Carried interest tax provisions have been politicized for more than a decade and are frequently criticized as a tax loophole that benefits investment managers. The Originally Proposed Reducing Inflation Act 2022 (the “Bill”) included substantial changes to the tax laws governing deferred interest, including extending the holding period for the treatment of long-term capital gains. This and the other changes would have had a major impact on the real estate sector.
The revised version of the bill passed by both the Senate and House, however, omitted any changes to the tax treatment of deferred interest, and the final bill signed into law by President Biden contained no changes to the rules on deferred interest. . In this article, we discuss carried interest, how it is taxed, and its impact on the real estate industry.
What is a carried interest?
Deferred interest is the portion of profits paid to an investment manager for meeting certain performance criteria. In the real estate industry, this is usually referred to as profit sharing or “promotion”. A promotion is generally paid once the sponsors of a transaction recover their capital plus a preferential return. Depending on the complexity of the transaction, a promotion may have several benchmarks and obstacles to reward the manager for exemplary performance.
How is it taxed?
Typically, carried interest is granted in the form of a share in the profits of a company in exchange for services (investment management). The Internal Revenue Code designates this type of profit interest as an “applicable partnership interest.” Generally, the granting of a profit sharing is a non-taxable event for both the partner and the partnership. However, it is important to carefully consider how the operating agreement is drafted to avoid immediate taxation upon receipt of interest.
When deferred interest is earned and paid, a corresponding allocation of taxable income is made to the manager. This is significant because the income items attributed to the manager retain the same character as if they were earned by the general partnership. For example, if an entity had interest, dividends, or taxable capital gains, the manager would be allocated its share of those income items based on the management fees earned. This provision has been controversial because many critics of carried interest see it as a mechanism to convert ordinary service income – taxable at the top marginal rate – into capital gains, which are taxable at reduced and preferential rates.
The Tax Cuts and Jobs Act of 2017 (TCJA) lengthened the holding period for long-term capital gains versus carried interest. For capital gains to retain their longevity, the underlying assets must have been held for at least three years whereas the usual long-term capital gain applies to an asset held for one year or more. If the assets fail to meet the three-year holding period, they would be reclassified as short-term capital gains, which are generally taxable at ordinary rates.
What were the proposed changes?
Currently, the three-year holding period does not apply to gain on real estate used in a trade or business. The original proposal would have extended its scope to real estate as well as other preferentially taxed items such as qualified dividends. The proposal extended the holding period for long-term capital gains treatment from three to five years for taxpayers with adjusted gross income over $400,000.
However, this extended detention period was somewhat misleading. The holding period would begin on the later of when the taxpayer acquired “substantially all” of its owned interest or when the partnership acquired “substantially all” of its assets. Many funds are open-end and constantly move investments in and out, in which case the holding period may never technically begin. Additionally, there was also a provision to charge deferred interest if transferred regardless of other sections of the code which might otherwise treat the transfer as a non-taxable event. Ultimately, the interest bearing provisions were removed from the final version of the bill.
While many breathed a collective sigh of relief when these provisions were dropped, it is highly likely that there will be future attempts to revise the current law regarding deferred interest. Although it is extremely difficult to plan ahead for proposed laws, it is important that property owners communicate with their advisors to prepare for future changes in tax laws.
James Lockhart, CPA, JD, is a partner at Anchin LLC, and Kevin McHale, CPE, is senior tax manager.