Marcum 2021 Year-End Tax Guide

SALT CAP WORKAROUNDS AND TIERED PARTNERSHIPS As part of TCJA, a $10,000 limit was imposed on individuals’ state and local tax deductions. The limit, commonly referred to as the “SALT cap,” has been in effect since 2018 and will remain so until 2025, pending further legislation. Taxpayers have been eagerly awaiting ways to work around this limitation, and many jurisdictions are now providing that relief. The SALT cap is a direct hit on individuals who itemize deductions on their federal income tax returns and has sent states into a frenzy on workarounds for their residents. There are currently 20 states with legislation on Pass-through Entity Tax (“PTE Tax”), enabling individual owners to benefit from the deduction without such $10,000 limitation. After rejecting some of the earlier workarounds, it was uncertain where the IRS would fall on the PTE Tax. In November of 2020, the IRS approved of both mandatory and elective entity-level income tax on pass-through entities. Notice 2020-75 confirmed that the PTE Tax could be deducted by the partnership or S-corporation. In turn, the deduction would be reflected on the owner’s Schedule K-1 and not subject to the $10,000 SALT limitation. Once the IRS issued the above guidance, many states jumped on the PTE workaround bandwagon. A particular area where state guidance varies is with a structure familiar to most real estate investors: the tiered partnership. Below is a sampling of how some jurisdictions adopted the tax for this type of structure: California California enacted a PTE tax effective for taxable years between 2021 and 2025. A PTE may only claim the tax if its owners are individuals, trusts, estates, fiduciaries or corporations, which means an entity with a tiered partnership structure would be ineligible. Maryland The Maryland PTE tax is effective for tax years beginning January 1, 2021 or after. PTE owners that are themselves PTEs can pass through the credit paid to its owners. A PTE owner may also make its own PTE election.

A “carried” interest, also called a “promote,” is the interest in profits that the general partner receives for its management of the investment. Under current law, carried interest is treated as a long-term capital gain as long as the asset that generated the gain was held for at least three years. A shorter hold period will result in short-term capital gain, taxing the partner at ordinary rates. Understanding the terms used in the final guidance is important in determining whether gains will be recharacterized. Recharacterization of holding periods applies to a partner’s distributive share of long-term capital gain and/or gain on disposition of an applicable partnership interest (“API”). • An API is a partnership that is directly or indirectly held by a taxpayer in any “applicable trade or business.” • An applicable trade or business is defined as any “regular and continuously conducted activity that consists in whole or in part of raising or returning capital, and either invests in or develops specified assets.” • Specified assets include securities, commodities and, most notably for real estate investors, real estate held for rental or investment. Once a taxpayer has determined it is subject to the carried interest rules, it must look to the type of transaction to determine the holding period. Sale of Asset. When an asset is sold, the holding period dictates the character of the gain or loss, even if the partner has held the interest for less than three years. Sale of Partnership Interest. Upon sale of a partnership interest, the partner first looks to the amount of time the interest was held, subject to a look- through rule. Carried interest holding periods do not apply to §1231 gains, which result in the sale of property used in a trade or business, including rental real estate. However, owners of real estate investments should beware that real estate not used in a trade or business, such as a triple net lease or vacant land, does not qualify as a §1231 transaction and is subject to carried interest holding periods. Installment sale gains are also considered under the carried interest rules. With the final guidance on the carried interest rules, taxpayers can make more informed decisions when structuring real estate deals to maximize potential outcomes for investors.

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