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[IMGCAP(1)]DALLAS-The first test for Texas’ new margin tax is right around the corner just as a new CRE-rattling battle heats up in Washington, DC. If the legal and financial preparation hasn’t been completed or even started, it’s time for commercial real estate owners in the state to hunker down to get ready for 2008.

By now, deed holders should have decided which of their ownership structures will be included in the margin tax report or as some prefer to call it, the revised franchise tax. “There is the potential to start slicing and dicing your businesses. If this hasn’t been done, it needs to be done as soon as possible,” Labry Welty, shareholder of Dallas-based Munsch Hardt Kopf & Harr, tells GlobeSt.com. “We’re finding a large number of owners don’t understand they have to file a combined report.”

Legislators have changed parts of the law since it was enacted in 2006, but there’s been no deadline waiver. Effectively, returns are due after Jan. 1. For companies operating on calendar years, the first report is due by May 15.

The ownership test is the tricky part of the equation. HB 3, as passed, included a passive ownership test for “gains from the sale of real estate,” but that was subsequently modified to capital gains. “That really restricts passive activities,” Welty says. That and a language change from net rents to gross rents are the most significant changes.

“Now that we’ve had the amendments, there is, at least among the privately owned companies, an increased sense of focus on the margin tax,” Welty says. “A lot of companies really don’t know what the impact is going to be long term.”

The fear of the unknown has brought rumors that some locally based hedge funds and financial services that don’t need to be headquartered in Texas are weighing moves to states with friendlier tax structures. Welty says the banter could be more rumor than fact.

What has happened, though, is pass-through clauses in new leases are being changed to accommodate the new law. Triple net leases are more likely to be changed because pass-throughs historically dealt with escalations and not reductions in property taxes.

“From a real estate perspective, it’s caused concern. The economics of triple net leases may be impacted. There have been some lease revisions this year in the provision for pass-throughs,” Welty says. “But smart tenants are pushing back to pay for that percentage that relates only to the reduction in property taxes. They are having this discussion and it’s happening on a very frequent basis.”

The legislature built its hopes on beefing up the educational fund coffer by tapping into the business sector and lowering property taxes in general. Ironically, there has been little to no reduction in property taxes because assessments climbed and many school districts raised their rates to offset any funding losses.

When it was passed, the margin tax came under intense scrutiny amid calls for legal challenges over its constitutionality because it was viewed as an income tax, which is illegal in Texas. “Very likely it will be at the beginning of 2008 when the law is effective. A lot of people felt it was best to wait until it become effective before challenging the constitutionality,” Welty says. “The issue will be ripe for challenge then. Real estate lends itself as the potential of being the biggest area for challenge.”

Many accounting firms have been treating the margin tax as an income tax. But, the Texas Supreme Court will have the first say if a challenge is lobbed. “In my opinion, I think it closely resembles an income tax or some sort of limited income tax, but there’s no telling what the Supreme Court will say,” Welty says.

The future is uncertain, but the reality of the present is real estate owners need to get ready for 2008. “Probably a limited partnership still may have some advantages over a corporation or LLC ownership because you still have the ability for passive ownership treatment,” Welty explains. “I think more investors have held tight and maintained the structures that they had before.”

As Texas owners brace for 2008, a new battle looms in Washington, DC over a proposed tax increase on a partnership’s long-term investment return. The House Ways and Means Committee Thursday passed a proposal that sparked a letter from the Real Estate Roundtable and 11 industry partners denouncing the action.

The proposal would increase the treatment of a partnership’s carried interest return from the current 15% capital gain rate to the ordinary income rate of 35%. Carried interest is the amount that a general partner is compensated by other investing partners for successfully managing a long-term venture, including real estate assets, and is paid if the property appreciates in value over the life of the investment. For a general partner, carried interest compensation supplements reasonable or specified management fees and individual investment contributions to the venture.

[IMGCAP(2)]In a press release, Roundtable president and CEO Jeffrey D. DeBoer cautioned the industry that the proposal could reach the House floor for a vote in November. “It is imperative that policymakers fully understand this is the most significant and potentially most disruptive tax on real estate since the 1986 Tax Reform Act,” he says. “The change in tax treatment of carried interest unfairly hits real estate entrepreneurs throughout the country while leaving other business enterprises using the same investment partnership model unscathed. It amounts to permanent tax unfairness in the guise of a ‘Temporary Tax Relief Act.’”

According to the press release, real estate partnerships that are subject to the tax hike account for nearly one-fourth or more than $1 trillion of all investment real estate in the US. It’s also projected that the carried interest proposal represents a tax increase of more than $1 billion annually on real estate investment ownership and development. “A tax increase on real estate entrepreneurs across the country of over 133% will have a pervasive effect on jobs, economic growth and the tax base,” DeBoer concludes.

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