2017 Essential Tax and Wealth Planning Guide

2017 Essential Tax and Wealth Planning Guide | Tax implications of fund investing 53 Ω Introduction 今 What is an investment fund? Types of investment funds and income tax characteristics • Marketable securities Hedge funds • Private equity/venture capital . Publicly traded partnerships Real estate funds . Fund of funds Investment fund attributes • Trader versus investor entities Passive versus non-passive income Separately stated activity (including PTPs) Qualified small business stock (QSBS) Unrelated business taxable income • State tax reporting Conclusion . Resources Tax implications of fund investing Types of investment funds and income tax characteristics Real estate funds Real estate funds (REF) are investment funds that pool capital for investment in real estate (including direct investment in property, other real estate partnerships, real estate investment trusts (REITs) or real estate operating companies). Traditionally, REFS include US taxable (usually individuals), US tax-exempt, foreign taxable (generally individuals or corporations), and foreign tax-exempt investors. Similar to other funds operating as partnerships, income and loss flows through to the partners resulting in one level of tax at the partner level. Investors in REFS may also be subject to the Foreign Investment in Real Property Tax Act (FIRPTA) rules.5 REFS often operate similarly to private equity and venture capital funds from a capital commitment and liquidity perceptive. Shares of REITs are often traded on public exchanges and encourage widespread passive investment in real estate by investors interested in liquidity. A REIT is a special entity for US federal income tax purposes that meets certain technical requirements and elects REIT status. The key difference between a regular US corporation and a REIT is that a REIT is allowed a tax deduction for dividends paid to its shareholders. In order to qualify for this special treatment, a REIT must, among many other requirements, distribute at least 90% of its taxable income (exclusive of capital gains) to its shareholders. As a result, REITS rarely pay federal income tax, but REIT shareholders will pay tax on amounts distributed as dividends, resulting in one level of income tax. In many instances, REITS may be formed to facilitate investments by REFs. These REITs are frequently referred to as private or "baby" REITs. These REITs are frequently formed to reduce an investor's exposure to state income taxes and attract foreign and tax-exempt investors. Character of income considerations- real estate funds Most REF investments generate taxable income or loss from the rental of properties to 3rd parties, and in those cases, rental real estate income is taxable as ordinary income. In many instances, real estate may operate at a loss as a result of depreciation and interest deductions. The deductibility of these losses may be deferred as a result of the application of the passive activity rules (discussed further in the passive versus non-passive section on page 57). Note, the passive activity rules apply to individuals and other entities, such as trusts, that are not considered real estate professionals that materially participate in the rental activity.6 Generally, gain or loss upon the sale of investment real property is taxed as IRC Section 1231 gain or loss. Gain is typically taxed at capital gain rates, except to the extent the gain is considered depreciation recapture. Loss is generally treated as ordinary loss. When REF investments are sold, typically any gain is going to be taxed at a 25% rate (to the extent ordinary deductions were taken for tax depreciation) with the remainder of the income being taxed at the long-term capital gain preferential rate of 20%. <弓 ☑ |||| A 5 FIRPTA requires foreign individual, trust, and corporate investors to treat gain or loss on the disposition of a US real property interest ("USRPI") as if such gain or loss is ECI. 6 Real estate professionals must spend the majority of their time in the real estate property business and have a minimum of 750 hours a year.

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