Question about short term vs long term capital gains taxation when electing the QEF.
The PFIC statement must provide a breakdown of ordinary earning and net capital gains. I don’t see any mention of a breakdown between short term and long term capital gains. Does that mean that all gains will be taxed at short term capital gains/ordinary income rates? I would imagine these funds would produce long term capital gains and it’d be nice to pay the corresponding rate.
Presumably the PFIC statement should be accurate and account for that since it is part of the data required for you to accurately file a return.
I think I figured it out. I think all capital gains are treated as LTCG:
Tax Consequences for Shareholders of a QEF
A shareholder of a QEF must annually include in gross income as ordinary income its pro rata share of the ordinary earnings of the QEF and as long-term capital gain its pro rata share of the net capital gain of the QEF.
Spoke with a reputable international tax firm and they said that if it is likely a fund will qualify as a PFIC in the future, even if your fund has no clear payouts or appreciation for 2020 (or whatever your first year is investing in a fund), you should treat them as a PFIC, file form 8621, designate as QEF and enter zeros in the form. It can always be amended if things change but this protects you down the road. Take it FWIW.
that makes complete sense to me. the fund would have to do the paperwork each year to determine if they are PFIC or not anyway, so cranking the form out doesn’t seem like a huge additional deal.
It’s seeming more and more to me (an amateur, to be sure), that this doesn’t have to be an unbearable burden and uncontrollable risk. There’s a well-established process, which I linked to earlier, for performing a “deemed sale”. As long as you have a trustworthy annual accounting of NAV, you can perform a deemed sale and get back into a low-risk state with regard to PFIC taxation.
My fund, which is not a PFIC in their own opinion or in my opinion, is content to work with American investors on their preferred terms. Based on my own research and circumstances, my personal inclination is this:
This is subject to change if my fund’s legal and tax advisors offer different recommendations; they are still doing their own research.
Curious if any US citizen is considering the Rock Capital fund and has thought about how their 30% performance fee after reaching a 30% hurdle rate would impact our taxes. My concern is that because the performance fee is collected at the end of the life of the fund, we’re going to be paying taxes on all earnings and capital gains over the life of the fund and then Rock will take their fee at the very end leaving us with a capital losses at the very end.
Of course capital losses can be carried forwards but I personally plan to be be a 0% LTCG tax bracket at that point and thus will not be able to apply those losses. So in essence, I’d be paying taxes on their performance fee.
Am I missing anything?
Rock is not paying anything out, I don’t believe (have to check my notes), until the end of the fund when divestment occurs. Their performance fee - calculated based on total performance at that time - should not affect payment timing or taxes.
That’s precisely the issue. If the performance fee was paid out yearly, the reported capital gains and resulting tax would be less. But because the performance fee is not applied until the end, we’re paying capital gains taxes every year on an amount (the performance fees) that we will never receive.
What are you paying on annually? Nothing. They won’t have gains or dividends until they sell so it will all occur at once. You won’t notice the difference.
The Rock funds makes two types of investments: 1) Rental properties that it buys, holds, rents, and then later sellers at the divestment period and 2) Properties that it redevelops and sells within 3 years. The former will begin yielding income starting in the first few years and since they plan on 2 cycles of redevelopments, there will be capital gains starting in years 3-4. So basically, i expect ~4% returns in income every year from rental incomes and then large amount of capital gains in years 3/4 and then even more in years 6/7 before finally closing the fund.
They have none of those at the moment. Focusing on the rehab side. But even if they do, the rehab side is where the primary profits come and where they would take their fee.
loheiman is right in the broad sweep of what is being said, Larry. You have to pay taxes on the gains as they’re realized over the 7 years, then you’re whacked with the performance fees at the end. There isn’t any income now, no, but there will be a fair bit of rental income that will be realized yearly over the course of the 7 years, and since the plan is to hold properties for ~3-4 years, you’re going to get a bunch of cap gains realized in the middle.
I don’t think they’re going to be able to avoid PFIC status in the long run, which means you’re going to start realizing gains somewhere in the middle, probably around that 3-4 year mark - and under QEF rules which basically make the whole thing emulate a limited partnership, that stuff’s all going to show up on your tax return as the fund realizes it, whether or not you get a dime of it. I’ve written about this elsewhere. It’s just how it works.
That said -
Performance fees… are not tax efficient in any sense of the word. They used to at least be deductible on sched-A under the 2%-AGI limits, but that went away a while ago. You just pay them post-tax. Congress went out of their way to make them not tax deductible under the Obama administration as a dig at hedge funds.
As long as it’s a PFIC and subject to QEF and therefore operating as if it’s a limited-partnership… those performance fees are “manager expenses” and there is no scenario under which they can be deducted. (*)
I know this will seem like it makes no sense. “How can this be? Shouldn’t it come off basis? Isn’t it an expense the fund is realizing? It’s money I’m not getting, why am I being taxed on it!!!” I know. I get it. I was there once, staring at this 1099 and and fighting with my sched-K and looking for any way to get out of it and asking my tax lawyer “Why!!! Why oh why dear Lord!!!” (Said tax lawyer is the one all of us who work for this fund use and is part of a major firm. He has every motivation to want it to be deductible and every resource available to make it so if it could be. It isn’t.)
Just trust me - it doesn’t work that way. You’ll have to go through the 5 stages of grief on this one; may as well get started now.
So frankly, the whole discussion is moot. loheiman will be better off than most because at least some of his/her income won’t be being taxed in the first place so there won’t be as much of an insult of paying the perf fee AND the taxes.
Sorry. Welcome to the world of private equity.
If somehow they avoid PFIC, and I don’t know how, then the rules are different, and I can’t say how it works since I’ve never looked into it.
(*) there is one. I know this because one fund I am invested in falls into this specific category. It’s insanely arcane and completely inapplicable here. It’s so tenuous that they need a special IRS ruling on the matter and they’re concerned it’s subject to reconsideration at any time. The only way I get my tax software to calculate it correctly is to lie to it, and I keep written instructions on the exact lie I have to tell it lest I forget.
So, with all this continuing discussion (and the speculation that even though a fund may not consider itself a PFIC currently, it may very well meet that criteria in the future), do most of the US investors here agree with dlward’s advice to go ahead and file the 8621 and QEF in year one, with zero values?
Yes @jb4422 I understand all that. A few points 1) They have no rental properties at the moment and no plans to get any so all that may be moot at least for now. They are focusing on rehab and that process will take 2-4 years per project without plans to rent. 2) yes one way or another they will be a PFIC, sooner if they do rentals and later if they are only rehab and resale. 3) the point being made was that somehow the performance fee would be deducted at the end and leave us with a loss after paying thru the process. My explanation was that this will not happen because as they divest at the end, the performance fee will be deducted after totals are calculated and investors are paid. You have to look closely at their payment waterfall but this is clear.
Now to your point - the performance fee is not a part of the profit and we don’t pay on that. If you are saying we somehow do, please include documentation of that being the case.
No, I do not plan to falsely claim that my investment is a PFIC if the facts suggest otherwise. My reasoning and references are given here (and elsewhere):
With respect to (3), I think this is all interpretation. You’re right, in that the performance fee is deducted at the end and you won’t ever end up with a total loss over the 7 years as a result of the fee. L has a point for their situation, in that from a pure tax standpoint, the cap gains you realize in year 7 may be less than the performance fee - imagine if they sell most of the properties in years 4 and 6, if you will, and only residuals are realized in year 7 - depending on how the accounting works, the tax accounting for year 7 might well end up negative. Now, if you’re assuming a constant LTCG rate over the 7 years, this would all wash out. But if you are paying 20% LTCG in year 4 but 0 in year 7, this is kind of a bite. It’s not a loss so much as “don’t get full tax benefit”, which often feels like a loss . 
With respect to the performance fees - I’m sorry. I don’t truly know. I am thinking “PFIC == limited partnership” but I might well not be correct.
For US based hedge funds and limited partnerships, performance fees are not deductible. The basis is this: as a LP, all of the income and expense items of the fund flow through to your tax form pro-rata, as if you personally did the activities. This is the purpose of Sched K-1 issued by the partnership - to itemize all the bits so you can fit them into your tax form. Cap gains, interest, dividends, interest paid, business income and loss, etc. All straightforward, right? The problem is that the fee that a fund pays to the manager for services rendered simply is not deductible. There is nowhere to put it on your tax forms. You want to think it’s a legit business expense, and if the fund were a regular corporation, it would be… but for you, it’s not. You USED to be able to deduct these on sched A as a miscellaneous itemized deduction subject to the 2% limit, but the deduction got nerfed and now the investor just has to eat it. (I incorrectly associated this with Obama but it was actually in TCJA.) See publication 5307, page 7.
How this actually plays out with a PFIC is less clear. On the surface, you seem to only pass through income and cap gains. How those get calculated by the fund is another matter entirely that is opaque to me. I suspect the same rule apply - that the PFIC information form is generated simply by applying the normal US rules to the activities of the fund - but I don’t know that.
No one is falsely doing anything. My experience with the IRS is that it is better to over report if you are uncertain - and amend later if needed - than to omit or under report. I think it is pretty clear from this whole thread that nothing is set in stone, and opinions will vary. We each have to do what we feel comfortable with and based on the advice we are given for our specific situation.
I spoke to a CPA today and while it helped me understand the situation a little better, it also left me with more questions:
The IRS requires the PFIC annual statement to have certain information and I believe you also have to send in the PFIC statement in with your return when making QEF election. This blog has the detailed information about PFIC statement and lots of information about PFIC I found useful.
https://hodgen.com/can-you-make-a-qef-election-without-the-pfic-annual-information-statement/