The traditional private equity secondaries market has relatively straightforward tax implications. The market’s more niche relative, the private real estate secondaries space, however, is layered with added complication stemming from regulations in the primary marketplace. Investors, therefore, must approach this burgeoning sector expecting greater tax-related administration.
Such administration is more salient for the buyer in a private real estate secondaries trade, says Dan Kolb, a partner at Boston-based law firm Ropes & Gray. “[The seller] has been in that fund for however many years, so presumably they’ve crossed that bridge in terms of the taxes they expected up front,” he says. “Sometimes you can do a secondary where you get to move all the pieces around. But that’s unusual. Usually you’re buying into the position and you’re buying into the way the deal was structured for [the outgoing investor].”
In order to identify the relevant tax implications and then the most helpful structuring tactics, investors – as they relate to US funds – must first evaluate their own investor classification. For international buyers, the categorisation of investor type determines the tax rate under a US law, the Foreign Investment in Real Property Tax Act (FIRPTA), which dictates income tax withholding on the disposition of a US real estate asset.
“When you’re buying an interest from existing investor, you as the buyer have to invest in the fund through the access point of the original investor,” says Sarah Schwarzschild, head of real estate secondaries at Metropolitan Real Estate.
“That access point may or may not be the most attractive from a tax perspective for you as the new buyer of that interest. There may have been a tax-exempt investor that went through a door that mitigates effectively connected income, for example, but that’s not the right door for you to go through. We employ various structures to try to alleviate the tax burden for our own investors.” Some groups, such as sovereign wealth funds, are exempt from FIRPTA, and a law signed last December could widen the investor base for those institutions that can be categorised as Qualified Foreign Pension Funds, although whether it will is currently being clarified. “They haven’t come out with any quality regulation on those rules explaining who is or is not included. It’ll take years…[but] it will bring money into the US,” says Kolb.
Know the transaction
After investors understand their tax code, they must next evaluate the particular real estate secondaries deal at hand for tax implications – and the earlier the better to avoid wasting both the buyer and the seller’s time, cautions Russell Gardner, the UK and Ireland real estate head for advisory firm EY.
“There are certain situations when what was advertised to that incoming investor and then the reality of what they’re really being asked to buy into has a sufficiently big gap that stops the transaction from happening,” says Gardner. “If [the deal] is $100 million, you can afford to spend some time diligencing and trying to get under the skin of it. If it’s a $10 million, $20 million interest you’re buying, sometimes the fixed cost of getting the comfort level you want can be too much.”
Investors must consider the tax efficiency of the existing fund stake, evaluating the effective tax rate with respect to the underlying assets of the fund and any existing blockers or other structures set up to facilitate tax efficiencies for the original investor. In this stage, an incoming investor in a US fund, or one with US investments, should also be concerned about effectively connected income (ECI). Under FIRPTA, gains from the sale of a US property interest are taxed as ECI, which can necessitate filing tax concerns and additional compliance requirements, says Jesse Criz, a partner at law firm DLA Piper. Even with a tax ‘blocker’ in place to circumvent a given tax, if the previous investor had a different classification under a US tax code, the incoming investor could end up with up to a 55 percent federal tax rate, and that would seriously challenge the worth of a trade.
US investors looking to buy stakes in European funds, on the other hand, should evaluate the vehicle’s underlying assets to understand if they are investing in a pure-play real estate fund, with expected taxes on passive income. Gardner says some investors are surprised to find that the fund includes real estate operating businesses subject to active income taxes. Similarly, foreign investors considering US funds should ask if the fund includes real estate investment trusts because, depending on investors’ classification, they could be subject to a 30 percent withholding tax.
Structuring the transaction
After understanding the purpose of the fund, there are several points of consideration for incoming investors wishing to minimise tax drag. For any secondaries transaction in the US, buyers can request the fund hold a 754 election, which allows the incoming investor to reflect the valuation of a transaction at the point it is executed rather than an historic moment in time. The exercise is known as “stepping up.”
“If there’s built-in gain in the partnership, and thereby the tax basis of the underlying assets of the partnership is lower than the value, the purchasing investor can make the 754 election so that its respective inside basis equals what the investor pays rather than taking a lower tax basis,” Criz says. “If there’s a built-in loss and the value of the assets has gone way down, then you’d presumably not want to make a 754 election.”
He demonstrates this practice with a hypothetical: If the value of the assets is $100 and the tax basis is $50, and the buyer’s purchase price is $75 for the fund stake, then it would likely make sense for the buyer to make a 754 election, which would step up the inside basis of the buyer’s interest in the fund to $75, rather than $50, and the $25 in built-in gain would be shifted to the existing partners so that the new partner’s interest is based on the difference between $100 and $75.
One US real estate secondaries-specific tax consideration is the 1250 recapture gain, a part of the tax code that addresses the recapture of accelerated depreciation, Criz says. A seller of the partnership interest generally avoids recognising unrecaptured 1250 gain on the sale of the partnership interest, rather than the sale of the underlying assets and the distribution of the proceeds, which would pick up the depreciation recapture. A tax-savvy buyer may ask for price adjustments or certain structure requests depending on the magnitude of the recapture.
A tax consideration relevant to both sides of secondaries transactions comes in the allocating of income between the buyer and seller. Most transactions are allocated through a means known as the “interim closing of the books,” in which any gains or losses that occur prior to closing are allocated to the seller, and anything for the portion of the year post-closing is allocated to the buyer. The deal can also be structured on a pro rata, per diem basis, in which the gains or losses are allocated at year-end according to the number of days in which the partnership interest was owned by the buyer or seller during the year of sale. Criz notes that the interim closing of the books is the more popular choice for sellers to avoid responsibility for the portion of the year in which they did not hold an interest.
Avoid last-minute panic
No matter the individual structuring choices, EY’s Gardner cautions that investors begin the tax discussion early. In his experience, an investor may have deal discussions for months before considering the tax implications, which could derail a transaction.
“Most of the investors we’re talking about here are relatively sophisticated, have significant amounts of capital to deploy and yet invariably get excited about an investment way ahead of any rational appraisal of things like tax,” he says. “We’ve certainly seen situations where an incoming investor’s confidence gets undermined quickly when they ask the manager a question on tax and the answer isn’t clearly articulated back, where you just generate a bit of uncertainty, unnerving the investor when the fund manager doesn’t really understand the tax issues with the fund.”
To avoid this uncertainty, he recommends that fund managers either maintain a data room or have a ‘mental data room’ of tax positions to summarise the fund’s tax standing easily. Investors, for their part, should start the due diligence process early on, prepared with a checklist that includes the aforementioned tax considerations. “From experience, there feels to be more secondaries trades happening,” he says. “It still feels much less practiced than it should be to allow people to execute these trades in an efficient way that doesn’t have those last-minute panic attacks.”
This article first appeared in sister publication PERE‘s Secondaries supplement.