New Carried Interest Rules of Interest to Real Estate Developers and Asset Managers

Burr Forman McNair
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Prior to the passage of the Tax Cuts and Jobs Act (the “Act”), one of the more controversial and hotly-debated tax benefits was the so-called “carried interest,” which allowed certain fund managers and venture capital firms to pay income taxes on what would typically be considered ordinary income at favored long-term capital gains rates. Both Presidential candidates took aim at the treatment of carried interests in their platforms.

While the Act didn’t entirely repeal the carried interest, it did impose new rules that will have a material impact on fund managers and others who may have been caught unaware—such as real estate developers and asset managers. Real estate developers often include the concept of a “promote” in their operating or partnership agreements, providing them a greater return than their capital interest in the partnership. This “promote” is typically considered a profits interest, which is  a carried interest.

The Act introduces the concept of an “Applicable Partnership Interest” (API), which targets profits interests. The receipt of a profits interest continues to be generally tax free under the Act, but now holders of a profits interest will only be eligible for preferential long-term capital gains treatment for gains realized on dispositions of capital assets, sold after December 31, 2017, and held for more than three years. Importantly, this treatment extends to profits interests created prior to the effective date of the new Act, thereby imposing a new three-year holding period on existing profits interests. According to House Ways and Means Committee Chairman Kevin Brady, the new holding period rule encourages “long-term, traditional real estate partnerships.”

An API does not include partnership interests held by either a Subchapter C corporation or a Subchapter S Corporation, so managers and developers may start taking a closer look at the Act’s favorable treatment of C corporations and the new pass-through rules applicable to S corporations to analyze whether leveraging those structures could provide a benefit. While each individual’s unique set of facts and circumstances will ultimately drive her decision making, the new rules applicable to APIs further emphasize the principle that the Act is a substantial rewrite of existing tax law.

 

UPDATE: In Notice 2018-18, published March 1, 2018, the IRS announced its intention to issue regulations clarifying that S corporations will be subject to the extended carried interest holding period.

Prior to the passage of the Tax Cuts and Jobs Act (the “Act”), one of the more controversial and hotly-debated tax benefits was the so-called “carried interest,” which allowed certain fund managers and venture capital firms to pay income taxes on what would typically be considered ordinary income at favored long-term capital gains rates. Both Presidential candidates took aim at the treatment of carried interests in their platforms.

While the Act didn’t entirely repeal the carried interest, it did impose new rules that will have a material impact on fund managers and others who may have been caught unaware—such as real estate developers and asset managers. Real estate developers often include the concept of a “promote” in their operating or partnership agreements, providing them a greater return than their capital interest in the partnership. This “promote” is typically considered a profits interest, which is  a carried interest.

The Act introduces the concept of an “Applicable Partnership Interest” (API), which targets profits interests. The receipt of a profits interest continues to be generally tax free under the Act, but now holders of a profits interest will only be eligible for preferential long-term capital gains treatment for gains realized on dispositions of capital assets, sold after December 31, 2017, and held for more than three years. Importantly, this treatment extends to profits interests created prior to the effective date of the new Act, thereby imposing a new three-year holding period on existing profits interests. According to House Ways and Means Committee Chairman Kevin Brady, the new holding period rule encourages “long-term, traditional real estate partnerships.”

An API does not include partnership interests held by either a Subchapter C corporation or a Subchapter S Corporation, so managers and developers may start taking a closer look at the Act’s favorable treatment of C corporations and the new pass-through rules applicable to S corporations to analyze whether leveraging those structures could provide a benefit. While each individual’s unique set of facts and circumstances will ultimately drive her decision making, the new rules applicable to APIs further emphasize the principle that the Act is a substantial rewrite of existing tax law.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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