Carried Interests—How to Produce Long Term Capital Gain
Those promoters that have assembled a group to invest in real estate (also sometimes known as a syndication or group investment) and who receive, for such efforts, a share in the profits and/or ownership of the entity because of their efforts, may have taxable income generated from such activity.
When is it taxed?
Such promotional work as a sponsor or syndicator can be profitable. However, the interest received, generating current taxable income, is something that most syndicators would prefer to avoid. This is an issue that has been of concern to syndicators for many, many years. (See Code Section 83.) The details of these issues have been covered in our Treatise, Real Estate Transactions, Tax Planning, Levine, Mark Lee and Segev, Libbi (Thomson/West 2020). The government in Internal Revenue Code (Code) Section 83 and the relevant Section 83 Regulations also addresses these questions.)
What Holding Period is Deemed Long Term?
There is a concomitant issue that runs hand-in-hand with this concern of current, taxable income. This additional issue is the character of the income. That is, is the income, whenever it is taxed, subject to treatment as ordinary income or long-term capital gain?
What is of concern in this Tip is the newest Proposed Regulations issued by the Treasury on the changes made by Code Section 1061 as to this issue of the tax treatment of the promotional interest received by a syndicator. Code Section 1061 provides, under Code Section 1061 (a), that the interest received by the promotor/syndicator, when taxed, is not taxed as long term capital gain (LTCG), unless the promoter has held this part of the promoter’s interest for a period of time greater than 3 years. (In the Proposed Regulations, see 26 CFR Part 1, REG-10723-18, RIN1545-BO81, Guidance under Section 1061.)
Taxpayers are generally familiar with the rule under Code Section 1222, that a taxpayer generally must hold a capital asset greater than 1 year, to produce LTCG. This change by Code Section 1061 requires a holding of greater than 3 years to produce the long-term treatment. These Proposed Regulations, referenced above, have produced guidance for promoters/taxpayers as to this issue.
Thus, although Section 83 of the Code provides that an interest granted to the syndicator for efforts to put the group together is taxed currently, unless the taxpayer can show that the interest is not freely transferable or not subject to a substantial risk of forfeiture, the character of the taxation as long term capital gain was addressed by Code Section 1061.
In turn, if the interest is not transferable or is subject to a substantial risk of forfeiture, the interest will, potentially, be taxed at some time in the future. If this is the result, to obtain LTCG treatment, the holding period must be in excess of 3 years.
Code Section 83 determines if the interest is currently taxable. When the interest is taxed, Code Section 1061 states whether the interest will be considered held for the short term or the long term. LTCG treatment under this rule is not obtained without holding the interest in excess of 3 years.
Thus, Code Section 1222 (covering holding periods) was modified in this setting to require a greater than 3 year holding period to produce the LTCG treatment. These new, Proposed Regulations address more details on how and when the 3-year holding period will be met.
Dr. Mark Lee Levine,
Professor, University of Denver