The “Inflation Reduction Act of 2022” recently announced by Senators Manchin and Shumer to be added to the Fiscal Reconciliation Bill of 2022 proposes several significant changes to Section 1061 of the Internal Revenue Code of 1986, as amended (the “Coded”). These proposals will impact a wide range of taxpayers, including real estate funds and developers operating through partnerships or other vehicles (such as limited liability companies) that are treated as partnerships for the purposes of the federal income tax. Section 1061 of the current Code (which was added to the Code in 2017 by the Tax Cuts and Jobs Act) provides for a holding period of 3 years (instead of 1 year) for the treatment of long-term capital gains related to certain carried partnerships (or “profits” interests referred to as “applicable partnership interests” (“Apis”). These API rules apply specifically to interests in partnerships that hold real estate for rental or investment purposes. In general, however, APIs do not include the portion of equity issued for capital contributions that is treated pari passu with the capital of third-party investors (non-service provider equity).

Notwithstanding the increase in the 3-year holding period provided for in existing Code Section 1061, many real estate developers and operators can currently rely on Code Section 1231 to obtain long-term capital gains treatment both that the underlying improved property has been held for at least 1 year. Existing Code Section 1061 does not apply to income allocated by a partnership from the sale of a Code Section 1231(b) asset that is held by the partnership. As a backdrop, Code Section 1231(b) assets are not technically “capital property” for tax purposes, but may benefit from capital gains rates upon disposition if certain conditions are met. Code Section 1231(b) assets include real property (including improvements) used in a trade or business and held for more than one year. The new bill does not change the general treatment of Code Section 1231(b) assets outside the context of Code Section 1061, but the bill does affect the treatment of APIs for the purposes of Code Section 1061. Code, even when the underlying partnership is selling a Code Section 1231. (b) active.

The following highlights some of the more significant proposed changes to Code Section 1061:

  • The general holding period required for carried interest is increased from 3 to 5 years (but in practice the proposed changes may result in holding period requirements longer than 5 years).
    • This is accomplished by providing that for all IPAs, all “applicable net partnership gains” (which are essentially all gains or income that would otherwise qualify for long-term capital gain treatment in respect of of any IPA held in the applicable tax year) will be treated as a short-term capital gain (taxed at ordinary rates) unless otherwise specified.
    • First exceptional holding period of 5 years — The first exception provides for interests and assets held for a holding period of 5 years.
      • Changing the start of the holding period – One of the most significant impacts of the bill is that it would change when a period of detention for these purposes is deemed to begin.
      • The 5-year holding period may not start at the time of acquisition of the stake (this is how current holding periods are determined for the purposes of the Code). Instead, the holding period is deemed to begin on the later of the following dates: (1) the date on which the partner acquired “substantially all” of the API and (2) the date on which the partnership has acquired “substantially all” of the assets held by the partnership.
      • Although ambiguous, these standards do appear to be designed to prevent one or more of the following:
  1. The holding period beginning on the date a partner acquires its API where the relevant partnership has not yet acquired most of its assets (for example, in the context of a newly launched investment fund, this may mean that the major part of the committed capital must be deployed before the start of the long-term holding period in any associated API);
  2. The beginning of the holding period of an API subject to vesting (e.g., time-based or performance-based vesting) before the time when substantially all of the API has been acquired to the Partner; Where
  3. A partner acquires an API, then the partnership then sells an asset held by the partnership for at least 5 years, but at a time less than 5 years after the partner has acquired substantially all of the partner’s API.
      • For purposes of Code Section 1061, as revised by the Bill, (i) special elections under Code Section 83 to treat a partnership interest as (in fact) wholly vested shall not affect not treat APIs under Code Section 1061, and (ii) special rules may apply when dealing with “tiered” partnerships.
    • Second exceptional retention period of 3 years for real estate limited partnerships – Under a second exception, the 5-year holding period mentioned under the first exception is reduced to a period of 3 years in certain circumstances, in particular:
      • For taxpayers whose adjusted gross income is less than $400,000; and
      • With respect to any API attributable to a trade or real estate business within the meaning of Section 469(c)(7)(C) of the Code (generally, any real estate development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, rental, brokerage or trade).
  • Specific income types are no longer excluded from API rules, resulting in a 5-year holding period (subject to a 3-year holding period, as noted above in the second exception) for all API-related revenue, including revenue from the sale of active Section 1231(b) Code by the partnership.
    • This is effectively accomplished with the new definition of “applicable net partnership gain” discussed above, which effectively encompasses gains and income from all property, including goodwill and certain other special classes of property for which a one-year holding period requirement is still available. according to the law in force (that’s to sayincome which, under applicable law, avoids the taint of Section 1061 of the Code), such as:
      • the gain determined under section 1231 of the Code is treated as a long-term capital gain;‎
      • ‎the gain determined under section 1256 of the Code is treated as a long-term capital gain;‎
      • ‎qualified dividends included in the net capital gain for the purposes of Section 1(h)(11)(B) of the Code; and
      • Capital gains and losses characterized as long-term or short-term without regard to the holding period rules in section 1222, such as certain capital gains and losses characterized under the mixed straddle rules described in section 1092( b) of the Code and sections 1.1092(b)-3T, 1.1092(b)-4T and 1.1092(b)-6 of the Treasury Regulations.
  • Any transfer (including otherwise unrecognized transfers) of an API will trigger the gain described above.
    • This provision is particularly troublesome because it would apply to transfers that are otherwise tax-exempt or tax-deferred, including gifts, contributions to partnerships and corporations, and distributions from partnerships.
    • A partnership restructuring transaction after an API is issued may result in the recognition of a gain even though the transfer would otherwise have been a non-taxable event. This may result in a tax liability when no money is actually received. To avoid or mitigate this unintended outcome, alternatives will need to be considered before implementing a partnership restructuring operation, which historically would not have raised concerns.‎
    • The current wording of Code section 1061(d) refers to the recognition of potential gain with respect to certain related party transfers, but is not and remains clear. Instead of clarifying these types of transfers, the bill simply provides that earnings recognition will apply to all transfers (not just transfers between related parties). This recognition of the gain will apply regardless of whether the underlying transaction would have been exempt from tax. Section 1061(d) of the Code, as revised by the bill, very clearly provides that “[i]a taxpayer transfers a [API], the gain is recognized notwithstanding any other provision of this subtitle. Even so, the wording does not specify whether indirect transfers would be considered a “transfer” that would trigger taxation.
    • At first glance, it appears that the transfer provisions of the bill may apply to cause recognition of earnings even after the 3 or 5 year holding period (presumably at long-term rates if the applicable holding period 3 or 5 years is otherwise respected) since it simply applies to any API transfer (regardless of when it occurs).
  • The bill contemplates issuing Treasury regulations to prevent waivers and other contractual arrangements intended to circumvent the treatment of short-term capital gains.
    • Presumably included is reference to additional Treasury guidance to prevent work around structures including partners waiving distribution rights to circumvent the 5/3 year holding period requirement.
  • Effective Date – December 31, 2022
    If passed as currently drafted, the bill will likely result in the following consequences for many real estate developers:
    • A property developer will be taxed at ordinary rates in respect of at least its carried interest if the partnership interest or underlying assets are sold before the expiration of a 3-year holding period (with a start date uncertain).
    • For many single-asset real estate developments, the start date of the relevant holding period would likely not be earlier than the substantial completion of the relevant improvement (that’s to say., the acquisition of “substantially all” of the assets of the partnership).
    • The partnership and the real estate developer concerned would be limited with regard to restructuring operations. Although the scope of the exceptions or limitations is unclear, transfers that would previously have been non-recognition transfers may result in current taxation.

It is important to note that the bill is currently only a proposal. All of the above may change before the bill is enacted. In particular, as of the date of this rapid study, it is unclear whether the bill will receive enough support to pass in its current form. Senator Sinema recently indicated that she will seek changes to the tax proposals contained in the bill and that she supports maintaining the current treatment of carried interest. His support will be needed to pass the bill.