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THE CARRIED INTEREST THREAT

A bill currently being floated by Rep. Charles Rangel (D-NY) and Sandy Levin (D-MI) is likely to crank up the tax burden on the real estate industry. According to Commentator Charles Temkin, director at Deloitte Tax LLP, so-called carried interest, as the legislation is dubbed, is a misnomer for a tax hike that will affect far more than private-equity circles. And yet 25% of respondents to last week’s Feedback Poll said the legislation won’t apply to real estate at all; 7% think it will impact only large deals; and 20% think only private equity will feel the pinch. Those who believe it will sweep through all real estate partnerships weighed in at 44%. Here’s Temkin’s take:

“Some people have heard there’s legislation but haven’t focused on it as much as they might because it’s always referred to as ‘carried interest,’ and that’s a phrase not typically used in real estate. I think the term comes from the oil or gas industry, but I’ve heard it only in connection with private-equity deals. But the concept has been in every real estate deal I’ve ever worked on.

“Essentially, the bill would change the tax treatment of everyone who receives a partnership interest as a result of providing management-type services relating to securities, real estate or commodities. Even if the partnership recognizes capital gain, the service provider partner’s distributive share, except to the extent it is attributable to any capital he or she contributed, would be taxed as ordinary compensation income.

“I’ve heard of at least one person who was confused, thinking it applied only to an investment-services partnership. The actuality is that it applies to any partnership interest someone has received for investment services. And investment services includes what the average real estate professional is doing with real estate. I think the industry as a whole understands that this is a bad thing.

“Without judging it in policy terms, we’re talking about a very basic change in the way people who own partnership interests are going to be taxed. And it’s very difficult to make such changes to the tax system without being confusing and causing interactions in unexpected ways with other provisions. So I anticipate that the whole thing will be fairly messy in its resolution.

“How will it affect real estate? It will affect deals and, depending on the effective date, it will affect existing transactions. Transactions entail the contributions of a number of different people, including investors and lenders putting in money and professionals putting in knowledge and expertise. Typically, in partnership transactions, there are different splits of profit, and the people who put the deals together–the expertise part–could be motivated to get increased shares beyond any capital contribution. If you change that tax treatment, you’re essentially imposing an additional cost on that structure. Those persons would end up with a lower net after-tax amount, but they also may well charge more for their services.

“And those charges could come in different ways. There would be less overall activity; investors would pay increased management fees; and, to some extent, the real estate industry would become unattractive for people who want to work in it. It will take a concerted effort to diminish the impact of this on real estate.”

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