That is not good news for the real estate industry, of course. Many,if not most, joint ventures and partnerships will be affected by adoubling, if not tripling, of the tax rate they currently pay.
Perhaps most frustrating of all, planning for the change is difficultbecause--quite obviously--no one knows what the final version ofthe bill will look like. Also, it appears as though Congress isclosing off certain avenues that firms may take to do an end-run--legally of course--around the law.
This is not the first time this proposal has been made by Congress,notes Harold Levine, head of the tax practice at the New YorkCity-based law firm Herrick, Feinstein. "Two years ago, when facedwith one iteration of similar legislation, we found a way around itand advised that the investors lend to the service partners so theservice partner could come in with real cash for an equity interest,"he tells GlobeSt.com. Unfortunately for these firms, it looks asthough the government will close off that particular avenue.
Another possible strategy would be to sell properties before theeffective date to avoid the ordinary income treatment, but there aresignificant potential downsides with that, he says. "You could find a glut of properties on the market, with everyone trying to do the same thing at the same time, and that would depress prices. You could also have claims of a lack of fiduciary duty on the part of the manager. So that solution is hardly a panacea."
That said, real estate advisors are still thinking through other scenarios. Levine says the firm is looking at the possibility of advising clients to sell property and then effectively re-buy it by selling to a new entity that they're in. "But even that might require recognition of income that would be taxed as ordinary income instead of capital gains, and it will require more thought when we know the provisions of the legislation."
Another thought, subject to the legislation, is to do a preferred/common structure and have the service partner purchase thecommon interest, based on a valuation, Levine continues. "If the service partner pays the true fair-market value of the common interest, that service partner may be entitled to better tax treatment than the service partner who pays nothing for the carried interest," he explains. "So the bottom line is that we--and our clients and all real estate companies--will have to play a waiting game until we see the final version," he concludes.
Martin T. Goldblum, chairman of the Tax Department at TroyGould in Los Angeles is thinking about scenarios where a participation would be able to avoid meeting the definition of carried interest. "For example, a sponsor might acquire an option to purchase an office building with the intention of raising the funds from investors for the exercise of the option through an entity that would then own and operate the building. The option could be contributed to the entity by the sponsor in exchange for the sponsor's participation," he tells GlobeSt.com.
"Any amount paid by the sponsor for the option and its appreciation in value while held by the sponsor should constitute a contribution of property in exchange for the interest in the entity, and to that extent the participation should not be regarded as a carried interest," says Goldblum. In other words, the sponsor might acquire property in advance of syndication with the intention of contributing some--by way of a partial sale--or all of it in exchange for an interest in the entity.
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