By Demetri Yatrakis, partner and COO, WeiserMazars LLP
Hotel development and investment in New York City is booming.
A rebound in the city’s tourist industry has run headlong into a dearth of hotels caused by out of date buildings and buildings in need of restoration.
Many funds and deal sponsors are looking to buy into this hot market by raising capital from tax exempt investors (e.g., certain charities, foundations, and pension funds).
These deal promoters should keep in mind that tax exempt investors may be subject to the Unrelated Business Income Tax (UBIT).
At its broadest definition, UBIT can create taxable income for otherwise tax exempt investors. However, proper tax planning can reduce UBIT and improve tax exempts’ net internal rate of return thereby accelerating promote payments to the sponsors.
In 1950, as a response to the growing use of tax exempt entities in tax shelters and the increase of charities’ investments in new activities (i.e., buying commercial real estate and businesses), Congress passed UBIT as a way to protect taxable businesses against unfair competition from tax exempt entities.
UBIT seeks to achieve equitable treatment of tax exempt and taxable investors by taxing (at trust or corporate rates) the income of certain tax exempt entities.
Under section 512 of the Internal Revenue Code, the term “unrelated business taxable income” (UBTI) is defined by three pre-requisites.
First, the income must be derived from a business. Second, the business must be unrelated to the tax exempt’s charitable purposes. And finally, the business must be ongoing.
Two additional rules to keep in mind are that (1) certain “passive income” such as dividends, interest, rent, and capital gains are excluded from UBIT, and (2) income, including “passive income just mentioned, from debt- financed investment” is subject to UBIT to the extent of the acquisition indebtedness relative to basis in the property.
Operating income from hotels is generally UBTI. In contrast, gain from the sale of a hotel may not be subject to UBIT (assuming that there is no debt financing associated with the hotel). The distinction from hotel operating income is that holding and selling a hotel can be classified as a passive investment.
The key is that there is not generally a regular and ongoing business associated with the one-off sale of a hotel. This dichotomy in how operating income and sale income is treated for UBIT purposes is important when considering structuring.
Tax exempt entities often request that funds provide a C corporation as an entry point into the fund. Since the corporate entity pays a corporate tax, the purpose of the corporation is not to minimize taxation. Instead, inserting a corporate “blocker” into the structure causes the tax/drag on internal rate of return to be recognized at a level below the tax exempt entity.
For those looking to minimize taxation, a corporate “blocker” is therefore not the best structuring solution.
Before putting in place a complicated structure just to reduce taxes, identify what income (from operations or sales) will drive investors’ profits.
It may be worthwhile to undertake a “Cost Segregation Study” which analyzes the hotel’s assets and related depreciation in the hopes of maximizing the allowable deduction.
If the hotel is expected to generate significant operating income and significant gain on sale, it may be tax-efficient to form an operating company (OpCo) and a separate property owning company (PropCo). Under this structure, OpCo and PropCo enter into a lease arrangement.
UBTI from operations is thus isolated in OpCo, which is generally a corporation, and gain from the sale (generally not subject to UBIT) flows through PropCo to the tax exempt investors.
Moreover, UBTI is managed and reduced through a properly structured lease agreement which is intended to shift income (in the form of non-UBTI rental income) to PropCo.
Tax exempt investors in operating businesses (i.e., hotels) have specialized tax needs that should be addressed early in the investment process.