Every real estate syndication and private investment fund involves a “carried interest” for the sponsor, also known as a “promoted interest.” The IRS just issued final regulations on how those interests are taxed.
A carried interest is what the sponsor gets for putting the deal together. For example, a typical waterfall might provide that on sale of the project investors receive a preferred return, then investors receive a return of their capital, then the balance is divided 70% to investors and 30% to the sponsor. That 30% is the sponsor’s carried interest.
For as long as anyone can remember the sponsor’s 30% carry has been taxed as capital gain. This favorable tax treatment has been the subject of considerable controversy given that the carry is paid to the sponsor not for an investment of capital but for the performance of services. Why should fund managers and deal sponsors be taxed at capital gain rates while hardworking Crowdfunding lawyers are taxed at ordinary income rates? Or so the issue has often been posed.
As a gesture in the egalitarian direction, the Tax Cuts and Jobs Act of 2017 – the same law that gave us qualified opportunity zones – added section 1061 to the Internal Revenue Code. Section 1061 provides that while carried interests are still taxed at capital gain rates, the threshold for long-term rates is three years rather than 12 months.
That means if an investment fund buys stock in a portfolio company and flips it at a profit after two years, the investors are taxed at long-term capital gain rates while the sponsor is taxed at ordinary income rates, a big difference.
IMPORTANT NOTE: In the real estate world section 1061 applies to vacant land or a triple-net lease, but not to a typical multifamily rental project. (The issue is whether the asset constitutes “property used in a trade or business” under Code section 1231.)
The final regulations just issued by the IRS clarify a few points:
- They clarify that the three-year holding period doesn’t apply to an interest the sponsor acquires by investing capital along with other investors.
- They clarify that if the sponsor receives a distribution with respect to its carried interest and reinvests the distribution, the interest the sponsor receives as a result of the reinvestment is not subject to the three-year holding period.
- They provide that if the sponsor sells its carried interest, you “look through” the partnership to determine the holding period of the partnership’s assets.
- They provide that if the sponsor transfers the carried interest to a related party, the sponsor can recognize taxable phantom gain.
- They deal with in-kind distributions of assets to the sponsor with respect to the carried interest.
Section 1061 is one more tripwire for deal sponsors and their advisors. Be aware!