Real Estate Right Now is a video series covering the latest real estate trends and opportunities and how you can make the most of them. Part one of our mini-series on real estate investment through syndication focused on the use of a clause called a ‘waterfall provision.’ We’ll continue with part 2 of our series, which discusses syndication and carried interest.
Watch the video:
A real estate syndicate is an organization, or combination of investors, who pool together capital to invest in real estate. The syndicate shares in the investment’s profits, even though it does not invest any of its own capital. When it realizes a profit, that profit is called a ‘carried interest’ or a ‘promote.’ The carried interest serves as compensation to the syndicator for the risk it assumes during the development of the project and the efforts made prior to its sale.
If a property has been held for more than a year before it’s sold, the carried interest has traditionally been treated as a long term capital gain. This is important because Uncle Sam recognizes a carried interest as a return on investment. So, it’s taxed at a lower capital gains rate than is ordinary income.
However, the IRS later extended that holding period from more than one year to more than three years. Does this paralyze a syndicator for three years, disallowing favorable tax benefits on an earlier sale? Apparently not. On January 13, 2021, the IRS posted final Treasury Regulations for Section 1061 of the Internal Revenue Code. Section 1061 extended the 1-year holding period required for long-term capital gains treatment to a 3-year period for entities termed, “applicable partnership interests” (APIs).
Section 1061(c)(1) defines the term “applicable partnership interest” as “any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.”
There’s an interesting – and potentially profitable – caveat built into the IRS’ definition. Section 1061 rules inadvertently include a favorable exception for real estate investors. After careful review of the updated code, practitioners realized that this new restriction omitted interests resulting from certain services. These services include investing and disposing of real estate held for rental or investment. In our scenario, the syndicate provides these real estate investment services for the investors. This means that a syndicator’s profits at the time a property is sold are the result of an allowable service that, if held for one year, can be treated as a long term capital gain. It is free of the three year holding period requirement and subject to advantageous capital gains tax rates.
Here’s the bottom line: A syndicators’ profits at the time a property is sold will be treated as long term capital gain, free of the three year holding period requirement, and subject to advantageous capital gains tax rates.
Speak to your professional advisor about investing through syndication to build wealth.
This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for, legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
