Tax-optimized investing strategies don’t have to sacrifice growth
A little bit of planning goes a long way
Real estate funds historically have raised funds from pensions, endowments, and other non-taxpayer investors. More recently, however, they have sought capital from family offices whose capital is less costly and more patient. Since these investors are taxpayers, they desire to invest in tax-optimized funds.
Structuring real estate funds to accommodate the objectives of both non-taxpayer and taxpayer investors — particularly family offices seeking tax-optimized investments — requires a balance that addresses diverse tax needs.
There are several structuring options that can allow for the allocation of depreciation and losses to maximize tax benefits while considering the needs of non-taxpayer investors, including:
1. Preferred Equity Structure
How it works: Investors are divided into different classes of equity, with the tax-paying investors receiving a higher share of depreciation allocations. The preferred equity class could have priority in receiving depreciation benefits, while other equity classes receive less or none.
Advantages: It allows tax-paying investors to receive the majority of the tax shield benefits from depreciation, while other investors who may not need these benefits can focus on returns and cash distributions.
Disadvantages: May create imbalances in overall return structures and require careful negotiation.
2. Waterfall Structure with Allocated Depreciation
How it works: In a tiered waterfall distribution model, depreciation benefits can be allocated more favorably to tax-paying investors, while cash flow distributions or gains are distributed differently. This can be done through disproportionate allocations during the early stages of the investment.
Advantages: Allows flexibility to allocate depreciation early when it’s most valuable to tax-paying investors, while still maintaining equity balance.
Disadvantages: Complex to structure and requires clear communication about how and when distributions of profits vs. depreciation occur.
3. Side Letter Agreements
How it works: The fund can offer side letter agreements to certain tax-paying investors, giving them preferential treatment with regards to the depreciation allocation. This is a custom agreement outside the standard operating agreement of the fund.
Advantages: Flexible and allows specific investors to negotiate their tax benefits while other investors remain unaffected.
Disadvantages: Must be carefully negotiated, and transparency may become an issue if other investors feel it’s unfair.
4. Depreciation Allocation through Special Purpose Vehicles (SPVs)
How it works: A separate entity (SPV) can be created that holds a portion of the real estate assets, with that SPV’s ownership reserved for tax-paying investors. The SPV is structured to maximize depreciation allocation to its investors.
Advantages: This isolates the tax benefits for investors who need them and allows the broader fund to maintain a different allocation strategy for others.
Disadvantages: Adds complexity to the fund’s structure and requires additional legal and operational oversight.
5. Tenancy-in-Common (TIC) Structure
How it works: In a TIC structure, tax-paying investors own a direct interest in the property and are allocated their proportional share of depreciation. Other investors may invest via a different structure that is not as depreciation focused.
Advantages: Allows direct pass-through of depreciation to tax-paying investors.
Disadvantages: TICs can be administratively burdensome and may limit certain financing options due to multiple owners.
6. Bonus Depreciation Allocation
How it works: Bonus depreciation, especially under current U.S. tax laws, can be allocated disproportionately to tax-paying investors. This could be a one-time adjustment at the beginning of the investment, where tax-paying investors take full advantage of accelerated depreciation.
Advantages: Immediate tax benefits and flexibility in structuring the deal.
Disadvantages: Only works in the early stages of the investment and may not benefit investors who enter later.
7. Section 704(b) Allocations
How it works: Section 704(b) of the Internal Revenue Code allows for disproportionate allocation of tax items, including depreciation, as long as it has “substantial economic effect.” This structure can allocate more depreciation to certain investors without violating tax rules.
Advantages: Provides significant flexibility and is backed by tax code provisions.
Disadvantages: Must meet strict IRS rules, and the substantial economic effect test can be complicated to manage over time.
8. Cost Segregation Study
How it works: The fund performs a cost segregation study to accelerate depreciation on specific asset components. Tax-paying investors receive a higher share of the accelerated depreciation.
Advantages: Maximizes tax benefits by breaking down the assets into components with shorter depreciation lives, offering significant upfront tax benefits.
Disadvantages: Requires upfront cost and effort to perform the study, and long-term tax strategy must be considered.
Each option has trade-offs, and a real estate fund should carefully evaluate and potentially combine these strategies. These structures should be designed in close consultation with legal, tax, and financial advisors to ensure compliance and optimize benefits for both tax-paying investors and the fund overall.