IRS Section 1061: Clarifications for Real Estate and Investment Fund Professionals

IRS Section 1061: Clarifications for Real Estate and Investment Fund Professionals

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By Lindsey Nelson, CPA, Tax Senior Associate and Paul Staples, CPA, Tax Manager | Real Estate & Construction Industry Team | Financial Services Team

IRS Issues Proposed Regulations on Section 1061 Carried Interest Rule

In 2017, the Tax Cuts and Jobs Act introduced Code Section 1061, which requires the recharacterization of certain long-term capital gains related to applicable partner interests (API), or carried interests, into short-term capital gains. The recharacterization relates specifically to interests received by partners from an applicable trades or business (ATB) in exchange for a performance of services. Such businesses include those that raise or return capital, invest in or dispose of specified assets (such as commodities, real estate held for rental or investment, regulated futures and certain other derivates), or those that develop such specified assets. All in all, Section 1061 speaks directly to real estate, hedge fund, and private equity professionals and managers.

The TCJA tightened up carried interest rules by extending the mandatory holding period of certain carried interest arrangements, requiring that for a partner to receive the favorable long-term capital gain treatment (whether derived from the disposal of the carried interest by the partner, or a distributive share of capital gains received from the partnership in which the carried interest is held), a partner must hold their carried interests for at least three years. The three-year holding period is an increase from the standard 1-year period in place pre-TCJA. Any gains related to a carried interest held for less than three years will be levied with the higher short-term capital gain rates, which is then reported on the partner’s individual tax return.

Proposed IRS Regulations Regarding Section 1061 Provide Clarity for real estate and Investment fund professionals

In the wake of the TCJA, many tax professionals and partners in ATBs looked to the IRS for additional guidance regarding Section 1061, specifically for more transparency related to how real estate and investment fund professionals would treat Section 1231 gains (related to the disposal of depreciable property) and Section 1256 gains (related to the sale of derivates). Both Section 1231 and Section 1256 gains are those held for over a year, resulting in long term capital gain treatment assuming the proper holding period is met. Section 1061 did not indicate whether Section 1231 or 1256 gains would be subject to the short-term capital gains rates if the three-year holding period was not met.

Fortunately, the IRS recently released proposed regulations related to the interpretation of Section 1061, and clearly states that both Section 1231 and Section 1256 gains derived from sales of real estate or derivates, respectively, as well as qualified dividend income, and capital gain dividends from real estate investment trusts, are all excluded from Section 1061 holding period requirements. In addition to the clarification of applicable gains, the proposed regulations also include a clause indicating that the holding period of the asset being sold is determinative, subject to certain exceptions for transfers of interests in passthrough entities.

Sale of a General Partner’s Carried Interest

The proposed regulations also provide some clarity related to the sale of a general partner’s carried interest. If a general partner disposes of their applicable partnership interest, they are still subject to recharacterization if the three-year holding period is not met. However, the IRS does provide additional guidance about which portion should be considered capital gain if the partnership interest sold is a combination of a capital interest and carried interest. If the interest was acquired by an unrelated third-party who is not a service provider, the purchase is not subject to Section 1061.

Partnership Transition Amounts

The proposed regulations also discuss Partnership Transition Amounts: If a partnership were in existence on January 1, 2018, and had held assets more than three years as of that date, it may irrevocably elect to treat all long-term capital gains and long-term capital losses from those assets as partnership transition amounts. Such amounts allocated to an API holder are treated as long-term capital gains and losses and aren’t subject to recharacterization under the proposed regulations. This election is made simply by attaching a statement to the tax return in the year of application.

In addition, the proposed regulations also include clarifications related to gains from installment sales, sales to related parties and tiered reporting among other items not mentioned in this post. It should be noted that these regulations are not final and subject to change.

Please reach out to your Keiter Opportunity Advisor or Email | Call 804.747.0000 with any questions or to discuss your specific situation.

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About the Author

Paul focuses on business tax planning and compliance, general business consulting, transaction advisory, and individual tax for privately-held clients with an emphasis on limited liability companies and flow-through taxation. He works with clients in the real estate and financial service industries, equipment dealers, startup companies, and insurance brokers.

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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.

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