Tax complexities don't have to offset the benefits of open-end real estate funds

ARTICLE | August 08, 2023

Authored by RSM US LLP

Open-end real estate funds enable investors to prioritize flexibility in their investment decisions and stability in property income performance. With those benefits, however, come significant administrative and tax complexities due to the open-end investment structure.

Many of the tax complexities are driven by section 704(c), which generally requires any gain or loss inherent in the contributed property at the time of contribution to be allocated to the contributing partner when recognized by the partnership. The purpose is to prevent gain or loss associated with the property at the time of contribution (or due to admission of new partners) from being shifted to another partner or new partners. The fluctuation in value should stay with the partner when the gain is recognized.

Effectively, any gain due to the appreciation in property should be left with the legacy partners who owned a share of the property at that time instead of any new partners investing when the property is already at an appreciated value. Overcoming those obstacles requires advanced technology to handle tax complexities and comply with the latest jurisdictional tax laws.

Tax costs of flexibility

Open-end real estate funds continuously raise and invest capital over the life of the fund. Given that their primary investment strategy is acquiring and operating real estate, they are precluded from using special provisions that simplify tax complexities associated with open-end investment structures.

Open-end funds allow investors to enter and exit at the fund manager’s discretion. The fund may admit new partners based on fluctuating market value. This dynamic creates disparities in the existing partners’ economic capital and tax capital, which the fund generally wants to capture through the revaluation of partnership assets.

These revaluations, often known as reverse section 704(c) layers, require the partnership to allocate unrealized gains and losses back to the legacy partners. They also allocate cost recovery deductions that put the noncontributing partners in the same position as if there were no fair market value and tax disparities.

These allocations become problematic administratively for real estate businesses because these computations are required to be done by asset and for each revaluation event or layer. Each infusion of new capital will add another so-called layer of built-in gain or loss required to be tracked and recovered in addition to previously created layers.

Funds can also expedite property acquisitions by having investors contribute their appreciated properties in exchange for an interest in the fund, creating what is known as a forward section 704(c) layer. Similarly, to the extent the contributed property has value above the basis at the time of the contribution, the built-in gain will be specially allocated to the contributing partner after the sale of the property.

These types of transactions are advantageous to both the fund and the investor, as the partnership or its partners recognize no gain or loss. Forward section 704(c) layers are generally treated the same way as reverse section 704(c) layers and tracked and recovered on top of pre-existing layers.

If tax allocation complexities weren’t enough, section 704(c)’s reach extends to determining a partner’s share of nonrecourse liabilities.

The regulations prescribe that a partner’s share of nonrecourse liabilities equals the sum of:

1. Partnership minimum gain
2. Amount of any taxable gain allocated under section 704(c)
3. Excess nonrecourse liabilities as determined in accordance with share of partnership profits

The second item, section 704(c) minimum gain, requires that nonrecourse debt be allocated to a partner under section 704(c) principles as though the partnership hypothetically disposed of all partnership property for no consideration other than collateralized nonrecourse debt.

Exiting the open-end real estate fund

Investors may also exit the real estate fund at management’s discretion. If a liquidation were to occur, both the fund manager and the investor should be aware of the tax implications.

Often, the fund will make an election under section 754 that will allow the partnership to adjust the basis of its assets if there is a distribution of partnership property or a sale or exchange of partnership interest. It is important to note, though, that this election is irrevocable. It will apply to all distributions and transfers during the tax year of the election and all such transactions in any subsequent years, so it is not an election to make lightly.

If a valid section 754 election is in place, open-end funds are required to adjust the basis of partnership property anytime investors are redeemed for cash from fund operations or if an existing interest is purchased.

If a partner recognizes gain due to a cash redemption exceeding their outside tax basis, the partnership may increase the basis of their assets. Like forward and reverse section 704(c) layers, these tax basis adjustments are allocable to large real estate portfolios and attributed to individual partnership assets with significant unrealized gains and losses. The fund and its investors benefit through additional common basis tax deductions (e.g., depreciation), but these computations are often technically complex and administratively burdensome.

How tax technology helps

Tax practitioners have commonly used multiple spreadsheets for calculating section 704(c) allocations, tax basis adjustments and nonrecourse debt allocations. However, using spreadsheets for open-end real estate fund structures is sufficient only for a short period because a business can scale rather quickly.

To deal with the challenges, many open-end real estate funds must rely on sophisticated tax advisors with modern tax software to track built-in gain or loss by asset by the investor; calculate tax allocations in accordance with section 704(c) principles; compute, track and recover 734(b) basis adjustments; and allocate debt under section 752-tiered logic.

Leveraging modern tax applications can transform an organization’s tax compliance process and facilitate increased focus on activities that add value. Benefits include:

1. Decreased reliance on traditional spreadsheets and manual processes significantly reduces risk and improves the accuracy of calculations.
2. Less time spent producing and reviewing complex allocations enables tax departments to meet reporting deadlines and investor demands.
3. Increased focus on business insights and growth results from using technology that scales and adapts to meet your financial goals.

Realizing the benefits of open-end real estate funds

Open-end funds are attractive vehicles for real estate investors looking to counter market volatility with strong, stable cash flows. They are also an enticing avenue for real estate fund managers looking to offer an alternative investment option in the market from the rigidness of closed-end funds.

Fortunately, advanced tax technology applications can help them realize those benefits without being dragged down by significant tax and administrative complexities. The flexibility that an open-end structure provides investors doesn’t have to be a double-edged sword.