Maryland Commercial Real Estate Investors

SPECIAL REPORT
TAX CHANGE WOULD CUT PARTNERSHIP PROFITS

A heated debate over how profits from partnerships will be taxed could have an adverse impact on the income of general, or operating, partners in most real estate partnerships. The bill, H.R. 2834, would eliminate the currently favorable tax treatment for all carried interest received by any partner or fund manager who provides “investment management services” to a partnership or fund. Historically, carried interest has been taxed as a capital gain. H.R. 2834 specifies that those who provide services to manage and operate real estate partnerships must now pay taxes on the carried interest at ordinary income rates. If this bill becomes law, it could significantly increase the tax burden for commercial real estate practitioners who act as an operating partner for a partnership. A companion bill in the Senate, S. 1624, would focus only on private equity and hedge funds and would apply exclusively to publicly traded partnerships.

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Virtually all investment real estate has greatly appreciated over the recent real estate market surge. This good news for investors istempered by the income tax exposure that these gains face upon disposition. This tax exposure can be controlled with the use of a Code Section 1031 tax-deferred exchange, assuming the few restrictive qualification rules can be met. Stated simply, the inves­tor-taxpayer will be allowed to reinvest into other investment real estate on a completely tax-deferred basis, assuming he/she can identify and name replacement choices within 45 days and complete the acquisition settlement within six months of the sale-settlement of the disposed property. The special rules require that all the funds be solely handled by a QI (Qualified Intermediary) and not pass through the hands of the seller or CPA representative, unless the CPA also is a QI. A CES (Cer­tified Exchange Specialist) is a QI who passed an extensive examination on the requirements to properly meet 1031 rules; he/she should assure proper guidance in the proper and safe handling of funds and reinvestments. A 1031 exchange is an excellent tax deferral tool that is most widely known. However, it is clearly not the only deferral mecha­nism to consider in these situations where highly appreciated assets are about to be sold. Advisors need to ensure they bring attention to the consideration and evaluation of the investment and the economic aspects of the proposed transactions. Many people believe that real estate is highly over appreciated and forecast the valuation bubble to burst. Some real estate professionals say they cannot find any reasonably priced property to acquire. As a result, the advisor should raise the prospect that paying taxes may be a better choice—or look to alternatives. Every situation has its own unique features. What choices does the tax planner have to offer as alternatives? Primary Tax Deferral MethodsAll four possible methods will defer taxable gain recognition for many years, but each has positive and negative features. It is good practice to consider and evaluate each of these in virtually every tax planning situation analysis.

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Filed under: Taxes / Legal