Taxation of Carried Interest: Effect on CRE

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

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

Any speculation about what changes Congress might make to the taxation of carried interest has to include a look at the budgetary reality that Congress faces. Current Congressional rules, known as "pay-as-you-go" or "Paygo" rules, require that changes to the tax code not increase the federal deficit. The practical effect of this is that for every tax cut that Congress wants to enact, it needs to enact an equal tax increase or spending cut resulting in a net effect that is deficit neutral. The existence of these Paygo rules means that Congressional tax writers end up spending a lot of time searching for "revenue raisers" or tax increases to offset the tax cuts that they want to enact.

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

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

If either the House or Senate bill contains a carried interest provision, it is all but assured that any such provision would vary from the original Levin Bill mentioned above. However, it is unclear what a new provision might look like and how real estate partnerships will be affected by the proposal as congressional leaders and staff continue to examine the issue closely.

The National Multi Housing Council, National Apartment Association, and other representatives of the real estate industry are working closely with Congress to make it clear that capital gains is the proper tax treatment for the carried interests generated from real estate partnership arrangements.

Those who maintain that capital gains treatment is inappropriate point to the fact that the return received by many general partners in these transactions is in excess of the initial monetary contribution that they make to the partnership. Therefore, they argue, the carried interest is obviously a payment for services that should be taxed at ordinary tax rates like other forms of compensation.It is clear, however, that this simplistic analysis ignores the nature of real estate development transactions. General partners in real estate transactions are generally paid a specific fee 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 carried interest received by real estate general partners not merely due to the "sweat equity" involved in these deals but because of the risk that general partners are undertaking. That risk takes the form of investment risk--that the underlying asset will increase in value and a profit will be enjoyed--and often the additional risk of guaranteeing the construction financing, the risk of potential liabilities generated by lawsuits and environmental issues, etc. So it is clear that a general partner in a real estate transaction has much more at stake than merely his or her initial monetary investment and it is appropriate that he or she receive a return on this additional investment as well.

The partnership arrangements that utilize carried interests are vital to the development of new projects and the updating of existing properties. Inappropriate tax increases will make many of these projects unprofitable and the unintended consequences of imposing new tax rules on the real estate industry will be felt throughout the country--not just on Wall Street. If enacted, changes in the taxation of carried interests could affect which developments are built and could be the difference in determining which projects, particularly those located in underdeveloped areas in need of affordable housing, go forward.

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