Short answer: Tax-exempt investors such as pension plans, endowments, foundations and IRAs pay no tax on ordinary investment income. They do pay tax on unrelated business taxable income (UBTI): income from a trade or business that has nothing to do with their exempt purpose, and the leveraged share of income from debt-financed property. Because a fund is a partnership, any business income or debt-financed income it earns flows straight through to its exempt investors on their K-1s. That is why fund agreements promise to limit UBTI, why real estate funds care about the "fractions rule", and why many exempt investors invest through a blocker. This explainer goes deeper than our short UBTI glossary entry.

What counts as UBTI

UBTI is the gross income from an unrelated trade or business the organisation regularly carries on, less directly connected deductions. The law then excludes most passive investment income:

  • dividends, interest, payments on securities loans, loan commitment fees and annuities;
  • royalties;
  • rents from real property, together with rents from personal property leased with it, unless more than 50% of the rent comes from personal property or the rent depends on the tenant's income or profits (rent based on a fixed percentage of gross receipts or sales is fine); and
  • gains on selling property, other than inventory or property held for sale to customers.

The exclusions stop applying in two common fund situations: when the income comes from an operating business, and when the property producing it was bought with borrowed money.

Income through a partnership

If a partnership carries on a trade or business that would be unrelated for an exempt partner, the partner includes its share of that business's gross income and deductions in UBTI, just as if it ran the business itself. A buyout fund that holds an operating company organised as an LLC taxed as a partnership therefore passes business income straight to its exempt LPs. A fund that holds the same business through a C corporation does not: the LP receives dividends and gains, which are excluded.

Debt-financed income (UDFI)

Income from debt-financed property is UBTI in proportion to the debt:

Taxable share = average acquisition indebtedness ÷ average adjusted basis (capped at 100%)

Acquisition indebtedness is debt incurred to buy or improve the property, including debt taken on beforehand for that purpose and later debt that would not have existed but for the purchase and was reasonably foreseeable when the property was bought. Deductions are allowed in the same proportion, and depreciation must be straight-line. The rule turns otherwise excluded rent, interest, dividends and gains into UBTI, so it hits leveraged real estate funds, funds that borrow to buy securities, and potentially fund-level borrowing used to make investments.

The real estate exception and the fractions rule

Section 514(c)(9) says that debt incurred by a qualified organization to buy or improve real property is not acquisition indebtedness. Qualified organizations are:

  • educational institutions and their supporting organizations;
  • qualified pension trusts under section 401;
  • section 501(c)(25) title-holding companies; and
  • 403(b)(9) retirement income accounts.

Private foundations, most other charities and IRAs are not qualified organizations.

The exception is lost if, broadly, the price is not fixed, the debt depends on the property's income, the property is leased back to the seller or a related person, or the seller provides the financing. When the property is held through a partnership that also has non-qualified partners, the partnership must also satisfy one of three tests, usually the fractions rule: a qualified organization's share of overall partnership income in any year may not exceed its share of overall loss in the year its loss share is smallest, and allocations must have substantial economic effect. Preferred returns, catch-ups and promotes can break the rule unless they fit within the regulations' exceptions, which is why real estate fund waterfalls are often drafted around it.

The silo rule

Since 2018, an exempt organization with more than one unrelated trade or business must compute UBTI separately for each one. A loss in one cannot offset income from another. There is one useful exception for funds: investment activities can be grouped together as a single business. That bucket includes qualifying partnership interests, broadly fund interests where the investor holds:

  • no more than 2% of profits and capital (the de minimis test); or
  • no more than 20% of capital and does not significantly participate, for example through control or appointment rights (the participation test).

So a typical LP with small, passive fund interests can net UBTI and losses across all those funds. A large or controlling investor may have to silo each one.

Filing and tax

An exempt organization with $1,000 or more of gross unrelated business income files Form 990-T. It gets a $1,000 specific deduction. Exempt corporations pay tax on UBTI at corporate rates, 21%, and exempt trusts, including pension trusts and IRAs, at trust rates, which reach the top rate quickly.

Worked example

A real estate fund buys a $10 million building with a $6 million mortgage. For simplicity, average acquisition indebtedness is 60% of average basis throughout the year, and the building earns $1 million of net rent. Three exempt investors each own 10% of the fund, so each has $100,000 of net rent.

  • A private foundation is not a qualified organization. 60% of its rent, $60,000, is UDFI, and after the $1,000 specific deduction it has $59,000 of UBTI to report on Form 990-T.
  • An IRA is in the same position as the foundation: $60,000 of UDFI, $59,000 after the specific deduction, taxed at trust rates.
  • A university endowment is a qualified organization. If the fund's acquisition and allocations satisfy section 514(c)(9), including the fractions rule, its $100,000 of rent is excluded and it has no UBTI from the building.

The same building and the same debt produce three different tax results.

What this means for funds

  • Private equity funds generate UBTI mainly from operating businesses held as partnerships or LLCs, so they often hold those deals through corporate blockers for exempt investors.
  • Real estate funds live with leverage, so they draft waterfalls to meet the fractions rule for pension and endowment investors, and offer blockers to others.
  • Credit funds earn mostly excluded interest, but leverage at the fund level and fee income for services can create UBTI, so many offer a blocker or an offshore feeder.
  • Side letters commonly require the manager to "use commercially reasonable efforts" to avoid UBTI. They rarely promise none.

This explainer is general information, not tax advice.

Sources

Related reading

This explainer is analysis and general information, not tax, legal or investment advice.