The tax treatment of “carried interest” is high on the Congressional radar once again, and calls to dramatically change the current policy are gaining steam. If enacted, this proposal has the potential to be the most disruptive new tax on real estate since the 1986 Tax Reform Act that devastated many apartment owners.
A “carried interest” (or the developer’s “promote”) is an interest in the capital gains of a partnership when it sells its property. Investing partners grant this interest to the general partners to recognize the value these partners bring to the venture as well as the risks (recourse debt, litigation risks, responsibilities for cost overruns, etc.) they take. The policy has been a fundamental part of real estate partnerships for decades.
Under current laws, carried interest income is taxed at capital gains tax rates—15 percent. Now, lawmakers want to tax it at ordinary income tax rates, which are proposed to rise as high as 39.6 percent by 2011. A near-tripling of the tax rate is only the beginning. Reclassifying carried interest income from a capital gains to compensation would also subject that income, in most instances, to self-employment taxes.
The proposal currently before Congress—H.R. 1935, introduced by Rep. Sander Levin (D-Mich.)—is being marketed as a tax increase on hedge fund managers and other rich Wall Street executives. But the truth is that real estate partnerships—and the estimated 550,000 workers employed by the apartment industry as well as the 16 million Americans who rely on our sector for housing—will be adversely affected by such a change.
Although the real estate industry has been able to defeat comparable measures in the past, the task will be markedly more difficult this time around as lawmakers scramble to find revenue that will help offset a federal deficit that will exceed $1 trillion for the first time in history.
What’s at Stake?
The purpose of structuring real estate investments as partnerships that contain a carried interest component is not, as some argue, to avoid paying taxes. Rather, it is to create the proper vehicle to allow individuals with real estate development and operations experience—the general partner—to join with willing investors—the limited partners. Such partnership structures allow the flexibility to address the allocation of legal obligations and responsibilities among the various partners.
Taxing carried interest as income and not as a capital gain would have numerous unintended consequences. It would change the economics of apartment construction so significantly that many proposed communities would be financially unviable and would not proceed—ultimately exacerbating the nation’s affordable housing shortage.
Additionally, because H.R. 1935 does not include adequate transition rules, Rep. Levin’s bill would apply the tax increase to the entire carried interest realized on a deal, not just to the carried interest realized after the change was enacted. Potentially near-tripling the tax on several decades’ worth of gains on projects—the terms of which were established decades ago—would severely diminish the investment of long-term apartment entrepreneurs.
Perhaps more important, if the carried interest is held until death, a partner’s heirs could lose a substantial portion of their inheritance because the unrealized carry could possibly be considered “income in respect of a decedent” and be subject to income and estate taxes.
The Outlook for Passage
The November elections profoundly increased the likelihood of Congress passing carried interest tax changes. In contrast to the Bush administration, which opposed the legislation, President Obama supports the tax change and has endorsed—and even broadened—the proposal in his first budget submission to Congress.
Given the multiple competing priorities facing Congress right now, from climate change to health care reform, it is unclear when carried interest will be addressed. However, action is expected within the next three to 15 months. As with prior attempts to pass the legislation, the most momentum for an attack on carried interest appears to be in the House rather than the Senate. The House passed the proposal as part of larger tax legislation twice in the 2007 and 2008 sessions of Congress, but the Senate has yet to vote directly on it.
Take a Stand
The National Multi Housing Council has aggressively lobbied against changes in carried interest taxation, arguing that the current tax treatment is appropriate as it represents a return on an underlying long-term capital asset as well as risk and entrepreneurial activity.
Lawmakers would benefit from seeing real-world examples of the types of risks that entrepreneurs face when they undertake multifamily projects. This would help them understand why a carried interest in a real estate transaction is not compensation for services rendered but a return for risks assumed. Direct contact from constituents also highlights the practical impact that such a “theoretical” change in the tax laws will have on the Main Streets of local communities.
For more information on the carried interest issue, visit www.nmhc.org/goto/CarriedInterest.
JENNIFER BONAR GRAY is vice president of tax for the National Multi Housing Council in Washington, D.C.