize this potential benefit, the fund must not only satisfy the fractions rule (on both an actual and prospective basis), but also the general requirements relating to tax-exempt investments in real estate and the principles of substantial economic effect.
Adhering to the above requirements allows qualified tax-exempt organizations to avoid paying UBIT on allocations of debt-financed rental income and section 1231 gains. It is important to note that the fractions rule only cleanses debt-financed unrelated business taxable income (UBTI) from real estate investments. And as an aside, it is worth mentioning that the fractions rule does not, in its current form, benefit other ‘nonqualified’ tax-exempt organizations (e.g., private foundations).
Despite the potential perks, the complexity and uncertainty surrounding the application of the rules have led various professional groups and commentators to ask for clarification of or modifications to the existing rules.
In January 2010, the American Bar Association (ABA) Section of Taxation provided detailed commentary and suggestions on disregarded allocations, changes in interests and tiered partnerships in the context of the fractions rule. Notably, the ABA recommended broadening the scope of excluded partner-specific items to permit the special allocation of divergent management fees. The comments also aimed to make the fractions rule more accommodating to funds that employ staged closings or contend with partner defaults or capital commitment reductions. The ABA also advocated for new guidance confirming that a violation of the fractions rule with respect to an underlying partnership should not trigger a fractions rule violation with respect to the fund’s remaining, otherwise fractions rule compliant, investments.
Other commentators previously contemplated whether the IRS would be willing to broaden the scope of the fractions rule to allow other tax-exempt entities, such as private foundations, to share in the benefits previously enjoyed exclusively by qualified organizations.
Lingering uncertainty also persists around whether the increasingly prevalent targeted allocation schemes found in many partnership agreements are suitable for fractions rule compliant structures. After all, targeted allocations technically fall outside the section 704(b) substantial economic effect requirement.
More recently, questions have arisen regarding the interaction of the fractions rule and the new partnership audit rules. Specifically, some have voiced concerns that the payment of entity level tax and disproportionate allocations, if applicable, of the resulting nondeductible expense, would seemingly create a glaring fractions rule violation (to the extent a tax-exempt partner received a disproportionate share compared to a taxable partner with an equivalent partnership interest).
Although the preamble to the proposed regulations does not directly reference the 2010 ABA recommendations, it appears a number of the ABA’s suggestions were considered, and for the most part, adopted in the new proposed regulations. The new guidance is a step towards making the fractions rule more accommodating without sacrificing its underlying anti-abuse principle.
Specifically, the new guidance allows, for purposes of the fractions rule, allocations consistent with common arrangements involving preferred returns and the allocation of partner-specific expenditures (e.g., divergent management fees), subject to the satisfaction of certain limitations. The new guidance also lends flexibility around the chargeback of divergent management fees or other partner-specific expenditures.
The new guidance also provides an exception for certain special allocations resulting from staged fund closings occurring within 18 months of partnership formation as long as the terms of the partnership agreement satisfy certain requirements. With respect to tiered partnership structures, the proposed regulations simplify one of the existing examples, but do not go so far as to explicitly alleviate concern that a fractions rule violation for one investment will not necessarily taint an entire fund that would otherwise be fractions rule compliant.
Additionally, the new proposed regulations may provide relief for some taxpayers by inserting a new de minimis rule with respect to certain partnerships with only minimal qualified tax-exempt ownership and broaden an existing de minimis rule with respect to certain allocations away from qualified organization partners. The new de minimis rule exempts partnerships from fractions rule compliance as long as qualified organizations do not hold more than 5 percent of the partnership capital and profits. Further, the existing $50,000 exception for certain allocations away from qualified organization partners is expanded to $1 million, provided the $1 million does not exceed 1 percent of the partnerships gross income or loss for the year.
While the new guidance is generally favorable and likely to be well received in the real estate fund community, the changes are still relatively narrow in scope, at least in comparison to some of the broader suggestions previously noted above. Indeed, the proposed regulations do not directly address the interaction of the fractions rule and targeted allocation schemes
The new proposed regulations apply to tax years ending on or after the date the regulations are published in final form. With that said, the preamble indicates that a partnership and its partners can rely on any of the rules contained in the proposed regulations for tax years ending on or after the date the proposed regulations are published, in proposed form. Thus, it would appear that this new guidance could apply to both new and existing structures for purposes of the 2016 calendar year-end tax filings and any subsequent years.
With this new guidance in hand, real estate fund managers should continue to evaluate—or reevaluate, if applicable—the viability of a fractions rule compliant structure to accommodate qualified tax-exempt investors. In recent years, some real estate funds, at the urging of qualified tax-exempt investors, had migrated towards using private real estate investment trust (REIT) blocker structures, for example, in lieu of relying on the fractions rule. In light of the favorable new guidance, and the additional compliance costs that can accompany REIT structures, a fresh look at the fractions rule may be in order for certain managers.