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Carried interest regulations: Key considerations for real estate

May 3, 2023 / 5 min read

The carried interest rules recharacterize long-term capital gains held less than three years to short term. We break down related issues, including Section 1231 gains, triple net leases, selling an API and estate tax implications of related party transfers.

The carried interest rules recharacterize long-term capital gains held less than three years to short term. The holding period requirement applies to both applicable partnership interests (API) and the assets owned by the API.

The carried interest rules recharacterize long-term capital gains held less than three years to short term.

Several criteria lead to classifying a partnership as an API:

A partnership that owns a lower-tier partnership is only an API if the lower-tier partnership owns a specified asset. This is common in the real estate industry, where a fund that issues a partnership interest in connection with substantial services to a fund manager invests in a lower-tier partnership that owns real estate for rental or investment.

A partnership that owns a lower-tier partnership is only an API if the lower-tier partnership owns a specified asset.

There’s an exception for capital interests. An allocation will be considered a capital interest allocation if the allocation to the API Holder with respect to its capital interest is determined and calculated in a similar manner to the allocations with respect to capital interests held by similarly situated Unrelated Non-Service Partners who have made significant aggregate capital contributions. A significant capital account balance is considered five percent of the total capital account balance.

In this regard, the allocations and distribution rights with respect to API Holders’ capital interests and the capital interests of Unrelated Non-Service Partners who have made significant aggregate capital contributions must be reasonably consistent. The following factors are used to determine whether allocations and distribution rights are made in a similar manner among partners:

A capital interest allocation won’t be subject to the carried interest rules if they’re subordinate to that of unrelated partners or they aren’t reduced by the cost of services charged to unrelated partners. The key takeaway is to make sure operating agreements very clearly and specifically separate capital interest allocations from carried interest allocations.

The key takeaway is to make sure operating agreements very clearly and specifically separate capital interest allocations from carried interest allocations.

Carried interest holding period and IRC Sec. §1231 gains

The carried interest holding period applies to capital gains, but not IRC Sec. §1231 gains. A §1231 gain results from the sale of property used in a trade or business and includes rental real estate. It has a special treatment where it’s not considered a capital asset for purposes of the carried interest rules even though it’s taxed at capital gain rates (provided it’s not recapturing prior §1231 losses).

Consequently, even if the service provider receives an interest in an API, if the API sells the real estate that qualifies as a §1231 asset, the gain is not subject to the three-year holding period. For an API that owns Sec. 1231 assets, it’s only the service provider’s API that was issued in connection with substantial services that is subject to the three-year holding period.

Triple net lease properties

While §1231 gains are not subject to the three-year holding period, there’s a nuance for triple net (NNN) lease properties. A true NNN leased property isn’t considered trade or business property; instead, it’s considered a capital asset that’s used for the production of income.

This distinction has also been impactful to determining whether the rental property is eligible for the qualified business income deduction (a.k.a. passthrough deduction) and subject to the interest expense limitation rules. A capital asset used for the production of income doesn’t meet the criteria for a §1231 asset and is subject to the three-year holding period. Always perform a careful review of the lease to determine whether the carried interest rules are going to apply.

Selling an API

The sale of an API can result in short-term capital gain in the following situations:

In summary

While real estate owners are subject to the carried interest rules, careful planning can allow service providers to avoid having their gain recharacterized as short term. Given the industry standard is for the property owners to sell their real estate rather than their equity, most property owners will qualify for §1231 treatment, which isn’t subject to the reclassification (unless the property is rented pursuant to a NNN lease). Consequently, the rules may not have an impact in most situations. That said, it’s important to be aware of key considerations to ensure they won’t apply in other situations as well as of traps that potentially can be avoided. Please reach out to our tax experts to identify key steps before any future transaction.

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