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Allocation Issues for Open-End Real Estate Funds

February 2011

Allocation Issues for Open-End Real Estate Funds Private real estate investment funds often use a partnership to pool investments. Partnerships are chosen since they provide flexibility in allocating income to investors that have varying economic arrangements without incurring tax at the fund level. The economic allocation schemes for many real estate funds are complex and are likely to include special allocations of performance and management fees, preferred returns, income and distribution waterfalls, multi-tiered structures and target capital. Taxable income is allocated in an effort to follow each investor's economic return from the fund as provided in the partnership agreement. Complication with respect to taxable income allocations can vary significantly depending on the how often the fund allows investors to contribute and redeem their investment. In making these fundamental liquidity decisions, the difference in tax complexity may be overlooked or minimized. Openend funds, providing for the periodic solicitation of additional capital and allowing for the periodic redemption of partnership interests (sometimes after a lock-up period), are more complex from a tax perspective than closed-end funds, where contributions are made at formation, and interests are not redeemable until the fund liquidates. Even though a closed-end fund is simpler to administer, investors often prefer an open-end structure because it provides the greatest flexibility for entering and exiting the fund. For a private real estate fund, this structure presents certain fundamental problems, including: (1) the fund must determine an equitable net asset value for each

investor contribution and withdrawal, (2) after capital is deployed to illiquid real estate investments, the fund may need to find cash to satisfy withdrawal requests, and (3) tax allocations for the fund will need to be determined by maintaining each investor's economic capital accounts. The discussion below summarizes the complexity of the taxable income allocations. Tracking Built-In Gains and Losses In a closed-end fund, the built-in gain or loss (difference between original cost and fair market value of property) is generally equal for both economic and tax purposes. While the economic allocations may be complicated, the taxable income can be allocated (and capital account maintenance requirements can be met) without creating an entirely new set of books to track the differences between each partner's economic and tax items. However, when a fund allows new investors to be admitted for the market value, a disparity is created between a partnership's economic basis and its tax basis. This creates a need to revalue assets and determine new profit and loss sharing ratios as each additional contribution is accepted. Most commonly, this scenario is caused by a contribution in exchange for an ownership interest in the fund which triggers a fund revaluation under Regulation Section 1.704(b)-1(b)(2)(iv)(f) (commonly known as "reverse Section 704(c)" allocations). Absent an adjustment under these rules, the tax and economic income allocations would be distorted.

This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. Federal, state or local tax penalties.

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PwC Allocation Issues for Open-End Real Estate Funds

Consider the following example: 50 investors form a real estate fund to which each contributes $1,000. The partnership uses the proceeds of these contributions to purchase five real estate investments. Assume that a year after it is formed, the partnership has recognized no taxable net income or loss, but the real estate assets increased in value from $50,000 to $75,000. Thus, each investor's interest in the partnership now has a value of $1,500 ($1,000 capital, plus $500 interest in unrecognized appreciation). The fund is open-ended, allowing new investors to contribute annually. In year 2, new Investor X contributes $1,500 for an equal interest in the entity. In order to protect existing investors against economic loss, the "book" (economic) value of the partnership's property is increased by $25,000 to its current value of $75,000, and the $25,000 increase is credited equally to each of the original 50 investors ($500 each). In general, under Section 704, the "book-up" or "book-down" that is calculated in the event of a revaluation must be allocated on an asset-by-asset basis. In other words, the built-in gains and built-in losses cannot be aggregated based on the total disparity in the capital accounts. Because each real estate investment typically includes multiple assets (for example, land, building, improvements, fixtures and equipment), the number of assets required to be adjusted can be large. In addition, the adjustment for each asset may go up or down, each having different consequences upon the ultimate sale of each investment. In the example above, Investor A (one of the original 50 investors) has a built-in gain of $500. With respect to Investor A (and each other investor) an allocation is required to each of the five real estate investments (and the assets therein) to reflect the market value of each asset with respect to the new investor. As an example, Investor A's share of Asset 1 may have to be

increased by $25 of the $500 in built-in gain. This amount may be allocated as follows: increase in land by $20, increase in building by $10 and a decrease to fixtures by ($5). Significantly, each time a new contribution changes the ownership percentages, a new revaluation must occur, adding another layer of built-in gain or loss that must be tracked and depreciated on top of the prior book-ups and downs. The old layers are not adjusted; instead, they are maintained in addition to the new layers. As if tracking all of the built-in gains and losses for hundreds of assets and multiple layers were not complex enough, the tax regulations take it one step further. Section 704(c) requires that any tax items with respect to each property with built-in gains be shared so as to reduce the original built-in gain or loss. For real estate, this usually means a calculation of depreciation expense on the adjusted value of the assets and a special allocation of depreciation expense with respect to each asset. There are three nonexclusive methods outlined in the regulations— the traditional method, the curative method, and the remedial allocation method. Each of these methods has detailed nuances that could result in a different outcome to each investor, but all require that separate depreciation schedules be maintained for each asset using both the tax basis and the revalued market value basis. IRS Response to the Complication Recognizing the complication that could arise under the tax allocation rules for investment funds, the regulations allow a special provision for "securities partnerships" to aggregate the built-in gains and losses rather than maintain separate records for each asset and layer. In allowing this exception, the IRS recognized that the frequency of capital account restatements under Regulations Section 1.7041(b)(iv)(I) and the number of partnership assets may make it impractical for these entities to make reverse Section 704(c) allocations on an asset-by-asset basis. Unfortunately, under these rules, the definition of a

This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. Federal, state or local tax penalties.

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PwC Allocation Issues for Open-End Real Estate Funds

securities partnership does not include funds with real estate assets. Instead, a securities partnership is defined as one that (1) holds at least 90% "qualified financial assets" (generally assets that constitute marketable securities) and reasonably expects to make revaluations at least annually or (2) is registered with the Securities and Exchange Commission under the Investment Company Act of 1940 as a management company. Even if a real estate fund were able to meet these strict requirements, the aggregation would only apply to the qualified financial assets. While investors understand that the economic risks and rewards associated with investing in securities differ from the economic risks and rewards of investing in real estate, they may not appreciate that the current tax regime reduces some of the tax complications associated with open-end securities partnership, but provides no such relief for the typical open-end real estate partnership.

More Complication - Basis Adjustments The labyrinth that is each partner's share of taxable income does not end with the allocation issues discussed above. Mandatory basis adjustments, which result from common transactions like investor transfers and redemptions, also need to be maintained on an asset-by-asset basis. Similar to the situation described above, Congress recognized the administrative burden and costs associated with computing and tracking basis adjustments among large portfolios of investment assets, so it carved out an exception to the rules for electing investment partnerships. Unfortunately, real estate funds are once again precluded from using this exception due to the nature of its investments. Notwithstanding the practical limitations on applying these rules, the real estate fund world is left with a mandate to muddle through the complication asset-by-asset, event-by-event, and depreciation method by depreciation method.

Additional Events Causing Fund Revaluation As noted above, the issues covered in this article are commonly faced by open-end funds, not closed-end funds. However, fund transactions are not always as simple as they appear. Many closed-end funds that start with the intention of keeping things simple nevertheless may become complicated due to business changes. Often a fund may find itself with the need to revalue even in situations where new investors are never admitted. Revaluation events could result from a number of transactions, including: 1) Imposing a default remedy on a partner (for example, where defaulting partners are removed or their interest is diluted), 2) Where no new partners are admitted, but certain existing partners all allowed to make additional contributions to the fund (for example, a followon offering), 3) In certain cases where contributions of committed capital is made over a long period of time and significant market value changes occur in the assets during the period between contributions, 4) When certain performance fee allocations are crystallized, or 5) As a result of fund restructuring transactions, mergers, or other similar transactions. Tax Return Disclosure Given the challenges of complying with the tax rules in this area, questions may arise as to whether a disclosure is needed on the fund's tax return. A departure from the tax rules or regulations on a material item (including allocations) is required to be disclosed on Form 8275-R. Whether this disclosure is necessary for each fund's income allocations will depend upon the specific facts and circumstances. In determining whether to disclose, it is critical to distinguish between the use of a

This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. Federal, state or local tax penalties.

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PwC Allocation Issues for Open-End Real Estate Funds

reasonable estimate (and the use of assumptions) in attempting to report the technically correct allocations versus a departure from the technical rules. Technology Advances and Tax Compliance Standards Real estate funds often use spreadsheets to calculate the allocations required under Section 704(c) and basis adjustments under Sections 734 and 743. In many cases, spreadsheets appear to accomplish the objectives. Significant time is often spent in the first year, but then there may be a need to recreate the spreadsheet each year. Also, as complexity increases, the quality of the work product may begin to deteriorate over time. For tax allocations that are more intricate, accurate compliance with IRS reporting and subchapter K requirements the use of spreadsheets quickly becomes impractical. To address this problem, software programs have been employed by many real estate funds that (1) track detailed built-in gain and losses for each investor, (2) calculate depreciation on the economic value of properties and (3) maintain the required records for the allocations to be respected. These software packages are continually improving. The use of such a program can significantly reduce the time spent on tax allocations. In addition, such a technology will almost certainly improve the accuracy of the results, making compliance with the tax rules more practical and cost efficient.

to increasing complication, including potential tax return disclosures and the use of new technology tools.

For additional information concerning this issue, please contact: Dan Crowley 646-471-5123 [email protected] James Guiry 646-471-3620 [email protected]

Summary In structuring funds to maximize liquidity, when taking in new money on existing funds, or as a fund engages in other transactions that would create a tax and economic disparity, fund sponsors and investors should recognize the added complication and costs associated with tax allocations. In addition, with respect to the methods used to allocate income, an understanding of the various assumptions made and limitations inherent in the models that are used should be understood. All parties should be involved in solutions that address the tax issues that arise due

This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. Federal, state or local tax penalties.

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PwC Allocation Issues for Open-End Real Estate Funds

For more information, please contact your local PwC real estate tax service provider or one of the contacts below. Nationally Gary Cutson US REIT Tax Leader New York 646-471-8805 [email protected]

Paul Ryan US Real Estate Tax Leader New York 646-471-8419 [email protected]

Regionally Atlanta

New York

San Francisco

Dennis Goginsky 678-419-8528 [email protected]

Martin Doran 646.471.8010 [email protected]

Neil Rosenberg 415-498-6222 [email protected]

Boston

Joni Geuther 646.471.4526 [email protected]

Washington DC

Timothy Egan 617-530-7120 [email protected] Laura Hewitt 617-530-5331 [email protected]

Chicago Jill Loftus 312-298-3294 [email protected] Alan Naragon 312.298.3228 [email protected]

Dallas

James Guiry 646.471.3620 [email protected] Jill Hemphill 646.471.8080 [email protected]

Tim Trifilo 703-918-3338 [email protected]

Christine Lattanzio 646.471.8463 [email protected] James Oswald 646.471.4671 [email protected]

Colin Stevenson 214-756-1752 [email protected]

Steve Tyler 646.471.7904 [email protected]

Los Angeles

David Voss 646.471.7462 [email protected]

Adam Handler 213-356-6499 [email protected]

Kelly Nobis 703-918-3104 [email protected]

Phil Sutton 213-830-8245 [email protected]

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