Here are some guidelines through the UBIT-real estate thicket. Bear in mind that they are only guidelines; each institution should confer with its own legal and tax counsel prior to making any investment decision.

Real estate investment can increase risk-adjusted returns over the long term and can be one of the most effective hedges against unanticipated inflation. Many educational institutions and foundations hesitate, however, to invest in real estate for income, capital appreciation, or both. One of their concerns is whether income earned by that investment will be subject to unrelated business income tax (UBIT), which is a mechanism that removes some of the competitive advantages tax-exempt organizations otherwise would enjoy over taxable entities. Typically, UBIT is triggered when a tax-exempt organization earns income from a trade or business that is unrelated to its tax-exempt purpose. Such income is then subject to federal (and often state) income taxes.

As regards investment in a real estate fund, UBIT may result from the nature of the activities conducted by the fund, how the fund manager finances and operates its investments, or how the fund is structured. Moreover, all tax-exempt investors are not treated equally with respect to their investments in real estate. Depending on an organizations tax-exempt classification and the activities and operations of the real estate investment fund, certain tax-exempt investors may not be subject to UBIT on earnings from their investment, while others, who invest in the same fund, may be subject to UBIT. In addition, otherwise passive income may be subject to UBIT if it is considered "debt-financed income."

All happy families may be the same, as Tolstoy observed, but the same does not apply to real estate activities. Some activities, such as operating hotels, resorts, and health care facilities, and the development and sale of single-family residential communities, are generally considered by the taxing authorities to be business activities and not passive investments in real estate. Income derived from such activities is therefore subject to UBIT. While many investment managers often come up with creative deal structures to mitigate the tax consequences, such structures are typically cumbersome and may result in after-tax returns to exempt organizations that a re lower than that originally anticipated.

Real Estate and Exposure to UBIT
It is important to understand how the manager of a fund intends to operate its investment properties. Because rental income from real estate, interest income on loans (whether or not secured by real estate), and capital gains from the sale of property (including real estate) held for investment are generally exempt from UBIT, many either wrongly or prematurely conclude that they have no exposure to UBIT. In fact, "the devil is in the details." Under certain circumstances, rental income could become subject to UBIT. For example, rental income earned from providing services to a tenant that are not "usually or customarily rendered" in connection with leasing space could taint all of the rental income from the property and subject it to UBIT. This is a common problem for operators of luxury apartment and office properties, where managers are tempted to offer unique services, such as providing concierge services or valet parking, in order to attract tenants. It should be noted that the term usually or customarily rendered is not well defined and is continuously changing.

Certain types of lending structures may also generate income subject to UBIT. In general, interest income from loans is exempt from UBIT. However, the Internal Revenue Service may view certain types of "equity-like" mezzanine loans as equity and not debt. In the event that a loan is viewed as equity, the "lender" may be treated as a partner in a joint venture with the borrower. The lender would then be treated as earning a share of the borrower's business income, which could, depending upon the borrower's business, subject the lender to UBIT. The moral of the story is that one can't assume that making a loan instead of making an equity investment will insulate the investor from UBIT.

While capital gains are normally exempt from UBIT, gains resulting from the sale of "dealer property" (property bought or developed with the intent to sell within a relatively short period of time) are subject to UBIT. Generally, if a fund intends to hold its investments for at least 3 to 4 years and conducts itself as a long-term investor, the gains resulting from the sale of the fund's investments should not be subject to UBIT. Given the tendency of opportunistic fund managers to hold assets for shorter periods, there is a material risk of taxable dealer income from this type of investment strategy.

Real estate investment funds often use varying degrees of leverage to augment their equity capital to obtain improved diversification for their investors. Rental income, interest income, and capital gains derived from the ownership, operation, or disposition of leveraged property ("debt financed income"), even if it otherwise satisfies all of the other issues discussed above, may be subject to UBIT depending on how the fund is structured and whether the investor is a "qualified investor," as discussed below.

Avoiding or Mitigating UBIT
Real estate investment funds are generally organized as a private REIT (real estate investment trust), a limited liability company (LLC), or a limited partnership (LP). (A REIT is essentially a corporation or business trust that does not pay income taxes provided that it distributes all of its taxable income to its shareholders.) Each of these types of organizations is treated differently by the taxing authorities and therefore each has different advantages and disadvantages to a tax-exempt investor. Private REITs offer the best insurance against earning income that would be subject to UBIT because their dividends are exempt from UBIT. In exchange for the benefits of being a tax-free pass-through entity, the Internal Revenue Code imposes various restrictions on REITs. These restrictions include governing the diversity of its shareholders, the types of investments that can made, how such investments should be operated for the benefit of its investors, and the extent to which distributions must be made to shareholders. Some of these restrictions encompass the same issues as in the UBIT area - for example, favoring passive rents, interest, and gains while discouraging or prohibiting business or dealer income. Should a REIT engage in activities that violate these restrictions, the REIT itself will be exposed to income taxes and penalties, the severity of which generally insures compliance.

LPs and LLCs offer greater flexibility for a fund, as there are no restrictions on the nature of the activities in which they may engage. This is therefore the structure of choice for many opportunistic investment funds. Unfortunately, this same flexibility also opens the door for the manager of the fund to engage in activities that may generate income subject to UBIT (such as active businesses, non-customary tenant services, or dealer activities). Additionally, LPs and LLCs usually include both tax-able and tax-exempt investors because the general partner of an LP or the managing member of an LLC is often a taxable investor. Under these circumstances, the LP or the LLC must abide by a very complicated set of requirements called the "fractions rule." The fractions rule basically states that a tax-exempt investor's highest percentage share of income in any year generally cannot exceed its smallest percentage share of losses in any year. Failure to abide by the fractions rule will cause a portion (the debt-financed portion) of the earnings of the LP or the LLC to be subject to UBIT.

Tax Exempt Investors Treated Unequally
Income earned from real estate investments in a fund financed with debt ("debt-financed income") is generally subject to UBIT unless the exempt organization is a "qualified investor." The definition of a qualified investor is quite limited and typically includes only educational organizations (and their affiliated supporting foundations), qualified pension plans, and title holding companies. Private foundations, including those that support the purposes of higher education, are not qualified investors, and will be subject to UBIT on the part of their income from the LP or LLC that is treated as having been financed with the fund's borrowings. Therefore, the only way for a private foundation to participate in a leveraged real estate investment strategy without subjecting itself to UBIT would be to do so through a private REIT, as a REITs dividends are always exempt from UBIT, unless the investor itself finances its purchase of shares in the REIT.

Other UBIT Considerations
Finally, exempt organizations should be aware that to the extent an LP or an LLC generates earnings subject to UBIT, the investors pay the tax on the earnings; the tax is not paid by the LP or the LLC. Additionally, the LP or LLC may or may not make cash distributions during the same tax year to offset the tax liability. In funds where the manager of the fund is entitled to performance-based fees or cash distributions, the investor should carefully review the documents to see if such calculations are determined before or after the consideration of the tax consequences of generating income subject to UBIT.

For many endowments and foundations, the prospect of paying tax is not as significant as the scrutiny and resulting questions in the public's mind that might follow an IRS audit. Therefore, many endowments and foundations seek investment alternatives that minimize their UBIT exposure. While some funds are structured to avoid generating income that would be subjected to UBIT, others are structured to mitigate the consequences to investors but not to mitigate the need to pay UBIT itself. In general, funds that are either organized as a private REIT, or creatively structured to include a private REIT as a subsidiary to an LP or LLC, offer the best insurance against having the investor's income subjected to UBIT.

Although some of the IRS rules may seem counterintuitive or insurmountable, endowments and foundations have found ways to invest in real estate successfully. Real estate investment funds can offer competitive risk adjusted returns, but investors need to understand the potential tax consequences of their decisions. Therefore, investors should consult with their tax advisors before making a final investment decision.