The Tax Cuts and Jobs Act (TCJA) added a three-year holding period requirement for profits (carried) interest owners in order to benefit from capital gains rates. The new provision has a few gray areas but until a technical correction is issued, the current language excludes gain from the sale of rental real estate from the new holding period requirement.
The rules related to the tax-free issuance of profits interests have not changed. Also, the determination of whether an asset is held long-term vs. short-term remains the same, in other words, if an asset is held for more than 1 year, it is held long-term. What the new provision issued under TCJA does is re-characterizes certain long-term capital gains to short-term treatment.
The three-year holding period could be applied in two different situations: 1) the partnership’s holding period of an asset, or 2) the partner’s holding period of the carried interest (aka “API”—applicable partnership interest).
Upon the sale of a partnership asset, long-term capital gain attributable to carried interest is computed as follows:
- Determine the net long-term capital gain under “Section 1222”, then
- Subtract the net long-term capital gain from the sale/exchange of capital assets held less than 3 years.
The twist on the new law occurs here: Section 1222 provides for how to determine long-term/short-term capital gains and losses from the sale of capital assets. However, capital assets for this purpose specifically excludes real property used in a trade or business, thereby, excluding rental real estate from the application of the above formula. The tax treatment of gain from sale of real property used in a trade or business is defined under Section 1231 of the tax code, not Section 1222, as being long-term capital gain if the property is held for more than 1 year. Thus, under the current tax code, carried interest in a real estate partnership would be taxed at long-term capital gain rates as long as the partnership holds the rental real estate for more than 1 year.
As for the sale of an applicable partnership interest, because partnership interests are considered a capital asset, the three-year holding period is required in order to receive long-term capital gain treatment.
Partnership AB with rental real estate property (“Property”) purchased on 7/1/2016. Property sold on 12/31/2017. A holds a profits interest and B a capital interest. Gain is allocated from sale:
A. Because the real estate was used in a trade or business, gain allocated to A is long-term capital gain even though the property was held less than 3 years. B’s gain is long-term capital gain.
B. Property is not sold but A sells her profits interest to C on 12/31/2017. A’s gain from sale is short-term capital gain as A did not hold her API for more than 3 years. If B, a capital interest partner, sold his partnership interest, he would receive long-term treatment as he is not subject to the new carried interest rules.
C. Property is not a rental but is land held for appreciation/investment only. Sale of land on 12/31/2017 would result in short-term capital gain to A because AB did not use the property for its trade or business and did not hold the property for more than 3 years. B would receive long-term capital gain.
The new rules are effective for tax years beginning after December 31, 2017 and there are no grandfather provisions for carry positions established prior to that date.
Jackie Matsumura is a partner and the real estate industry group co-leader at BPM. Contact Jackie at email@example.com or 925-296-1035.