Inflation Reduction Act Proposes Limits to Tax Benefits of Carried Interest by John G. Ebenger, CPA
Posted on August 02, 2022
During the last week of July, Democrats in the U.S. Senate introduced the Inflation Reduction Act of 2022, which provides a new package of spending and tax measures designed to decrease the federal deficit while expanding adoption of clean energy, health insurance coverage and IRS compliance efforts. Among the policy changes recommended to help pay for these initiatives is a call to restrict the beneficial tax treatment of carried interest paid to general partners, fund managers or other partners in connection with their performance of substantial services.
Understanding Carried Interest
Carried interest, also referred to as “promoted interest,” is the share of an investments’ future profits paid to one of its partners as a success fee, reward for investment returns or other form of what might be called deferred compensation. Under current law, certain partners may pay lower taxes on these interests, treating them as long-term capital gains taxed at a preferential 20 percent rate plus the 3.8 percent Net Investment Income Tax (NIIT) when they hold it and its underlying assets for a minimum of three years. Assets held for less than the three-year holding period are taxed at ordinary income tax rates that can be as high as 37 percent plus the 3.8 NIIT.
Proposed Changes to Carried Interest
Under the Inflation Reduction Act, the holding period for taxpayers with adjusted gross income of more than $400,000 would be extended to five years beginning on the latter date of 1) when the partner holding the carried interest acquired “substantially all” of its applicable partnership interest (API) or 2) when the partnership issuing the carried interest acquired “substantially all” of its assets. Taxpayers with less than $400,000 in adjusted gross income and whose income is attributable to certain real property trades and businesses would continue to face a three-year holding period to qualify for long-term capital gain tax treatment of carried interests.
With the new five-year holding period, effective for tax years beginning on Jan.1, 2023, the beneficial long-term capital gain tax rate will depend on both the amount of time a partner/manager holds his or her applicable partnership interests and the period in which the partnership itself holds its assets. While the proposed legislation changes the holding period and the way in which taxpayers may determine the holding period, it fails to address how and when taxpayers may measure and satisfy the substantially all requirements.
Proposed Impact on Real Estate Issue
Carried interest has always played an integral role in real estate development and investment partnerships. In recognition of the value managing partners bring to a venture and the risks they assume in those roles, they are often paid a share of the profits resulting from property sales. Because this form of carried interest represents a return on a depreciable capital asset used in a trade or business (i.e. to generate rent) and held for at least one year, it qualifies under current tax law as Section 1231 property. This means it is eligible for preferential long-term capital-gain tax treatment at a 20 percent rate rather than the higher ordinary income tax rates.
Moreover, under current law, Section 1231 losses are considered ordinary losses that taxpayers may use to offset ordinary income in the current year and potentially forward to offset income in future years.
The challenge with the current wording contained in the Inflation Reduction Act is that it implies gains from the sale of Section 1231 property held for more than one year would essentially be recharacterized as short-term capital gains subject to onerous ordinary income tax rates that could be as high as 37 percent. Moreover, this language has the potential to further complicate the tax treatment of transfers of partnership interest for estate planning and mergers and acquisition purposes.
There is currently no way of knowing whether Congress will ultimately pass the Act into law this summer or approve an amended version down the road. However, it is important that taxpayers meet with their advisors and accountants on a regular basis to consider alternative strategies for maintaining tax compliance and efficiency in a constantly evolving political environment. The professionals with Berkowitz Pollack Brant are closely monitoring this proposed legislation and will continue to provide updates as they become available.
About the Author: John G. Ebenger, CPA, is a director in the Real Estate Tax Services practice of Berkowitz Pollack Brant Advisors + CPAs. He works with developers, landholders, investment funds and other real estate professionals as well as high-net-worth entrepreneurs with complex holdings. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or firstname.lastname@example.org.