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BPM Real Estate Insights
A Twist on the New Carried
Interest Rules
By Jackie Matsumura
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.
Examples:
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. n
Jackie Matsumura is a partner and the real estate industry group co-leader
at BPM. Contact Jackie at [email protected] or 925-296-1035.