The rule is difficult to apply as it requires the sponsor to anticipate and test every possible allocation of income and loss over the life of the fund. The purpose of the Fractions Rule is to prevent tax avoidance by limiting the transfer of tax attributes from tax-exempt participants to taxable participants and vice versa. If a real estate fund includes both taxable and tax-exempt investors and will utilize leverage on its underlying investments, income attributable to the debt-financed portion of its investments will constitute unrelated business taxable income (UBTI) to the tax-exempt investors unless the fund complies with the detailed restrictions on tax allocations set forth under the so-called 'Fractions Rule' in the Internal Revenue Code (Code) and the related regulations issued thereunder. federal tax purposes, and sponsors and their counsel face additional complications imposed by pension and securities laws that overlap and often conflict with the tax laws and require a careful balancing of rules and objectives in the design of efficient structuring solutions. Private real estate funds are typically structured as pass-through entities for U.S. federal tax law limits the type of income that tax-exempt entities can receive on a tax-exempt basis, most tax-exempt organizations are highly motivated to assure that their investment in a real estate fund is structured to avoid the creation of taxable income. Tax-exempt organizations such as pension funds, university endowments and private foundations are firmly ensconced as a significant source of real estate fund capital and consequently, fund sponsors are faced with coordinating a complex set of rules and regulations in properly structuring their funds.Īs U.S. Private funds continue to be one of the fastest growing and most aggressive segments of the real estate investment industry, with equity raises reaching and exceeding the $5 billion mark.
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