Investors are attracted to private equity real estate funds for the potential to grow wealth through appreciation in value and income. Private equity investments also offer added tax advantages compared to some other investment alternatives, such as the ability to use expenses, depreciation and interest deductions to offset gains. The structure of private equity real estate funds also offers some added tax incentives.
Private equity investments are often structured as a limited liability partnership (LLP) or some other form of “pass-through” entity. What that means is that profits earned (or losses incurred) pass directly through to the partners, whether that is an individual, a family trust or some other ownership entity. The tax obligation also passes through to the partners or owners in a private equity investment fund. That is a very different scenario as compared to owning stock in a publicly traded company.
Two Different Tax Rates
The simple way to look at an investor’s tax obligations for private real estate investment funds is to think about returns that fall into two separate buckets. The cash flow a fund generates goes into the income bucket, while any gain (or loss) realized when an asset is sold falls into a separate capital gains bucket. Combined, both of those “buckets” contribute to the overall return an investment generates over time. However, for tax purposes, they are treated very differently.
- Understanding Capital Gains Taxes
Similar to the sale of any investment asset, a capital gain is realized when a property or shares of a private equity real estate fund are sold for a higher value than the original purchase price. The capital gain is the “net” difference between that buy and sell price, less any expenses or deductions. Capital gains are taxed at different rates from ordinary income. Depending on an individual’s income bracket, that federal tax rate can be 0%, 15% or 20%.
- Understanding Taxable “Pass-Through” Income
Limited partnerships do not pay income tax directly on their earnings as they “pass through” this income to the shareholders or individual investors. However, the IRS requires limited partnerships to file an annual Return of Partnership Income where they disclose income and expenses. The partnership is also required to provide individual shareholders with an annual Schedule K-1 that reports each partner’s share of the taxable earnings. The K-1 is also filed with the IRS and includes several different categories of taxable income as well as deductions.
K-1 documents typically detail:
- Investment interest
- Capital gains or losses on the sale of assets
The partner may not have actually received the income. For example, income may be reinvested into a property or fund. However, the individual shareholder must still report that income on their annual federal and state tax returns, and he or she would be taxed at the current federal individual income tax rate and any relevant state income tax for the state where they reside. (Some U.S. states, such as Florida and Texas, have no state income tax.)
Tax Reform Impacts Pass-Through Income
The current federal income tax rate for individuals in the highest tax bracket is 37%. As part of the new Tax Cuts & Jobs Act of 2017, owners of certain pass-through entities may be eligible for a new tax deduction of up to 20% on their pass-through income. Potentially, that represents significant savings for private equity real estate investors.
For example, if a private equity real estate fund generates $100,000 in annual income for an individual shareholder, the individual investor may be able to avoid paying federal tax on $20,000 of that income if they are eligible for the full 20% deduction. Owners of REIT stocks where at least 90% of earnings are passed through to shareholders also qualify for the 20% tax deduction.
Considerations for Foreign Investors
One note for non-U.S. investors in private equity real estate funds is that they may be subject to the Foreign Investment in Real Property Tax Act (FIRPTA) rules. Current rules require that a foreign investor would be required to withhold 15% of the sale price for tax purposes when selling real property, which would include the sale of a private equity real estate fund. However, if an individual investor is physically present in the United States for at least 183 days in the previous calendar year, he or she would qualify as a resident alien and would not be subject to FIRPTA withholding.
As with any financial investment, it is wise to consult with a tax professional or trusted advisor to fully understand the tax implications for each individual.