September 2015

Carried interest is fair tax law for all investors

September 22, 2015 | By: Robert A. Green, CPA

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Carried interest is long-standing tax law that benefits investment managers and investors alike. Historically, carried interest contributed to the growth of the investment management, private equity, real estate and energy industries, and it’s had a positive effect on the overall economy and increasing tax revenues. Carried interest treats all partners the same. It is fair and not withstanding populist politics, the established partnership tax law should be maintained.

If Congress repeals carried interest provisions in investment partnerships, investors will be stuck with large investment expense itemized deductions that generate few tax deductions. There’s the 2% AGI threshold, Pease itemized deduction limitation and non-deductibility for AMT, the nasty second tax regime. Currently, investors have a reduction of capital gains as a share (carried interest) is allocated to the investment manager, which translates to full tax deductibility for investors.

A repeal of carried interest for investment managers will likely lead to the disuse of it in investment operating agreements for investors, which will put a chill on growth in the investment management, private equity and other investment-related industries. That will slow down the economy, choke finance of start-up companies and impair restructuring transactions. In other words, it’s the classic tax-hike/choke-growth policy which reduces tax revenues.

Investment managers are partners too, and they should be treated equally with other partners, the investors. Equal treatment ensures common goals and outcomes. This is, in fact, what happens with carried interest provisions. If investors receive a long-term capital gain, so does the investment manager who’s taking a risk in the transaction. Many pundits and Democratic presidential contender Hillary Clinton are calling for more long-term investment goals with related fiscal incentives. Clinton proposed stretching out long-term capital gain holding periods with graduated long-term capital gain tax rates. Why repeal carried interest, which is this fiscal incentive for investment managers to make more longer-term investments? Investment managers control the underlying transactions; not the investors.

Playing politics
President Obama and Congressional Democrats are campaigning to repeal carried interest; they claim it only benefits rich hedge fund managers and private equity executives, arguing they don’t pay their fair share.

Republican presidential candidate Donald Trump got on the populist bandwagon, riding shotgun probably so he isn’t pigeonholed by voters into the same corner as private-equity-rich-guy Mitt Romney who lost the last presidential election partially due to class warfare issues. It’s funny that Trump probably built a portion of his fortune from receiving carried-interest tax breaks in his real-estate syndication partnerships years ago.

When President Obama called for repeal of carried interest for investment managers in his two presidential campaigns and annual budget proposals, Senator Chuck Schumer (D-NY) objected, saying it singled out the finance industry (hedge funds and private equity) which obviously were concentrated in his state and New York City. Senator Schumer argued that carried-interest tax breaks were used in other industries — including oil and gas and real estate — all around the country, and if repealed, it should be repealed everywhere in all industries.

There are similar tax breaks throughout American industry in areas such as start-ups and tech companies. Companies grant stock options to executives and many executives benefit from lower long-term capital gains after exercising the options (the gain on option exercise is ordinary income). Companies use restricted stock units (RSUs) as another form of executive compensation, and they grant shares for sweat equity, too. How are these pervasive practices much different from carried-interest provisions in the investment management and private equity industries? As Senator Schumer argued, why single out and penalize investment managers and (I argue) investors, too?

The energy industry receives many special tax breaks including master limited partnerships (MLPs) and overly generous depletion allowances which some argue are phantom tax deductions. The real estate industry gets many special tax breaks with REITS and real estate partnerships with carried-interest provisions.

A call for the repeal of carried-interest on investment managers and private equity reminds me of another progressive-Democrat tax proposal for a financial-transaction tax (FTT) — a “small tax” on each purchase or sale transaction in financial markets. (Eleven EU countries are trying to adopt a version of FTT in the EU.) The FTT proposal is another populist attack to win over voters and while the intended targets are rich Wall Street institutions, FTT falls mostly on investors and retirees all around the country. FTT will also put out of business market makers and traders, which will significantly decrease liquidity and cause flash crashes more often. Even President Obama recognized that and it’s the reason why he prefers a tax on financial institution liabilities over a FTT on investors.

Politically motivated populist attacks are a dangerous game. Often a populist attempts to stab his target with a pitchfork, only to miss and stab his constituents in the foot.


Defer Capital Gains On Real Estate Using Like-Kind Exchanges

September 15, 2015 | By: Robert A. Green, CPA

(From our Feb. 2015 Monthly Newsletter written by cpasitesolutions)

If you’re a savvy investor, you probably know that you must generally report as income any mutual fund distributions whether you reinvest them or exchange shares in one fund for shares of another. In other words, you must report and pay any capital gains tax owed.

But if real estate’s your game, did you know that it’s possible to defer capital gains by taking advantage of a tax break that allows you to swap investment property on a tax-deferred basis?

Named after Section 1031 of the tax code, a like-kind exchange generally applies to real estate and were designed for people who wanted to exchange properties of equal value. If you own land in Oregon and trade it for a shopping center in Rhode Island, as long as the values of the two properties are equal, nobody pays capital gains tax even if both properties may have appreciated since they were originally purchased.

Section 1031 transactions don’t have to involve identical types of investment properties. You can swap an apartment building for a shopping center, or a piece of undeveloped, raw land for an office or building. You can even swap a second home that you rent out for a parking lot.

There’s also no limit as to how many times you can use a Section 1031 exchange. It’s entirely possible to roll over the gain from your investment swaps for many years and avoid paying capital gains tax until a property is finally sold. Keep in mind, however, that gain is deferred, but not forgiven, in a like-kind exchange and you must calculate and keep track of your basis in the new property you acquired in the exchange.

Section 1031 is not for personal use. For example, you can’t use it for stocks, bonds and other securities, or personal property (with limited exceptions such as artwork).

Properties of unequal value

Let’s say you have a small piece of property, and you want to trade up for a bigger one by exchanging it with another party. You can make the transaction without having to pay capital gains tax on the difference between the smaller property’s current market value and your lower original cost.

That’s good for you, but the other property owner doesn’t make out so well. Presumably, you will have to pay cash or assume a mortgage on the bigger property to make up the difference in value. This is referred to as “boot” in the tax trade, and your partner must pay capital gains tax on that part of the transaction.

To avoid that you could work through an intermediary who is often known as an escrow agent. Instead of a two-way deal involving a one-for-one swap, your transaction becomes a three-way deal.

Your replacement property may come from a third party through the escrow agent. Juggling numerous properties in various combinations, the escrow agent may arrange evenly valued swaps.

Under the right circumstances, you don’t even need to do an equal exchange. You can sell a property at a profit, buy a more expensive one, and defer the tax indefinitely.

You sell a property and have the cash put into an escrow account. Then the escrow agent buys another property that you want. He or she gets the title to the deed and transfers the property to you.

Mortgage and other debt

When considering a Section 1031 exchange, it’s important to take into account mortgage loans and other debt on the property you are planning to swap. Let’s say you hold a $200,000 mortgage on your existing property but your “new” property only holds a mortgage of $150,000. Even if you’re not receiving cash from the trade, your mortgage liability has decreased by $50,000. In the eyes of the IRS, this is classified as “boot” and you will still be liable for capital gains tax because it is still treated as “gain.”

Advance planning required

A Section 1031 transaction takes advance planning. You must identify your replacement property within 45 days of selling your estate. Then you must close on that within 180 days. There is no grace period. If your closing gets delayed by a storm or by other unforeseen circumstances, and you cannot close in time, you’re back to a taxable sale.

Find an escrow agent that specializes in these types of transactions and contact your accountant to set up the IRS form ahead of time. Some people just sell their property, take cash and put it in their bank account. They figure that all they have to do is find a new property within 45 days and close within 180 days. But that’s not the case. As soon as “sellers” have cash in their hands, or the paperwork isn’t done right, they’ve lost their opportunity to use this provision of the code.

Personal residences and vacation homes

Section 1031 doesn’t apply to personal residences, but the IRS lets you sell your principal residence tax-free as long as the gain is under $250,000 for individuals ($500,000 if you’re married).

Section 1031 exchanges may be used for swapping vacation homes, but present a trickier situation. Here’s an example of how this might work. Let’s say you stop going to your condo at the ski resort and instead rent it out to a bona fide tenant for 12 months. In doing so, you’ve effectively converted the condo to an investment property, which you can then swap for another property under the Section 1031 exchange.

However, if you want to use your new property as a vacation home, there’s a catch. You’ll need to comply with a 2008 IRS safe harbor rule that states in each of the 12-month periods following the 1031 exchange you must rent the dwelling to someone for 14 days (or more) consecutively. In addition, you cannot use the dwelling more than the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented out for at fair rental price.

You must report a section 1031 exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with your tax return for the year in which the exchange occurred. If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.

While they may seem straightforward, like-kind exchanges can be complicated. There are all kinds of restrictions and pitfalls that you need to be careful of. If you’re considering a Section 1031 exchange or have any questions, don’t hesitate to contact us.


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