All of the above provisions can impact real estate funds and their investors and managers. A few other new provisions of potential relevance in the fund setting are as follows:
An investor’s share of fund expenses, including management fees paid by the fund, are not deductible during the 2018-2025 period as a miscellaneous itemized deduction due to the latter’s temporary repeal by the Act. Such expenses may not be capitalized as part of the investor’s cost basis, so the investor will not receive any tax benefit from its share of management fees paid to fund managers. (Under pre-Act law, such expenses were deductible to the extent such expenses exceed 2% of adjusted gross income.)
Tax Exempt (TE) Investors
- Excise Tax: The Act provides for a 1.4% excise tax on the net investment income of a private institution of higher education of a certain size (i.e., at least 500 tuition-paying students, more than 50% of which are in the United States, and an asset value of $500,000 per student excluding assets used by the institution in its educational purposes) that would apply to income from an investment fund.
- UBTI Computation: Under the Act, a TE Investor may no longer use an NOL from one trade or business to offset UBTI (meaning unrelated business taxable income) from another trade or business. Rather, the NOL must be carried forward and used only against income of the same trade or business. The application of these new limitations in the context of debt-financed income is not clear under the new provision. These new UBTI rules may prompt TE Investors to use blocker entities or request contractual limitations on the percentage of fund capital that may be invested in operating company pass-throughs that generate UBTI (including debt financed income). Absent blockers, TE Investors may require separate information reporting from the fund of net income and loss sourced to each operating partnership that the fund is invested in.
- Foreign Investment in Real Property Tax Act (FIRPTA): The Act makes no changes to FIRPTA regarding taxation of the disposition of U.S. real property interests.
- Investments in Rental Real Estate: Foreign individual investors investing through pass-throughs would benefit potentially from the 20% QBI deduction against income generated by U.S. real estate rental business (subject to the same limits that apply to domestic taxpayers) and otherwise continue to benefit from capital gains rates on FIRPTA gain on disposition. Foreign investors that invest through a U.S. corporate blocker will benefit from the 14% rate reduction (from the pre-2018 corporate tax rate) on both rental income and gain on sale, but the new corporate rate alone does not make a corporate investment structure more tax-efficient than a pass-through investment structure.
- Sale of Partnership Interests: The Act overrides the recent Tax Court decision in Grecian Magnesite by imposing U.S. tax on gain on the sale by a foreign person of an interest in a pass-through entity to the extent a sale of the underlying partnership assets would produce effectively connected income (ECI), apart from FIRPTA gain attributable to U.S. real property. These new rules apply generally even where the disposition of a partnership interest is otherwise within a non-recognition provision, but provide Treasury regulatory authority to prescribe situations or conditions where a non-recognition provision may apply to defer gain recognition.
- New Withholding Tax: A buyer must now withhold 10% of the gross purchase price on the sale by a foreign person of an interest in a partnership unless the seller establishes that it is a U.S. person or that no portion of the gain is attributable to ECI-generating assets. Funds should consider requiring as a condition of transfer that the fund receive a copy of the withholding certificate and evidence of payment of withholding tax. The new withholding obligation should also apply to redemptions of foreign investors, although not explicit in the new provision. The 15% withholding tax applicable to dispositions of U.S. real property interests by foreign persons continues to apply.
- The foregoing new provisions impose on a range of investors some form of new tax cost on income or gain from investing in a U.S. fund.