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Leonard W. Wood is a director of Atlanta-based Wood Partners LLC and is the chairman of the National Association of Home Builders’ Multifamily Leadership Board. He may be contacted at [email protected].

Multifamily housing developers, builders and property managers should be extremely concerned about a Congressional proposal that would change the tax treatment of private equity.

The consumer press has presented a somewhat skewed take on the proposed change–which involves the tax treatment of what is called “carried interest”–by focusing mostly on the proposal’s effect on the taxation of capital gains earned by hedge funds, venture capital firms and private equity businesses. Less publicized, however, is how the proposal will negatively affect most real estate partnerships, including the development and sale of multifamily assets.

The bill (H.R. 2834), which was introduced by Rep. Sander Levin (D-MI) in June, would amend the tax code to treat carried interests in investment partnerships as ordinary income. Currently, such income is classified as a capital gain, which is taxed at 15%. Because ordinary income can be taxed at rates up to 35%, those of us involved in real estate partnerships that include carried interest could see our tax bills on that carried interest increase by a whopping 133%.

If allowed to become law, this bill would, in effect, change the way we do business. Not only would it dampen our enthusiasm for risk, but it would also disrupt the relationship we have with our investors, potentially affecting both the pricing of deals and the amount of capital available to be invested.

Given the time, money, and risk involved in real estate development, partnerships have always been essential to the way we do business. Most of us who act as general partners in a development deal typically receive two kinds of income from these partnerships.

First, we receive a fee for development and operation services. This fee, because it is a return for services or labor, is presently taxed as ordinary income. We have no argument with that. However, in addition to this fee for service, most multifamily development deals include a “carried interest” provision. The “carry” is a share, perhaps 20%, of capital gains that arise after the successful sale of the developed property. The “carried interest” is a means of payment for our investment and entrepreneurial efforts as multifamily housing developers.

Because most of us are putting “sweat equity” into these deals, funding the pre-development costs and guaranteeing the construction budget and financing, the share associated with the carry is more than the amount of equity we invest at the front end of these projects. When the project is completed, the asset is sold, and all equity repaid with a return, we are entitled to our share of the partnership’s profits. In other words, the amount and timing of the carried interest payment depends on the success of the partnership venture. The profits–and none are ever guaranteed–represent the return on an asset. Or to say it another way, they represent a capital gain. Such income, therefore, is appropriately taxed as a capital gain.

Partnerships with promoted or carried interest mechanisms are excellent financial arrangements because they allow us, as real estate entrepreneurs, to share the economic risks of a deal with outside investors. And regardless of tax considerations, it is important to remember this: outside investors often demand carried interest provisions because they believe such a provision increases the incentive of the builder/developer to generate profit for the limited partners by aligning their respective economic interests.

Carried interest provisions also reduce the investor’s business risk. If the tax treatment changes–the amount of money flowing into our deals is almost sure to change too. It will become even more expensive and more difficult to develop and build multifamily housing projects, especially those in underdeveloped communities, where it is already nearly impossible to make the numbers pencil out.

The National Association of Home Builders, along with a coalition of other real estate groups, is working on our behalf to enlighten Congress about the negative impact such a change in the tax law could have on real estate entrepreneurship. But we as individual developers also must be involved to ensure that our interests are protected. You should be aware that Rep. Levin is not alone working this issue–H.R. 2834 has 12 other original sponsors, including Rep. Charlie Rangel (D-NY), who chairs the powerful House Ways & Means Committee, and Rep. Barney Frank (D-MA), who chairs the House Financial Services Committee.

In a time of federal budget deficits, Wall Street and the profits amassed by hedge funds and private equity firms may seem like an easy target for tax increases. We in the real estate business need to make sure that Congress understands the significant unintended consequences to our industry that could arise from such a change in the tax treatment of private equity. I encourage you to be proactive in writing our elected representatives concerning this issue.

The views expressed in this article are those of the author and not Real Estate Media or its publications.

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