Carried Interest Unexpectedly Re-emerges for CRE

WASHINGTON, DC—Congress has been trying to change carried interest's tax characterization for years and in some instances, came rather close to suceeding. More recently, the issue died down -- at least on the Hill -- as the conversation shifted to comprehensive tax reform.

'Carried interest' is safe for now, has been the unspoken message.

Last week that message changed.

On Wednesday the Internal Revenue Service quietly proposed a rule that would effectively do what numerous proposed acts and measures could not: ban companies such as private equity firms from converting the management fees they receive from their investors -- fees that would normally be taxed as ordinary income -- into capital contributions invested in their funds. These are taxed at a much lower tax rate.

As everyone versed on this subject knows, what is applicable to private equity firms is also applicable to commercial real estate companies that use this partnership structure -- and so many do -- to develop and invest in properties.

In case you are wondering how this happened, the measure, which was published in the Federal Bulletin, does give an explanation, albeit briefly: Section 707(a)(2) in the tax code "grants the Secretary broad regulatory authority to identify transactions involving disguised payments for services…"

The mechanics behind the change, though, are almost beside the point. The chief question in the commercial real estate industry to be answered is, will it have an impact on us?

Yes.

At least, that is according to most of the experts GlobeSt.com contacted for comment about the proposed rule.

The opinions that follow are based on how these individuals interpret the notice. And, of course, the proposed rule could change again after the public comment period.

For the moment, though, let's pretend this is the final version. How will it affect commercial real estate? The answers range from "a lot" to "not much" to "not much now but look out down the road."

Let's get started.

Yes, The Rules Will Have Major Implications

From where Jeff DeBoer sits, which is literally a ten-minute taxi ride to Capitol Hill, the proposed rules will be a major change for the industry to absorb.

"In their current form, the rules are not restricted to management fee offsets," DeBoer, who is CEO of The Real Estate Roundtable tells GlobeSt.com.

"On the contrary, it appears that the IRS could invoke the new regime -- rightly or wrongly -- anytime it believes a partnership has made a 'disguised payment for services' to one of its partners.

Assuming the rule goes into affect as it currently is proposed, it will likely have a significant impact on the industry, says Richard Morris, partner at Herrick, Feinstein LLP, flatly says.

He gives GlobeSt.com three scenarios that he believes will play out:

• The alignment of interest of sponsors and investors will shift and sponsors may require higher asset management fees, which is guaranteed. "This will make investment funds more expensive because the investors are taking more risk relative to the sponsor," he says. "This will adversely affect (1) prices and (2) the number of deals that are within the risk tolerance of investors."

• The sponsors will need to look to other investment vehicles such as REITs. An executive in a REIT would be able to retain capital gains treatment on the stock in the REIT. This will lead to an increase in compliance costs or less investment funds available to be deployed for investment, Morris concludes.

• Investment in real estate may be more levered. "If a sponsor is not going to obtain the benefit of capital appreciation, then there will be less incentive to provide an equity based investment vehicle," Morris says.

The rules could also have the unintended consequence of making brokers more detached from the deals they are structuring, speculates Joel Shackelford, partner at Kaufman Dolowich & Voluck.

"Many investors like it when their brokers have some skin in the game," he tells GlobeSt.com. "It gives the brokers extra incentive to make sure that a deal is good rather than just doing any deals to make the commission, and it fosters a long-term commitment to the client and the deal. It also aligns the client and the broker on the primary purpose of the deal, which is making thoughtful, profitable investments."

If you think about it, he says, an investor, especially one who doesn't know that much about real estate market intricacies, wants to work with a broker who is so confident in the deal he's willing to stake his own commission on.

"The regulation seems to create an artificial restraint on the broker's ability to trade on his own expertise without any public policy benefit to the investor," Shackelford. "This regulatory framework also appears to overlook that not every investment goes up in value."

No, The Rules Won't Matter to CRE Too Much

Jim McCann, a tax attorney, and Jason Polevoy, a real estate attorney, both at Kleinberg Kaplan in New York, are more sanguine about the proposal.

They tell GlobeSt.com that they do not think the rule is likely to materially affect business practices within the commercial real estate industry. It may affect just on the margins the fees managers receive from the various funds they oversee – but that it should not affect the "carry" or "promote" part of the equation -- that is, the manager's share of revenues that only comes out of profits.

Brian Diamond, partner and co-chair of Stroock's National Real Estate Department, agrees with this view as well -- to a point.

"I do not believe that the commercial real estate industry is going to be directly impacted by the proposed regulations at this point in time," he tells GlobeSt.com. "Unfortunately, the indirect impact might come over time where these important conceptual differences may become jumbled."

This is how he analyzes the situation: the proposed regulations target fee waiver arrangements where a manager waives all or a portion of its management and related fees in exchange for a partnership interest and puts into question whether such partnership interests should be treated for tax purposes as disguised payments for services or real entrepreneurial investments.

The distinction has significant economic impact, he says, because, if the form of compensation is a payment for services, high ordinary income rates would generally apply.

However, "in the real estate world, carried interests typically entail quite a bit of entrepreneurial risk and are structured to reflect that risk. This is a very important element of the current discussion."

"The fact that the economics of such carried interests are not guaranteed or somehow linked to the market cost of providing management services is important and distinguishes most real estate carried interests that I have seen from the carried interests more common in the hedge fund space which may be more directly impacted by the proposed regulations," Diamond concludes.

What's Next?

Well, the industry's lobbying apparatus is gearing up for pushback.

The Real Estate Roundtable, for instance, is consulting industry leaders and their tax counsel to assess whether the facts and circumstances set forth in the regulation are appropriate or overreaching, according to CEO DeBoer.