M id A tlantic Real Estate Journal — Owners, Developers & Managers — January 22 - February 18, 2021 — 3C
O wners , D evelopers & M anagers
How Captain Jack Sparrow Manages The Tax Rates On His Booty Internal Revenue Code Section 1061 Proposed Regulations – Pirates of the Carried Interest ntroduction
favorable LTCG rates. LTCGs are subject to tax at a maximum rate of 23.8%, which consists of the LTCG rate of 20% plus the 3.8% net investment income tax (“NIIT”), if applicable. It is prudent to note that ordinary income, as well as short-term capital gains, are subject to the 37% maximum rate. If NIIT was applicable, such in - come would be subject to the maximum rate of 40.8%.
partnerships owning capital assets with a holding period of three years or less. Such part - nerships could potentially get around Section 1061 by distrib - uting such assets in kind, rath - er than selling the assets. The resulting gain would then be allocated and the cash proceeds distributed. To ensure that this doesn’t occur, the proposed regulations provide that Section 1061 will continue to apply to any capital asset with a holding period of three years or less that is distributed in kind by a part - nership to an API holder, until continued on page 10C
requirement to obtain LTCG tax treatment. Prior to the enactment of Section 1061, the holding period to obtain LTCG tax treatment was only one year. Section 1061 only applies to applicable partner - ship interests (“API”s). An API is a partnership interest that is directly or indirectly re - ceived or held by a taxpayer in connection with their perfor - mance of substantial services. The substantial services must be in an applicable trade or business (“ATB”). An ATB is an activity that is conducted in a regular, substantial and
continuous manner, including real estate held for rental or investment. The remainder of this article will concentrate on several specific issues related to real estate held for rental or in - vestment and the “in-kind” rules, as well as planning opportunities under Section 1231. Section 1061 – Proposed Regulations One of the major clarifications of the proposed regulations, in terms of commercial and resi - dential rental real estate, was a possible workaround involving
During the time when pirates ruled the Caribbe -
an seas, sell- ers of goods needed safe transporta - tion to travel the seas in o r d e r t o reach pur - chas e r s o f those goods.
The fees that the pirates, such as Captain Jack Sparrow, were paid came in two forms. The first was a flat fee for safe transportation to the destina - tion. The second fee was a percentage on the gross sales revenue paid to the sellers. This second fee was known, in the pirate world, as “carried interest”, as it was above and beyond the fee paid for safe transportation. It was a per - centage based on protecting those goods that the pirates “carried to safety”, away from other fiends and scoundrels once both parties completed the sale. The notion of “carried in - terest” has been a part of the tax code for many years. It is typically used in the context of hedge funds where the manag - ers receive a flat fee, treated as ordinary income, and then an additional amount, based on a percentage (internal rate of return), treated as long- term capital gain (“LTCG”). Many critics have noted the disparity between the treat - ment of hedge fund manag - ers vs. investment bankers. For investment bankers, the percentage received is subject to ordinary income rates as opposed to LTCG rates. Such critics argue for the elimina - tion of capital gain rates for hedge fund managers in order to tax such managers in a manner similar to investment bankers. In 2017, the Tax Cuts and Jobs Act (“TCJA”) was passed by Congress and signed into law by the President. The In - ternal Revenue Code (“IRC”) addressed the issue of carried interest in the newly enacted Section 1061. The purpose of Section 1061 was to alter the differences in treatment of income as ordinary vs. capital gain as described above. Sec - tion 1061 imputes a holding period of three years before gain allocated to certain car - ried interest arrangements can be subject to the more
Section 1061 – General Rules
Section 1061 imposes a three-year holding period
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