Leonard W. Wood is a director of Atlanta-based WoodPartners LLC and is the chairman of the National Association ofHome Builders' Multifamily Leadership Board. He may be contacted at[email protected].

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Multifamily housing developers, builders and property managersshould be extremely concerned about a Congressional proposal thatwould change the tax treatment of private equity.

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The consumer press has presented a somewhat skewed take on theproposed change–which involves the tax treatment of what is called“carried interest”–by focusing mostly on the proposal's effect onthe taxation of capital gains earned by hedge funds, venturecapital firms and private equity businesses. Less publicized,however, is how the proposal will negatively affect most realestate partnerships, including the development and sale ofmultifamily assets.

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The bill (H.R. 2834), which was introduced by Rep. Sander Levin(D-MI) in June, would amend the tax code to treat carried interestsin investment partnerships as ordinary income. Currently, suchincome is classified as a capital gain, which is taxed at 15%.Because ordinary income can be taxed at rates up to 35%, those ofus involved in real estate partnerships that include carriedinterest could see our tax bills on that carried interest increaseby a whopping 133%.

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If allowed to become law, this bill would, in effect, change theway we do business. Not only would it dampen our enthusiasm forrisk, but it would also disrupt the relationship we have with ourinvestors, potentially affecting both the pricing of deals and theamount of capital available to be invested.

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Given the time, money, and risk involved in real estatedevelopment, partnerships have always been essential to the way wedo business. Most of us who act as general partners in adevelopment deal typically receive two kinds of income from thesepartnerships.

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First, we receive a fee for development and operation services.This fee, because it is a return for services or labor, ispresently taxed as ordinary income. We have no argument with that.However, in addition to this fee for service, most multifamilydevelopment deals include a “carried interest” provision. The“carry” is a share, perhaps 20%, of capital gains that arise afterthe successful sale of the developed property. The “carriedinterest” is a means of payment for our investment andentrepreneurial efforts as multifamily housing developers.

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Because most of us are putting “sweat equity” into these deals,funding the pre-development costs and guaranteeing the constructionbudget and financing, the share associated with the carry is morethan the amount of equity we invest at the front end of theseprojects. When the project is completed, the asset is sold, and allequity repaid with a return, we are entitled to our share of thepartnership's profits. In other words, the amount and timing of thecarried interest payment depends on the success of the partnershipventure. The profits–and none are ever guaranteed–represent thereturn on an asset. Or to say it another way, they represent acapital gain. Such income, therefore, is appropriately taxed as acapital gain.

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Partnerships with promoted or carried interest mechanisms areexcellent financial arrangements because they allow us, as realestate entrepreneurs, to share the economic risks of a deal withoutside investors. And regardless of tax considerations, it isimportant to remember this: outside investors often demand carriedinterest provisions because they believe such a provision increasesthe incentive of the builder/developer to generate profit for thelimited partners by aligning their respective economicinterests.

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Carried interest provisions also reduce the investor's businessrisk. If the tax treatment changes–the amount of money flowing intoour deals is almost sure to change too. It will become even moreexpensive and more difficult to develop and build multifamilyhousing projects, especially those in underdeveloped communities,where it is already nearly impossible to make the numbers pencilout.

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The National Association of Home Builders, along with acoalition of other real estate groups, is working on our behalf toenlighten Congress about the negative impact such a change in thetax law could have on real estate entrepreneurship. But we asindividual developers also must be involved to ensure that ourinterests are protected. You should be aware that Rep. Levin is notalone working this issue–H.R. 2834 has 12 other original sponsors,including Rep. Charlie Rangel (D-NY), who chairs the powerful HouseWays & Means Committee, and Rep. Barney Frank (D-MA), whochairs the House Financial Services Committee.

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In a time of federal budget deficits, Wall Street and theprofits amassed by hedge funds and private equity firms may seemlike an easy target for tax increases. We in the real estatebusiness need to make sure that Congress understands thesignificant unintended consequences to our industry that couldarise from such a change in the tax treatment of private equity. Iencourage you to be proactive in writing our electedrepresentatives concerning this issue.

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The views expressed in this article are those of the authorand not Real Estate Media or its publications.

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