What Real Estate Investors Need to Know about the Final Carried Interest Regulations

On January 7, 2021, the Treasury Department released T.D. 9945 providing the finalized regulatory guidance to the carried interest rules, which was created as part of the 2017 Tax Cuts & Jobs Act. These rules re-characterize certain net long-term capital gains (attributable to “carried interest”) of partners holding one or more applicable partnership interests (“API”) as short-term capital gains. Generally, an API holder’s distributive share of net long-term capital gain and/or gain on disposition of an API is re-characterized as short-term capital gain to the extent that the holding period of assets sold did not exceed three years.

Summary of Guidance

Under the statute, an API is defined as a partnership interest that is directly or indirectly transferred to, or held by, a taxpayer in connection with the performance of substantial services by the taxpayer or any other related person, in any applicable trade or business (“ATB”). An API does not include a capital interest in a partnership that shares in distributions and income in proportion to the capital contributed (or issued to such taxpayer as taxable compensation); this is referred to as the “capital interest exception.”

An ATB is any activity conducted on a regular, continuous and substantial basis which consists of raising or returning capital, and either investing in or developing specified assets.  Specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing assets, and interests in partnerships to the extent of such partnerships’ proportionate interest in any of the foregoing assets. The activity of raising or returning capital and the activity of either investing in or developing specified assets are not both required to be performed during the same year, as long as the activity not performed during the year, was performed in a previous year, or is anticipated to be performed in a subsequent year.

Many real estate investment partnerships meet the definition of an ATB, and therefore, to the extent that the sponsor is entitled to a promoted distributive share of the partnership’s profits (in excess of such sponsor’s distributive share that is commensurate with capital contributed), such sponsor’s interest typically meets the definition of an API. If a sponsor receives an allocation of the partnership’s long-term capital gains attributable to disposition of assets held not more than three years by the partnership, the partner’s distributive share of the gain attributable to carried interest must be re-characterized as short-term capital gain.

If the partner disposes of the API in a taxable sale that results in long-term capital gain, but the partnership interest was not held for more than three years, the partner must recharacterize any portion of the gain that is not attributable to a capital interest as short-term capital gain.  A special “look-through rule” may apply based on the holding period of the partnership’s underlying assets.

Special Considerations

The following items are not taken into account for purposes of the carried interest rules: (i) long-term capital gain or loss determined under IRC section 1231 with respect to sale of property used in a trade or business; (ii) long-term capital gain or loss determined under IRC section 1256; (iii) qualified dividends included in net capital gain; and (iv) other long-term capital gains not determined on the basis of a section 1222 holding period. Therefore, to the extent that a partnership realizes one or more of these items, such API holder’s distributive share of such items is not subject to recharacterization as short-term capital gain. Special rules apply for purposes of the capital gain dividends of Regulated Investment Companies (“RICs”) and Real Estate Investment Trusts (“REITs”) distributed to partnerships with partners who hold APIs in the receiving partnership.

Sales of operating real estate entities more often than not result in gains described in IRC section 1231. Fortunately, the final regulations confirm that the carried interest rules do not recharacterize IRC sesction 1231 gain as short-term capital gain. However, that does not mean that all interests in real estate partnerships avoid such recharacterization. To the extent that a partnership owns real estate that is not used in a trade or business (such as vacant land or triple-net leased real estate where the landlord provides no services to the tenant), any gain on the sale of such real estate would result in long-term capital gain rather than IRC §1231 gain, and would therefore be subject to re-characterization. Furthermore, if an API holder sells its API in the partnership, the resulting gain (if any) would be long-term capital gain subject to recharacterization.

The final regulations provide that if a taxpayer transfers an API or any distributed API property, directly or indirectly, to a related party (including family members, and colleagues who also perform services in the trade or business), certain capital gain would be required to be included in income as short-term capital gain, if the transfer is a taxable event. Transfers covered under this provision would include sales and exchanges; however, a transfer does not include a contribution of the API to another partnership.

Installment sale gains recognized in tax years beginning after December 31, 2017, are also subject to the carried interest rules, regardless of whether the initial sale transaction took place prior to that date.

Partnerships must report the relevant information needed by an API holder to enable such API holder to determine the amount of long-term capital gain (if any) that must be recharacterized as short-term capital gain. A partnership that fails to comply with these reporting requirements may be subject to penalties. Furthermore, if an API holder does not obtain the information necessary to calculate the recharacterization amount, the IRS will presume that all long-term capital gain attributable to an API has a holding period of three years or less.

The final carried interest regulations provide some much needed clarification to enable taxpayers and advisors to apply these rules. Please consult your Cherry Bekaert tax professional to determine how these final regulations may affect you.