Key Year-End Tax Areas for Real Estate and Private Equity Funds

Posted by Jen Baker, Ariel Chester and Jonathan Williamson

With 2024 coming to a close, it is time to shift gears to focus on wrapping up 2024 tax items and planning for 2025. Now is a perfect time for your real estate or private equity fund to complete any necessary maintenance, as well as a bit of planning, to help ensure you are set up to provide investors with required deliverables timely and efficiently.

Below is our list of tax planning areas to discuss with your tax adviser before the year is out.

1. The Impact of Current Year Income and Losses

Tax consequences, whether expected or unexpected, are a serious consideration for fund investors. As a fund manager, it is crucial to understand how financial statement income compares with taxable income, which investors will be allocated taxable income, and how that income will affect both the investor and the fund itself.

Characterization and Timing of Gains and Losses

Generally, an analysis of the current year's income and loss should be completed to fully understand the characterization and timing of income, as this can be drastically different from book treatment and expected capital gain treatment.

Not all gains or losses are created equal when it comes to tax consequences. Long-term capital gain treatment may be fully or partially unavailable if certain tax provisions apply. These provisions could convert capital gains to ordinary income, e.g., under certain recapture rules, or alter the holding period from long to short-term, e.g., under the carried interest rules. The timing of recognized gains and losses for tax purposes may also differ from financial statement treatment in some circumstances. For example, the timing of gain recognition on installment sales and redemptions for tax purposes likely will not align with financial statement recognition treatment. Also, other recognition events may occur for tax purposes, which can create unexpected tax recognition events, such as disguised sales.

Additionally, consider differences between tax and book investment basis and how those differences may impact a recognition event. Investment basis for tax and book purposes could differ significantly due to different approaches on items such as acquisition accounting, the impact and variability of flow-through income, and distributions. For example, debt-financed distributions generally reduce tax capital accounts and affect gain or loss on recognition, while for financial statement purposes these distributions may be considered recognized gains when they occurred. Another prevalent example of where significant differences arise in tax and book investment basis is accelerated depreciation for tax purpose.

Allocation of Taxable Income (Loss) and Tax Distribution Needs

Understanding your allocations of taxable income can be just as important as the estimation of taxable income items. The impact of timing differences, such as those mentioned above, can alter a fund's waterfall for tax purposes. These differences generally impact how taxable income and loss must be allocated. Estimating current year tax allocations could help partners understand their specific tax consequences and plan for tax obligations that may arise at the partner or partnership level.

Understanding the partnership allocation methodology throughout the life of the partnership and specifically at the time of a recognition event will allow your fund to proactively communicate to investors and timely provide deliverables. Additionally, your fund may be required to pay tax distributions to fund your partner's tax obligations arising from the allocation of taxable income. Having a good estimate of taxable income allocations for the year can provide an opportunity to budget for these tax distribution requirements.

State Tax Obligations

Estimating taxable income and allocations can also assist in determining your fund's state and local tax obligations from an internal and investor perspective. The fund could be asked any number of questions as they relate to the upcoming filing season; being prepared for these questions helps ensure investor satisfaction.

From an internal perspective, the more detail you can gather on state-level activity, the better. The fund will ultimately be responsible for not only filing in the states where activity takes place, but also may have a requirement to pay taxes for franchise fees and/or nonresident tax obligations. The fund will need to determine the type of filings required, as many states have more than one form type and due dates vary between each state. Common forms filed by a fund may include income/franchise tax, composite or withholding tax, and pass-through entity tax (PTET) filings, to name a few.

From an investor perspective, educating them of their state filing obligations early in the year helps ensure they can take the proper steps to avoid time consuming notices along with penalties and interest. Much like the fund, your investors may have similar filing obligations with state and local jurisdictions. Providing investors the time to digest this information assists in decision-making that could impact the fund's ultimate filing obligations. Common questions asked of investors that can impact the fund's filings include composite or withholding opt in/out, PTET determinations and investor residency changes.

2. State and Local Tax Planning

Pass-Through Entity Tax (PTET)

A trend many states are following is the enactment of legislation offering PTET elections. These elections fuel federal tax savings by offering a workaround to the $10,000 itemized deduction cap for state and local taxes imposed by the Tax Cuts and Jobs Act (TCJA). Under these elections, state withholding and composite returns payments, which are distributions to the investors, can be converted into ordinary deductions. To date, 36 states have enacted some type of PTET election.

Often the complexities of PTET elections can prohibit funds from making them; however, this should not dissuade your fund from looking throughout the structure for opportunities. Analyze and understand the partner composition throughout the structure to help ensure no opportunities are missed. Using the PTET election may be more beneficial where there is concentrated ownership, such as the management company or general partner entities where income or carried interest is present through operations.

Pass-Through Withholding and Composite Filings

Many states require pass-through entities to remit tax on behalf of their nonresident investors for income recognized in the state. If a fund did not execute a PTET filing, states use either the flow-through withholding or composite filings to make these payments.

States do not share a common definition of withholding or composite filings; however, the difference relates to the additional actions required by the investor. For withholding returns, the investor is generally required to file with the state. For composite returns, the investor is generally not required to file with the state.

An investor's desire to be included in one of these filings will depend on certain factors, such as their residency, vehicle that holds the investment (individually, trust, entity) and further activities they may have in the state personally. Both returns impose tax at the state's highest rate, with some restrictions on personal deductions; there may be an opportunity for a refund if the investor chooses to file personally with the state.

Work with your tax adviser to evaluate whether PTET, nonresident withholding or composite filing will be the most cost-effective pass-through filing.

3. Partner Information Maintenance

Partner W-8s and W-9s

Generally, a fund should obtain Form W-8s or W-9s for all partners at the time of subscription; year-end is a good time for your fund to ensure appropriate documentation is on file for all partners. These forms provide each partner's taxpayer identification number, address and taxpayer classification (partnership/individual/etc.). Keep in mind partners that are considered disregarded entities, such as single-member LLCs, grantor trusts, etc., may require follow up to meet reporting requirements.

Ongoing Maintenance

Ahead of tax season, confirm your fund's investor information. If there are any changes, including address changes, transfers of interest or partner deaths, let your tax team know. There may be additional information, such as amendments to the operating agreement or transfer of interest calculations, you need to complete. Additionally, a transfer of interest could trigger an adjustment requiring more information.

Foreign Partners

Foreign partners generally add complexity to a fund's reporting and withholding requirements. Several factors can affect these requirements, such as the foreign partner's entity type, country of residency and applicable treaties. Use this time to ensure you have any required information to have a clear picture of how to meet the requirements of your foreign partners.

4. Structure of Analysis and Organizational Document Revisions

Tax structuring and their supporting documents are an integral part of a fund's tax plan and its execution. Generally, tax professionals will be involved throughout the creation and implementation of these articles and will raise concerns along the way. However, there is always the potential a key aspect could get overlooked, or certain facts changed, which may create other issues to consider.

Tax Structuring Analysis

Fund and investment structuring can have several goals, which often include creating an efficient and beneficial tax structure. These benefits can take the form of creating depreciable basis adjustments, allowing for a preferable allocation methodology and blocking undesirable tax attributes from partners that would prefer to avoid them, among others. Now is the time to have your tax team review both new and existing structures to confirm they are achieving your tax goals. Depending on the nature, adjustments may be available to correct course, if necessary.

Agreement and Contract Revisions

In addition to considering where boxes and triangles live in your structure chart, you should also review underlying agreements to ensure they support and document the tax and management goals of an entity or contract. It is best practice to try and have agreement amendments and revisions in place by the end of the year to avoid having to make corrections retroactively. If there is an inconsistency in your agreements that your tax team has brought to your attention, try to get those issues resolved by year-end. For example, you may need to review your management fee agreements to confirm the proper party is incurring management fee expenses, and they are being used for tax purposes, if possible.

Execution of Management Fee Waivers

Fund advisers use fee waivers as a mechanism allowing them to waive the access to management fee income to defer income and/or recharacterize ordinary income as preferable capital gains.

Read "Management Fee Waivers: Potential and Pitfalls for Fund Advisers"

Take some time to familiarize yourself with how management fee waivers work, their benefits and risks, and consider if they are a good fit for your management agreement in the current year. To be effective, generally a management fee waiver must be in place prior to the end of the year, and it should specify the period and amount of the management fee being waived.

5. Expense Planning

Investment Expenses

Fund investment expenses are frequently considered nondeductible portfolio deductions for individuals. This means that these expenses provide most investors with no value while reducing their basis in their fund partnership interest. Given this treatment, funds may want to explore potential scenarios where it may be advantageous to capitalize such expenses to the balance sheet rather than deducting them; however, this option is only available for certain types of expenditures. Some examples of expenses that may be capitalized are costs associated with due diligence related to making a new investment, organizational costs and syndication costs.

Trade or Business Expense Accruals

Unlike investment expenses, expenses that apply to trades or businesses are generally eligible to reduce a partner's taxable income, subject to loss limiting provisions. For this reason, it is likely beneficial for funds to accelerate trade or business deductions, either their own or in their investments, as much as possible. Depending on the type of expense, the method of accelerating a deduction into 2024 could rely on when the payment for an accrued deduction is made. Some accruals need to be paid within 2.5 months, some within 8.5 months and some may need to be paid before December 31, 2024. Coordinate with your tax team to identify potential expense accelerations and understand when payment needs to occur to qualify.

6. Portfolio Company Planning

Portfolio Company Opportunities

In addition to tax planning for the fund, there may be several beneficial tax opportunities to consider for portfolio companies. Some of these tax strategies include cost segregation studies, section 163(j) interest expense planning, capitalizing versus expensing analysis using the repair regulations and more. Not only can you implement some of these strategies throughout the tax year, but you can also carry out many of them after year-end but prior to the filing deadline.

Read "7 Year-End Business Tax Planning Areas to Be Strategic About This Year"

Fund Tax Team and Portfolio Companies Connection

As a fund manager, providing timely deliverables to your partners is just as important as providing accurate and complete information. This is the time to establish an expected timeline with any underlying portfolios. Proactively, work with each portfolio to put together a timeline for estimates, if necessary, and final Schedule K-1s; discuss investment activity; and resolve any issues that led to prior year delays. Communicate your timeline early to allow portfolio companies to work through expected timelines with their tax and audit teams.

In addition to timing, it may be helpful to hold planning meetings with both your and your portfolio company's tax teams. A couple items to consider include:

• Expected tax treatment of any current year transactions, such as purchase, sale, reorganization, etc.;
• State and local filing obligations and whether any withholding/composite/PTET may be made on behalf of the fund; and
• Any additional reporting tax requirements necessary to report to partners in a fund structure.

7. REIT Considerations

Real Estate Investment Trusts (REITs) are afforded various tax benefits under the tax code, including the application of a dividends-paid-deduction to taxable income and the potential for reduced tax rates on dividend income under Section 199A. These benefits, however, come at the cost of strict guidelines. The cost of failing these guidelines may include punitive excise taxes or the removal of an entity's REIT status - making it imperative to plan out how the REIT will perform certain testing at year-end and understand the remedies if they should fail such tests.

Excise Tax Avoidance

While REITs' eligibility for the dividends-paid-deduction can be used to eliminate taxable income, REITs may also be subject to an excise tax if they do not distribute a required amount of their earnings during a taxable year. Generally, a REIT must distribute 90% of its taxable income each year to avoid excise tax application. This can be complex when considering that taxable income and cash flow aren't always mutual, and a REIT may have significantly more taxable income than cash available to distribute in a given year. There are several alterations and elections available under the tax law that help a REIT navigate these issues, but generally they all require a REIT to act proactively and have a good estimate of income to take advantage of these allowances, as some are time sensitive. REITs should be working closely with their tax team during this time to estimate taxable income and mitigate excise taxes.

Compliance with REIT Testing

In addition to income distribution requirements, REITs are also subject to strict guidelines on the types of assets they own and the types of income they earn. REITs must perform testing on their underlying assets (quarterly) and income (annually) to ensure they continue to meet required thresholds. There are some remedies available should a REIT fail an assets or income test, but these remedies generally only apply within a 30-day window of a failed test. This makes it imperative for REITs to have a plan in place to execute asset and income testing and apply for relief, if necessary. The consequences of failing asset or income tests without relief generally include removal of the entity's REIT status.

Funds have the ability during year-end planning to position themselves to provide timely, accurate information that is useful for investors. Even in years that lack realizations, it is a good practice to have a year-end meeting with your tax adviser and talk through any significant events that occurred. Doing so will allow all parties to go into 2025 prepared to execute efficiently and effectively.

Contact Jen Baker, Ariel Chester, Jonathan Williamson or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.

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