ASSESSING THE IMPACT OF REAL ESTATE TAX REFORM 32 EXCEPTIONS AND DRAFTING ANOMALIES • Interests commensurate with capital or taxed as compensation. The three year holding period does not apply if a service provider receives a share of profits commensurate with the service partner’s capital contributions or if such a partnership interest is granted as taxable compensation. • Interests held by corporations. Carried interests held by corporations are not subject to the new rules. • Real estate gains not covered. As drafted, the new rules do not require a holding period of more than three years for carried interest gains from sales of real property used in a trade or business (known as “section 1231 property”). That is, a carried interest holder’s share of section 1231 gain remains eligible for long term capital gain treatment so long as the property was held for more than one year. Whether the failure to cover such gains will be corrected in the future remains to be seen. • No express rule for REIT capital gain dividends. The TCJA is silent as to how the carried interest rules apply to capital gain dividends from a REIT subsidiary of a partnership. There is no express “look through rule” that would effectively treat a REIT capital gain dividend attributable to gain from the sale of an asset held by the subsidiary REIT for more than three years as eligible for long-term capital gain treatment or as retaining the character of gain from section 1231 property. We see no indication that Congress intended a different carried interest treatment for assets held through REIT subsidiaries, and we hope that the rules will be clarified in this manner. PRACTICAL OBSERVATIONS • Restructuring carried interest for funds with REIT subsidiaries. In light of the TCJA’s failure (at least for now) to extend the three year holding period requirement to section 1231 property, along with the absence of an express look through rule with respect to REIT capital gain dividends, service partners holding carried interest in partnerships with REIT subsidiaries might consider alternative structures, such as issuing the carried interest from a lower tier subsidiary partnership “below” the REIT subsidiary. Whether the countervailing tax and commercial considerations will outweigh the benefits of a below the REIT carry structure will depend on the specific facts. • Holding period issues. Capital gains from taxable sales of carried interest will not qualify for long term capital gain rates to the extent that the carried interest sold had a holding period for tax purposes of three years or less. Under the general holding period rules applicable to partnership interests, a grant of an additional carried interest could start a new holding period for a portion of both the newly granted carried interest and the holder’s existing carried interest. As a result, if an additional carried interest has been granted within the last three years, these rules could characterize a portion of the gain from a taxable disposition of a carried interest held for more than three years as short-term gain. We expect to see this issue arise frequently in connection with “LTIP” issuances by public REITs. On the other hand, the fact that the partnership holds assets with a holding period of three years or less will not limit long term gain treatment from the sale of a carried interest with more than a three year holding period. • S corporation holding company. The new rules exclude a carried interest held by a corporation. The term “corporation” is not defined and questions have been raised as to whether an individual could avoid the carried interest rules by holding carried interest through an S corporation. In light of the general tax rules applicable to S corporations and the manner in which they compute their taxable income, however, we expect that the exclusion for carried interest held by corporations is unlikely to extend to carried interest held through S corporations without future guidance. • Co-invest terms. Although the TCJA allows a service partner to avoid carried interest treatment on a share of profits commensurate with the service partner’s capital contributions or if such a partnership interest is granted as taxable compensation, the act does not specifically define “commensurate” or provide any safe harbors. Thus, while the carried interest rules should not apply when a service partner invests on exactly the same terms as third party investors, it is not clear whether some modest favorable terms (such as a fee break) would subject the entire investment to the carried interest rules. The safer path is to invest on the same terms as third party investors. Absent careful structuring, an ability to fund capital contributions through fee waivers will trigger the carried interest rules. • Estate planning and family transfers. While the statutory language is unclear, the provisions on transfers to family members could require recognition of gain based on the fair market value, not merely liquidation value, of carried interest gifted or otherwise transferred, directly or indirectly, to family members. A review of those rules should be part of any estate planning involving carried interests, including existing arrangements.