Carried Interest: What’s Next?

By Eugene Gilligan, Contributing Editor

Washington lawmakers are likely at the endgame with health care legislation, and Congress is under growing pressure to do more to address the high U.S. unemployment rate.

While these issues have taken center stage in 2010, the federal government’s budget deficit continues to grow, and solutions are being looked at to close the gap, projected to be $1.6 trillion in Fiscal Year 2010.

One way that some lawmakers are looking to increase revenue is by enacting “carried interest” legislation. Mostly aimed at reigning in high-earning hedge fund managers, the legislation, if enacted, would also affect real estate partnerships, and the major multifamily organizations say the change could severely inhibit multi-housing development.

“There is a box of corks available for legislators to plug the deficit,” says Jennifer Bonar Gray, vice president-tax of the National Multi Housing Council (NMHC). But the number of so-called corks is quickly decreasing.

The legislation is projected to raise approximately $24 billion over a 10-year period.

According to NMHC and the National Apartment Association, over $1.3 trillion is invested in real estate through partnerships, and the majority of these partnerships use a “promote” structure.

An analysis by the group found that more than half of the apartment communities developed in Los Angeles County in 2008 used a promote structure, and 60 percent of new apartment properties in Las Vegas in 2009 used one.

A typical real estate partnership includes a general partner and a number of limited partners. While the details of a partnership can vary significantly, for example purposes, a general partner contributes a small percentage of capital, perhaps 10 percent, while the limited partners contribute the balance. The general partner is responsible for various risks in excess of his 10 percent investment, including issues such as taking on personal recourse on construction and other loans, construction cost overrun guarantees and environmental issues. After construction is completed, the general partner typically receives fees, such as payment for construction management and apartment management, which are taxed at the ordinary income level.

In accordance with the original agreement, when the partnership eventually decides to sell the property, the limited partners receive an agreed-to priority return of their initial investment, plus a guaranteed return on that investment. The general partner receives a return of his initial investment, and possibly a guaranteed return that is subordinated to the guaranteed return of the limited partners. Any net gain after these payments is split equally among the partners, as was agreed to at the partnership’s inception.

Under current law, the general and limited partners are treated equally, with income from rental payments, for example, taxed as ordinary income, and gains from a sale of the capital asset taxed as capital gains.

The carried interest legislation alters that formula, though, stipulating that some capital gains profits by the general partner be taxed as ordinary income but remain taxed at the capital gains rate for the limited partners.

The promote, or carried interest, represents the difference between the percentage invested by the general partner and the percentage of the profits he receives. For example, if the general partner invested 10 percent, and he and two other limited partners each receives 33.33 percent of the profits, the difference of 23.3 percent is taxed in line with the character of the underlying income—the capital gains rate, or 15 percent, for capital income and ordinary income rates for ordinary income.

The new legislation mandates that the 23.3 percent the general partner receives attributable to capital gains would be taxed at the ordinary income level, regardless of whether it was attributable to ordinary income or capital gains income. The result could be subjecting long-term capital gains income to ordinary income tax rates, which are now as high as 35 percent, and which are increasing to 39.6 percent after this year.

On top of this, the proposal would subject the 23.3 percent to self-employment taxes, or an additional 2.9 percent. All told, this proposal would increase the tax rate on the promote from the current level of 15 percent to 37.9 percent (which will increase to 42.5 percent after 2010).

If the proposed change in the tax on carried interest becomes law, it is likely to have a chilling effect on multifamily development, and at a particularly inopportune time, says Sharon Dworkin Bell, senior vice president of Multifamily and 50+ Housing Council for the National Association of Homebuilders (NAHB).

“Because of the freeze in the capital markets, many multifamily properties that could have been built have not been,” Bell says. The law will further impede multifamily development, “and by 2012, we will really see a great increase in the cost of housing for consumers because of the lack of supply of that housing.”

There are four different streams of income that are taxed in different ways: wages, capital gains, interest and dividends, says Robert Dietz, tax economist for the NAHB.

A general partner in a real estate partnership clearly receives capital gains income as the result of the sale of a property, Dietz says, and any change in this tax structure is awkward.

In a 2009 study, Dietz concluded that the legislation would have far-reaching and negative consequences for the multifamily sector. He projected that if the legislation were enacted in 2009, multifamily construction starts would decline by approximately 15,000 housing units in 2010, and by nearly 29,000 in 2011, resulting in the loss of 18,000 jobs in 2010 and 33,000 jobs in 2011. State and local governments would see declines in revenues of $1.2 billion a year, because of reduced property taxes.

On Dec. 9, 2009, the House of Representatives included a carried interest provision in a Tax Extenders bill, which extends certain expiring tax provisions. However, a similar bill now in the Senate does not include carried interest legislation. At press time, the bill had not passed.

The House also passed carried interest legislation in 2007 and 2008, but it failed to become law.

Many members of Congress, particularly in the Senate, have expressed reservations about carried interest legislation, Gray says. However, in an environment where there is an increased focus on deficit spending, Gray says the fate of carried interest legislation is “extremely hard to predict.”

“This is a high-priority issue,” says Bell. “We are vigilant on this legislation, and we will continue to be so.”

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Get the Word Out

There can be strength in numbers, and the National Multi Housing Council (NMHC) is working with other organizations to prevent carried interest legislation from becoming law.

The NMHC is working with organizations such as BOMA (Building Owners & Managers Association) and the Real Estate Roundtable in their opposition to the legislation and is encouraging its membership to talk to their congressmen and senators, says Jennifer Bonar Gray, vice president-tax of NMHC.

Many congressional staffers are surprised when they’re informed of the negative impact that carried interest legislation is likely to have on multifamily development, says Robert Dietz, tax economist for the National Association of Home Builders.

New allies can also join the fray. The U.S. Conference of Mayors and the National Association of Counties recently came out in favor of retaining the current taxation structure for real estate partnerships.