Executive Summary On November 22, the Internal Revenue Service (“IRS”) and Treasury Department issued proposed regulations (REG-136978-12, the “Proposed Regulations”) under the “fractions rule” of Section 514(c)(9)(E) of the Internal Revenue Code of 1986, as amended (the “Code”). The Proposed Regulations attempt to address many of the problems that have dogged the fractions rule, as interpreted in the existing regulations, since its enactment thirty years ago. While the new rules would become effective only when they are made final, the preamble to the Proposed Regulations states that taxpayers may rely on them immediately. Therefore, the Proposed Regulations should immediately provide leveraged real estate partnerships more flexibility to implement various legitimate, non-tax motivated commercial arrangements that were previously subject to much uncertainty. Although interpretive questions remain, the Proposed Regulations are a welcome development for real estate fund sponsors and tax-exempt institutional investors.

Background -

Section 511 imposes a tax on “unrelated business taxable income,” or “UBTI,” of tax-exempt organizations. UBTI is generally defined as business income that is not connected to the organization’s exempt purpose, with important exceptions for various categories of passive income such as dividends, interest, royalties, real estate rents and gain from the sale of property (other than dealer property). In addition, pursuant to Section 514, UBTI includes a specified percentage of income (including the otherwise exempted categories of passive income) derived from debt-financed property. For a limited category of tax-exempt investors, in particular pension funds and university endowments (“qualified organizations,” or “QOs”), Section 514(c)(9) provides for an exception to the debt-financed property rules that applies to leveraged real property investments. Where such investments are held by one or more partnerships (or other entities such as limited liability companies that are taxed as partnerships), the Section 514(c)(9) exception is generally only available if the partnership meets the fractions rule, which is intended to ensure that parties do not allocate excessive income to tax-exempt partners and excessive losses to taxable partners.