On July 31, 2020 the Internal Revenue Service (“IRS”) issued proposed regulations as guidance under Internal Revenue Code (“IRC”) Section 1061, which was established by the Tax Cuts and Jobs Act of 2017 (the ”TCJA”). This article discusses how the newly released proposed regulations apply to real estate professionals.
Section 1061 is intended to limit the benefit of the long-term capital gain tax rate where partnership interests have been issued in exchange for services rendered or to be rendered and have been held for three years or less, referred to as the Applicable Partnership Interests (“API”). Per Section 1061, to fall within the limitation, the partnership must be involved in an Applicable Trade or Business (“ATB”). This is defined as an activity conducted on a regular, continuous and substantial basis, which consists, in whole or in part, of raising or returning capital, and either investing, disposing of, or developing, (including identifying assets for investment or disposition) Specified Assets. Included in the list of Specified Assets is “real estate held for rental or investment.”
In this context, the term “real estate professional” (“REP”) is not necessarily used in the same manner as it is used in more specific areas of tax law. Rather, it is used to describe someone whose career is in the realm of real estate.
Proposed Regulation § 1.1061-4 provides guidance as to the Section 1061 computation of the “Recharacterization Amount", which is the amount that an Owner Taxpayer must treat as short-term capital gain, as opposed to long-term capital gain, under Section 1061(a). An Owner Taxpayer is defined in the proposed regulations as the person subject to Federal income tax on the net gain with respect to an API. This guidance is maze-like in its delivery and creates API Distributive Share Amounts (amounts distributed out of a partnership) and API Disposition Amounts (amounts resulting from the sale of part or all of an API). For API Distributive Share Amount purposes, long-term capital gain and long-term capital loss determined under Section 1231 are excluded. Working through the one-year and three-year API Disposition Amount computations generally gets to the same conclusion. For additional insight, please FGMK’s Tax Alert regarding the Section 1061 proposed regulations.
Section 1231 provides capital gain treatment upon the sale of depreciable property used in a trade or business. The question of what constitutes a taxpayer’s trade or business, in the context of real estate, is far from settled, although it is clear that rental real estate can qualify as a trade or business. It is typical for a REP to generate Section 1231 transactions, however, not every REP related transaction will fall under Section 1231.
Treasury Regulation § 1.1231-1 (c)(1)(i) excludes property that is held by the taxpayer primarily for sale to customers in the ordinary course of business. In Private Letter Ruling 9426006, the IRS stated that the issue is ultimately one of fact, in which the scope of a taxpayer’s activities, either personally or through agents, in connection with the property, are so extensive as to rise to the stature of a trade or business. In Phipps v. Comm’r, 54 F.2d 469 (2d Cir.1931), the court said that persons with large incomes invest their surplus funds in something, and if to diversify their holdings they buy land with the expectation of selling it when a good price is offered, such an expectation cannot convert into a trade or business. Yet, there are numerous court cases taking a liberal view of this fact pattern as well.
Further, courts have determined that an individual in the trade or business of rental real estate might still engage in a real estate transaction that falls outside of Section 1231 by, for example, developing a project with a buyer in place from the start. This would constitute a “dealer” transaction, resulting in ordinary income, in which case Section 1061 would not apply anyway.
Under Section 1221, property held for investment is a capital asset unless it meets one of the definitions of excludible property. Property held for investment, as opposed to property used in the (real estate rental) trade or business is not Section 1231 property and therefore, the REP could be subject to Section 1061 on the sale of an API holding such property.
There is an exception to Section 1061 for Capital Interest Gains and Losses (a defined term under Proposed Regulation § 1.061-3(c)(2)). To the extent that, under the partnership agreement, the allocations are based on the partners’ relative capital accounts and the terms, priority, type and level of risk, rate of return, and rights to cash or property distributions during operations and liquidations are the same, the exception applies. The capital account allocations of the partner holding the API interest, the API Holder, can be subordinated to those partners who do not provide services in the relevant ATB and who are not related to the API Holder, referred to as Unrelated Non-Service Partners. For capital account purposes, besides the contribution of cash and property, the API Holder, which is the REP in this context, could include the amount of income that was taxed upon receipt under Section 83. Also, it appears that the capital account can include true loans and personal guarantees made by the API. Nonetheless, an API should be easily distilled from a capital interest by a review of the partnership agreement.
It is not uncommon for a REP to create one or more Limited Liability Companies (“LLC”) to act as the General Partner in a real estate activity. Section 1061 anticipates this by providing rules for tiers. For this reason, the proposed regulation use the term Passthrough Taxpayer. A Passthrough Taxpayer is an entity that does not itself pay tax on capital gains but is treated as a taxpayer for the purpose of determining the existing of an API. In the case of multiple tiers, each upper tier takes into account each lower tier’s determinations. Unrealized API Gains and Losses are also included if there has been a Section 704 capital account revaluation or a contribution of API property. At each tier level, it is important to keep in mind that awarding an API Interest does not start a holding period until the services to be provided in exchange for the API Interest actually begin.
For the REP, there may be an opportunity to exempt a partnership interest from Section 1061. Section 1061(b) states to the extent provided by the Secretary, subsection (a) shall not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors. In the preamble of the proposed regulations, this provision is briefly discussed. There is currently no proposed regulation with respect to the application of this exception, but a place holder in the proposed regulations has been reserved. At the same time, the preamble does acknowledge comments suggesting that the exception is intended to apply to family offices where portfolio investments are made on behalf of the service providers and persons related to the service providers. The explanation goes on to state that the Treasury and IRS generally agree with those comments and believe they are already effectively implemented with the exception for Passthrough Interest Direct Investment Allocations. These are found under the exception for Capital Interest Gains and Losses. They are allocations solely comprised of long-term capital gain and loss derived from assets (other than an API) directly held by a Passthrough Entity and the allocations follow the Capital Gains and Loss rules. Because this rule does not exempt the API, more guidance in the context of assets not held for portfolio investment would be helpful. For example, when a REP includes only the same business partners or friends and family in deal after deal, there are often times measures designed to protect the invested capital in ways that compromise the REP’s share. The implication being that the relationship among the parties are less “arms-length,“ as would be the case if a partnership of business partners shared in a deal based on not only every partner’s capital contributions but service contributions as well.
Proposed Regulation § 1.1061-4 makes a distinction between distributions and dispositions for long-term capital gain recharacterization purposes. The proposed regulations provide for a limited look-through rule which applies where 80 percent or more of the assets, based on fair market value, of the partnership in which the API is held, if disposed of would result in capital gain or loss and have a holding period of three years or less. It is used to recharacterize a portion of long-term capital gain to short-term capital gain where a portion or all of an API is disposed. Because the disposition of an API is not a Section 1231 transaction, the REP would be exposed to Section 1061. Often times there are buyers that prefer to acquire partnership interests rather than asset purchases.
Proposed Regulation § 1.1061-4(b)(3) includes long-term capital gains from installment sales with respect to an API through either a distribution or disposition. The holding period of the asset upon the date of disposition is used for purposes of determining whether capital gain is included in the taxpayer’s One Year Gain Amount or the Three-Year Gain Amount. The relevant holding period for the purpose of computing the Three-Year Gain Amount is the direct owner’s holding period in the asset sold. For example, Partnership A started operations on January 1, 2014. On that date, Partnership A purchased Asset X and Asset Y. On January 1, 2015, Partnership A purchased Asset Z. Taxpayer became a partner on January 1, 2016. All three assets were sold on January 1, 2018 on the installment method. Because the partnership holding period in all three assets was over three years on the date of disposition, Taxpayer would not have a Recharacterization Amount even though taxpayer’s holding period in the partnership is three years or less.
Under Section 731(a), distributions from a partnership in excess of a partner’s basis in the partnership interest would generally result in long-term capital gain where such ownership interest was held for more than one year. If this situation occurs with respect to an Owner Taxpayer’s API, it is treated as a Disposition Amount. If the API is held for three years or less, the capital gain is subject to recharacterization, thereby resulting in short-term capital gain. Note that an API Holder for this purpose (and most under the tax law), has one capital account which combines the API and capital interests so that there is basis splitting.
Under Section 752(b), any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership. This is treated similarly to a Section 731(a) distribution for Section 1061 purposes. Similarly treated is gain under Section 751(b), dealing with distributions and sales of partnership interests that include inventory and unrealized receivables.
If an Owner Taxpayer transfers any API, or any Distributed API Property, directly or indirectly, or if a Passthrough Entity in which an Owner Taxpayer holds an interest directly or indirectly, transfers an API to a “Section 1061(d) Related Person“ a recharacterization gain computation is triggered, even in the case of otherwise nonrecognition transactions. Distributed API Property means property distributed by a Passthrough Entity to an API Holder if the holding period in the hands of the API Holder is three years or less. Related Persons are people that are members of the taxpayer’s family within the meaning of Section 318(a)(1) (spouse, parent, grandparent, or child).
REPs may wish to transfer their partnership interest for estate planning purposes. If such a transfer includes an API, there will be gain recognition even in the case of a non-taxable transaction such as a gift. If the API Holder transfers an API to a related person, the excess of the net built-in long-term capital gain in assets held for three years or less attributable to the transferred interest will be included in the gross income of the transferor. An important exception to this rule is if the transferee is a grantor trust, a qualified subchapter S subsidiary or a single member LLC. Thus, gifting to a grantor trust continues to be a viable estate planning strategy for this purpose. However, the proposed regulations did not address the treatment in the case that the grantor status ends, including when a grantor dies.
Sometimes a partnership when engaging in a Section 1031 transaction will request additional capital to be contributed by either existing partners or new partners. If a REP holds an API in the partnership, care must be taken to determine that none of the value of the API, at the time of the trade, is inadvertently being directly or indirectly transferred to a related person. Furthermore, under Section 1031 regulations, depending on the amount of traded property not meeting the definition of real estate, a trade may result in a portion or all of the transaction being taxable. Also, while Section 1031 applies to real property held for investment, as discussed earlier, such property does not qualify under Section 1231 exposing such cases to Section 1061.
The proposed regulations create the API Holder Transition Amount and Partnership Transition Amount concepts. A partnership that was in existence as of January 1, 2018 may irrevocably elect to treat all long-term capital gains and losses recognized from the disposition of all assets held by the partnership for more than three years as of January 1, 2018 as Partnership Transition Amounts. They will not be taken into account for purposes of determining the Recharacterization Amounts. If the REP holds an API in an entity that, for example has acquired capital gain assets at different times such that at January 1, 2018 the entity owned some of the assets for more than three years and others for three years or less, the election provides a clear path to ignoring the “over three-year assets” for Section 1061 purposes. This will be an ideal action to take where a Section 1031 transaction is contemplated. There does not appear to be a downside for a REP to make this election but a statement making the election is required for the first year the election is made and there is appropriate record keeping involved.
The proposed regulations clarify that Section 1061 does not apply to what otherwise be an API if held by a C corporation. An S corporation is considered a Passthrough Entity, and thus does not fall under the corporation exception.
The regulations will be binding on or after the date the Treasury decision adopting the regulations is published in the Federal Register. Taxpayers are given the opportunity to apply them before then. If Owner Taxpayers and/or Passthrough Entities so elect, there is a series of reporting requirements that must be followed.
Please contact FGMK with any questions regarding this matter.
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.
FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For over 50 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.