CRE Ponders Presidential Tax Proposals

To recap the issue briefly, Carried Interest is the percentage of a fund's, joint venture's or limited partnership's profits that a general partner takes as compensation. Such profits are taxed at capital gains rates--15%--as opposed to ordinary income, which can be as much as 35%.

Carried Interest caught the attention of Congress last year after Blackstone co-founder Stephen A. Schwarzman received $600 million in Carried Interest when the firm went public. Bills were introduced to treat income received by partners for performing investment management services as ordinary income, that is, for it to be taxed at 35% instead of 15%. Such a change would affect private equity and financial firms as well as real estate development partnerships.

One of Barack Obama's proposals is to tax Carried Interest as ordinary income. McCain, by contrast, would continue the current policy of taxing it at capital gains levels, or 15%, according to the NAIOP National, which has compared the two presidential candidates' tax positions on many issues, such as the Alternative Minimum Tax--McCain wants to phase it out; Obama wants to extend the patch--and the corporate income tax--McCain wants to reduce it to 25% from 35%; Obama wants to maintain it at its current level of 35%.

Of all of these issues, Carried Interest, arguably, will have the greatest impact on real estate development, Terry Thompson, president of NAIOP SoCal and vice president Acquisitions with WCB Properties, tells GlobeSt.com. "It certainly is the most glaring difference between their two positions for our industry and one that could have a severe impact." Furthermore, the Carried Interest issue is likely to hit President Obama's desk--assuming, of course, that he wins the election tomorrow--in short order, Thompson says. Given the current economic situation there will clearly be a need to raise funds quickly; also of all the tax increases that could be implemented this particular one might be viewed by taxpayers as comeuppance for the financial system meltdown that necessitated a $700-billion bailout plan.

However, Obama's proposals are not completely against the real estate industry's interests. The proposal to tax Carried Interest as ordinary income is unpopular in the real estate community--but as some in the industry point out--there are compensations with an Obama presidency that would mitigate the Carried Interest tax change to some degree.

"If the capital gains taxes are increased, it would likely motivate sellers to trade assets and enter into more 1031 tax free exchanges, and thus grow those businesses further," Lawrence J. Selevan, principal with Chesterfield Faring Ltd., a merchant investment banking firm in New York City, tells GlobeSt.com."Both candidates will be forced to increase taxes on the upper middle class in order to reduce the $700-billion-plus deficit," he says. However, he speculates that "an Obama led recovery will be faster, less painful, and more broadly spread throughout the system, thus creating jobs faster." Obama would also focus on creating more affordable multifamily housing as well as on urban redevelopment for large mixed use and projects Transit Oriented Developments, Selevan concludes.

Miriam Vock Sheehan, an attorney with DLA Piper who focuses her practice on the taxation of exempt organizations' investments in real estate and on the use of tax credits to promote real estate development, also notes that any change in the Carried Interest structure "would not be well received by individual real estate developers." That said, she tells GlobeSt.com, there are other considerations. "Even the Obama capital gains rate is substantially less than capital gains rates of the recent past and still substantially less than his top individual rate of 39.6%," she says. "As long as there is such an ordinary income/capital gain differential there will continue to be a tax incentive for real estate investment. Notwithstanding this incentive, note that a large percentage of the investment in commercial real estate is by tax exempt pension plans who are entirely indifferent to tax rates."

There are no extenuating considerations, though, for Karla K. Dennis, CEO of Cohesive, a Tax Advisor Firm in Cypress, CA. "Commercial real estate is going to be positively impacted under John McCain's plan," she tells GlobeSt.com. "His position of lowering corporate tax rates will enable any corporations selling their commercial property to fare far better from a tax perspective, especially" if capital gains tax rates are not increased. "Investors holding commercial property that are on the fence will consider possibly selling buildings outright since they will have lower ordinary tax rates which come in to play during the gain on sale calculation."

By contrast, she continues, under the Obama plan, a seller will experience a much heavier tax burden, which may in turn keep buildings off of the market. "An increase in capital gains rates to 28% is really going to affect whether or not a person [thinks it is worthwhile to sell] commercial holdings," Dennis continues. "We may end up with a much worse slow down in the commercial real estate market. Tax planning will become more than a key factor in deciding how to maneuver your commercial real estate."