Section 1061’s Application to Real Estate Carried Interests (or Not)

Persons interested in investing in real estate may not have the capital to purchase or develop real estate. Ordinarily those persons will seek out investors to provide the capital, while retaining a profits interest in the venture (a “promote” in the real estate world) in exchange for managing and facilitating the venture. A promote held by such a service partner is known in the tax world as a “carried interest.”

Section 1061 of the Internal Revenue Code (IRC) was enacted as part of the Tax Cuts and Jobs Act of 2017. It characterizes certain gains allocated to partners holding a “carried interest” as ordinary income, instead of long-term capital gain. Specifically, for a partner with a profits interest in a partnership which invests in certain “specified assets,” a capital asset must be held by the partnership for three (3) years, instead of the usual one (1) year, for gain allocated to the service partner to be characterized as long-term capital gain.

The term “specified assets” in Section 1061 includes “real estate held for rental or investment.” Therefore, although “hedge fund manager” is the usual taxpayer associated with carried interests, Section 1061 applies equally to a real estate promoter or developer. It is worthwhile, therefore, to examine the extent to which Section 1061 may apply to a profits interest in a real estate partnership.

One practical limitation on the applicability to promoters of real estate partnerships is that real estate investments are very often held for more than three years. In that case, Section 1061 would not apply to convert gains otherwise characterized as long-term capital gains into ordinary income since the three-year holding period of Section 1061 would be met.

Another limitation to Section 1061 is that it excludes from its coverage Section 1231 property, generally described as depreciable property used in a trade or business. This was implied in Section 1061 as originally enacted, and was firmly settled with the passage of final regulations earlier this year.[1] Section 1231 property includes “real property used in a trade or business,” which is held for more than one year, and which is not held primarily for sale to customers in the ordinary course of taxpayer’s business.[2]

So when is real estate “used in a trade or business” such that it qualifies as Section 1231 property and is excluded from Section 1061? Property held purely for investment, such as undeveloped real property for which no activity is undertaken, would not be Section 1231 property. However, rental real estate which is acquired, managed, and held for a long period for the purpose of collecting rents is used in the business of real estate rental, and therefore could qualify as Section 1231 property and be excluded from Section 1061. But questions can arise when property is purchased, refurbished, rented for a brief period (if at all), and then sold. The IRS may argue that the taxpayer held the property primarily for sale, especially if the taxpayer has a history of similar transactions.

This is illustrated in the case of Cottle v. Commissioner[3], in which the taxpayer purchased, with a group of other investors, rental units in a residential complex. The taxpayer renovated and managed the complex. Shortly after the property had been held for one year, some of the other investors sold their units. Fearing that those sales would result in a deterioration of property values, the taxpayer sold his units. The IRS argued that the property was not Section 1231 property, but was held primarily for sale, because this transaction was one of many where the taxpayer bought, renovated, and sold property. The Tax Court, in holding that the property was Section 1231 property, found that the property was purchased as part of a plan to acquire, renovate, and operate rental properties, so that the refurbishing was to enhance rentability, not salability. Further, the Court found that the sale was the result of changed conditions. The Court concluded that the taxpayer’s sale of the property was the last step in the liquidation of a rental venture which had not developed according to plan.

Example 1. Taxpayer forms an LLC and issues membership interests to raise $20,000,000 to purchase an office building as a rental property. Taxpayer receives a membership interest without contributing any capital, but pursuant to which he will receive distributions of cash from operations, and a 20% promote upon the profitable sale of the building. The LLC acquires the building, taxpayer works to fill it with tenants and manages the building, and the LLC collects rents for 30 months, at which point the building is sold at a profit. Taxpayer is allocated an amount of gain commensurate with his promote.

If Section 1061 applies, the gain allocated to Taxpayer will be characterized as ordinary income since the property was held for less than three years. The office building, however, will likely be characterized as Section 1231 property, since it was used in the trade or business of real estate rental. This will exclude the gain from the application of Section 1061, and the gain will be characterized as long-term capital gain, subject to the Section 1231 netting rules.

Example 2. Taxpayer forms an LLC and issues membership interests to raise $1,000,000 to purchase a duplex. Taxpayer receives a membership interest without contributing any capital, but pursuant to which she will receive a 20% promote upon the profitable sale of the duplex. The LLC acquires the duplex, which taxpayer works to refurbish, and the duplex is sold 18 months later. Taxpayer is allocated an amount of gain commensurate with her promote.

The duplex seems unlikely to be characterized as Section 1231 property, since it was not used in the trade or business of real estate rental, but acquired to refurbish and sell. Section 1061 will require the gain allocated to taxpayer to be characterized as ordinary income.

Two additional things are worth noting:

1.  In addition to applying to gain allocated from the sale of partnership property, Section 1061 applies to gain on the sale of the profits interest itself. The exclusion for Section 1231 property applies only upon the sale of Section 1231 property. But a profits interest, unlike the actual property owned by the partnership, is a capital asset falling within the scope of Section 1061, even if the property held by the partnership is Section 1231 property. Therefore Section 1061 would apply to the sale of the profits interest itself.
2. U.S. Representatives Bill Pascrell, Andy Levin, and Katie Porter have recently introduced the Carried Interest Fairness Act of 2021 as H.R. 1068. This legislation would repeal Section 1061 in its entirety and introduce new IRC Section 710 as part of Subchapter K. The general effect would be to characterize all net capital gain and loss allocated to service partners in specified partnerships (including real estate partnerships) as ordinary income and loss. Section 1231 assets would be expressly included as “capital assets,” and subject to proposed Section 710.[4]

[1] Treasury Reg. Section 1.1061-4(b)(7)(i).

[2] Section 1231(b)(1).

[3] 89 T.C. 467 (1987).

[4] Proposed Section 710(a)(4)(A)(iii) under H.R.1068.