Continued Tax Planning Opportunities for Real Estate Professionals

President Joe Biden signed the Inflation Reduction Act of 2022 on August 16, 2022. The enacted version of the Inflation Reduction Act didn’t contain the proposed expanded provisions of the Internal Revenue Code (IRC) Section 1061 related to carried interest. However, it’s a reminder that change is always present and complacency in tax planning can yield unpleasant results for real estate owners and investors.

The carried interest rules of IRC Section 1061 can recharacterize long-term capital gains as short-term capital gains. If the carried interest rules apply, a 36-month holding period applies, rather than the typical 12-month holding period.

The provisions of carried interest under IRC Section 1061 remain unchanged by the Inflation Reduction Act, but the originally proposed modifications are important to note for possible future legislative packages and shifting industry trends.

Below is a high-level summary of the proposed changes in the initial draft of the Inflation Reduction Act that were removed prior to the finalization of the bill.

  • Five-year holding period instead of three-year holding period for gains subject to the carried interest rules
  • A delay in the measurement of when the holding period begins
  • Expansion of income types subject to carried interest rules to include IRC Section 1231 gains and losses and real estate investment trust (REIT) capital gains
  • Acceleration of gains on transfers of partnership interest

Key Planning Opportunities

While the changes described above didn’t occur, the continuing focus on the carried interest rules should be monitored. In addition to carried interest uncertainty, the following are tax planning areas real estate professionals should continually monitor given the economic and legislative environment.

Fee Waivers and Property Transfers

Fee waivers have historically been used by fund sponsors and managers subject to IRC Section 1061 rules to provide an income deferral for carried interest treatment on assets with a holding period of less than three years.

Many fund managers and associated personnel hold a partnership interest entitling them to a carry, or additional profit allocation on certain investment disposition gains. Such a partnership interest is referred to as an Applicable Partnership Interest (API) under the IRC Section 1061 rules and can convert gains on investment dispositions held for less than three years to short term capital gain.

To provide a tax planning mechanism to avoid the conversion of gains on disposition of investment assets held between one and three years from tax at ordinary income tax rates, many fund partnership agreements contain fee waiver provisions.

A fee waiver may allow an API holder the right to elect to forego gain on disposition of assets resulting in the gain being allocated to the other partnership interest holders under the terms of the partnership agreement.

In exchange for foregoing or waiving the carried interest gain allocation in certain years, the API holder typically receives an additional carried interest on the remaining investment assets held in the fund. Fee waivers may also be used in development and management fee structures as well as carry on asset disposition gains.

The IRS proposed IRC Section 1061 regulations in 2019, which attempted to address perceived abuses of fee waivers that would otherwise recharacterize long-term gain as short-term under IRC Section 1061 rules.

The proposed regulations indicate the IRS is also interested in related party transfers of carried interests that may be received as part of a fee waiver arrangement. Additionally, the preamble to the proposed regulations mentioned the IRS would monitor carry waiver arrangements, but it wasn’t addressed in the final regulations. While the fee waiver regulations aren’t final, they should still be considered when it comes to structuring investments or planning for an exit transaction.

Property owners should frequently review their waivers in agreements, considering the proposed IRC Section 1061 regulations and Proposed Treasury Regulation 1.707-2, to maintain compliance with the new regulations.

Looking Ahead Amid Rising Interest Rates

Real estate cycles ebb and flow, and the current environment of interest rate increases is giving pause to some property owners, especially those with near or mid-term investment plans.

Taxpayers should consider their strategy and response to the current environment. Critical items to be examined include:

  • Holding periods
  • Exit strategies for properties
  • Debt covenants to ensure proper coverage ratios are met

Property owners may also consider making a real property trade or business election for IRC Section 163(j) interest expense. This election slows depreciation lives, but in return allows a greater deduction for business interest expense in a time when the cost of financing has increased.

This is also a great time to review pledges and guarantees on existing and future debt for purposes of tax basis to partners.

Frequently Evaluate Tax Planning Opportunities

Contact a tax advisor prior to entering a transaction to establish an efficient tax planning strategy, for example, the use of IRC Section 1031, which allows for the deferral of gain on exchanges of like kind property.

Real estate investors and owners should consider timing around:

  • Partnership contributions
  • Distributions
  • Purchases, sales
  • The use of debt for cash and liquidity

These areas can be very complex and trigger taxable gain in certain circumstances, for example, if parties are considered related. As the laws evolve, trusted tax advisors are an invaluable resource for real estate investors and owners in making fully informed tax decisions.

Provisions of the Inflation Reduction Act, the continued application of the carried interest rules, fee waiver arrangements, and broader market trends support the mantra of seasoned investors and their advisors alike: plan ahead and review tax and business strategy often.

We’re Here to Help

To learn more about real estate tax planning opportunities, contact your Moss Adams professional. You can also visit our Real Estate Practice.

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