Inside the New Tax Plan’s Changes to Carried Interest

To the surprise of many, the new tax policy included changes to the carried interest provision. Under the new policy, carried interest now has a three-year holding period. The policy has significant implications for commercial real estate investors, who will need to make immediate adjustments to comply with the new provision. We sat down with Phil Jelsma, a partner and chair of the tax practice team at San Diego-based commercial real estate law firm Crosbie Gliner Schiffman Southard & Swanson LLP, to talk about the changes to carried interest, how this will impact commercial real estate investment and what investors should do now to comply.

GlobeSt.com: How has carried interest changed in the new tax policy?

Phil Jelsma: Often referred to as profits interest or promote, carried interest is what is received for contributing services to a partnership, LLC fund or project. In real estate, it is often the interest received for taking the entrepreneurial risk of an enterprise. One of the most difficult—and unexpected—provisions of the Tax Cut and Jobs Act is the three-year holding period on ‘carried interests,’ which has especially significant implications for those in the real estate industry. Capital gains allocable to a carried interest or profits interest in a partnership or LLC, which would otherwise be entitled to capital gains rights, will only be available if the partnership or LLC interest is held for more than three years. If held for less than three years, the capital gain will be subject to tax as short-term capital gain rather than long-term capital gain. Exceptions exist for a capital interest attributable to capital contributed by the taxpayer.

Generally, the three-year holding period applies with respect to long term gains allocated to an ‘Applicable Partnership Interest’ or ‘API’—a partnership or LLC interest received in an exchange for services provided by the taxpayer or a related party. If the API wasn’t held three years, the gain allocated to the API is recharacterized from long-term capital gain to short-term capital gain, which is taxed at ordinary income rates. Long-term capital gain treatments are available to all other partnership interests that are not considered an API. The new three-year holding period, which applies retroactively and applies to any partnership or LLC interest where the underlying asset is disposed of after January 1, 2018, and possible ways of minimizing its impact. Congress elected not to grandfather APIs issued before January 1, 2018.

GlobeSt.com: What are the implications of the three-year holding period on commercial real estate?

Jelsma: An API must be issued pursuant to an applicable trade or business that consists of, in whole or in part, raising or returning capital and either investing in or disposing of or identifying specified assets for investing or disposition specified assets or developing specified assets. Specified assets include securities, commodities, real estate held for rent or investment and cash. Engaging in a trade or business, buying or developing real estate for rent or investment would be subject to the new three-year holding period. The recharacterization of long-term capital gain to short-term capital gain applies whether or not the taxpayer has made an election under Code Section 83(b) with respect to the carried interest. If a taxpayer receives an interest for both capital and services, the partnership or membership interest is bifurcated. The portion of profits applicable to the services would be subject to the new three-year holding period.

The three-year holding period applies if the taxpayer transfers an API to a related person – who includes a family member or an individual who performs a service in the applicable trade or business for which the taxpayer performed a service.

Exceptions to the three-year holding period include any partnership or LLC interests held directly or indirectly by a corporation. In addition, the three-year holding period for an API does not include an interest held by a person employed by one business who provides services to an applicable trade or business. This suggests that the limitation does not apply to assets held for portfolio investments on behalf of third party investors. There is an argument that the three-year holding period also does not apply to Section 1231 assets, which includes depreciable property held for use in a trade or business.

GlobeSt.com: Do you have recommendations for real estate investors to navigate or mitigate the impact of the new provision?

Jelsma: It may be possible to restructure a company so that the employee receives a profits interest from an entity other than one engaged in the applicable trade or business, which consists of, in whole or in part, raising or returning capital and either investing in or disposing of or identifying specified assets for investing or disposition specified assets or developing specified assets.

Because there was an exception for profits interests held by corporations, a number of hedge fund managers immediately transferred their carried interest to S Corporations beginning in December, 2017. Recently in Notice 2018-18, the Treasury Department announced that the IRS intends to issue regulations that will provide that the term “corporation” does not include an S Corporation. Although this IRS announcement has provided a chilling effect, some professionals have questioned the Treasury’s ability to reinterpret the word “corporation.”

It is important to note that the three-year holding period may not apply to Section 1231 property, which is depreciable property used in a trade or business i.e. a rental business. There is an argument that if a partnership or LLC sells Section 1231 property i.e. rental property with a one year holding period, the holder of the API is still entitled to long term capital gains even if he or she has held its profits or carried interest for less than three years.

If a property has been held for less than three years, the partnership or LLC could consider a Section 1031 exchange to avoid recognizing gain that could be recharacterized as short-term capital gain.

Under the right circumstances, an undivided interest in the property could be distributed to the profit holders. By selling an undivided interest in property and profits interest holder could sell the property personally, which means they would no longer be subject to the recharacterization rule.

Finally, the profits interest holder could sell the interest to anyone other than a related person, or the person who performed a service within the current calendar year or the preceding three years with respect to an applicable trade or business in the year which the taxpayer performed the service. Related person includes anyone who is a member of the taxpayer’s family within the meaning of Section 318(a)(1). Importantly brothers and sisters are not within the definition of a family member under Section 318. Although this restriction would appear to limit sales to co-workers and co-owners, it appears that an entity created by a co-worker such as an S Corporation may be able to acquire the carried interest without running afoul of the three-year limitation.

All of these rules point to the importance of careful planning if the underlying profits interest has been or will be held for less than three years. The carried interest provision was unexpected, and with foresight, it may be possible to plan around—and mitigate—some of its adverse effects.

GlobeSt.com: How do you expect these changes to investment impact activity in the market?

Jelsma: Individuals who are issued profits interests now want to establish their holding periods as soon as possible. Documentation of profits interests is now moved to the beginning of the transactions to help prove a holding period. On real estate deals that are not entitled, often entitlements take two years to obtain so a three year holding period may not be a problem; however, for short term transactions, planning for profits interests and capital gains has gotten more difficult.