Largely, it appears, in reaction to news stories of the excessesof some Wall Street "Masters of the Universe", two proposals wereintroduced in Congress this summer. First is a bill introduced bythe leaders of the Senate Finance Committee that would tax ascorporations those partnerships that elect to become publiclytraded and that derive income from investment advisory services.This bill, S. 1624, is limited in scope and will likely have verylittle direct impact on the real estate industry.

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Of significantly more concern to real estate, however, is a billintroduced in the House, H.R. 2834, by Congressman Sander Levin(D-MI) and supported by Chairman Charles Rangel (D-NY) of the HouseWays and Means Committee and Chairman Barney Frank (D-MA) of theHouse Financial Services Committee. This bill would result in thetaxation of the "carried interest" or "promote" received by ageneral partner in a partnership as ordinary income. This couldhave a significant impact on many real estate partnerships byraising the taxes on this income from the current 15% capital gaintax rate to ordinary income tax rates, which are currently as highas 35%.

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Any speculation about what changes Congress might make to thetaxation of carried interest has to include a look at the budgetaryreality that Congress faces. Current Congressional rules, known as"pay-as-you-go" or "Paygo" rules, require that changes to the taxcode not increase the federal deficit. The practical effect of thisis that for every tax cut that Congress wants to enact, it needs toenact an equal tax increase or spending cut resulting in a neteffect that is deficit neutral. The existence of these Paygo rulesmeans that Congressional tax writers end up spending a lot of timesearching for "revenue raisers" or tax increases to offset the taxcuts that they want to enact.

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The Outlook for Passage
The future of the two current bills or any other legislativechanges addressing the issue of carried interest is unclear.However, actions in the next few weeks could give some indicationof whether and how quickly changes are likely to be seen as majortax legislation is expected to be introduced by the chairmen ofboth the House and Senate tax-writing committees.

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The most momentum for an attack on carried interest appears tobe in the House rather than the Senate. Rangel has recentlyannounced plans to introduce two bills in the coming weeks: a majortax reform package that will contain full repeal of the AlternativeMinimum Tax (AMT), thus requiring revenue-raising offsets of over$800 billion and a second bill to provide a one-year "holdharmless" patch of the AMT that will require offsets in excess of$50 billion. Meanwhile, in the Senate, Chairman Max Baucus of theSenate Finance Committee has announced plans to introduce veryshortly his version of a one-year "hold harmless" bill and hasremained vague about plans to include a carried interest provisionin that legislation.

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If either the House or Senate bill contains a carried interestprovision, it is all but assured that any such provision would varyfrom the original Levin Bill mentioned above. However, it isunclear what a new provision might look like and how real estatepartnerships will be affected by the proposal as congressionalleaders and staff continue to examine the issue closely.

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The National Multi Housing Council, National ApartmentAssociation, and other representatives of the real estate industryare working closely with Congress to make it clear that capitalgains is the proper tax treatment for the carried interestsgenerated from real estate partnership arrangements.

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Those who maintain that capital gains treatment is inappropriatepoint to the fact that the return received by many general partnersin these transactions is in excess of the initial monetarycontribution that they make to the partnership. Therefore, theyargue, the carried interest is obviously a payment for servicesthat should be taxed at ordinary tax rates like other forms ofcompensation.It is clear, however, that this simplistic analysisignores the nature of real estate development transactions. Generalpartners in real estate transactions are generally paid a specificfee in compensation for their operations and management services;that fee is currently and undisputedly taxed as ordinary income.However, capital gains is the proper treatment for the carriedinterest received by real estate general partners not merely due tothe "sweat equity" involved in these deals but because of the riskthat general partners are undertaking. That risk takes the form ofinvestment risk--that the underlying asset will increase in valueand a profit will be enjoyed--and often the additional risk ofguaranteeing the construction financing, the risk of potentialliabilities generated by lawsuits and environmental issues, etc. Soit is clear that a general partner in a real estate transaction hasmuch more at stake than merely his or her initial monetaryinvestment and it is appropriate that he or she receive a return onthis additional investment as well.

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The partnership arrangements that utilize carried interests arevital to the development of new projects and the updating ofexisting properties. Inappropriate tax increases will make many ofthese projects unprofitable and the unintended consequences ofimposing new tax rules on the real estate industry will be feltthroughout the country--not just on Wall Street. If enacted,changes in the taxation of carried interests could affect whichdevelopments are built and could be the difference in determiningwhich projects, particularly those located in underdeveloped areasin need of affordable housing, go forward.

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Jennifer Bonar Gray is vice president of tax for theNational Multi Housing Council/National Apartment Association JointLegislative Program. The views expressed in this article are theauthor's own.

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