Important Real Estate Interests Getting Carried Away

As the real estate industry struggles to find firm ground amidst the uncertainty of the economy, it is about to be dealt another blow. An important tax incentive is being threatened which will put more negative pressure on real estate values.

The House of Representatives passed H.R. 4213, the “American Jobs and Closing Tax Loopholes Act of 2010” (the “Bill”), on Friday, May 28, 2010. The Senate is expected to vote on a similar or identical version of the Bill.

One of the issues at stake is known as “carried interest,” which is the incentive that private real estate investment managers, developers, sponsors, or other service partners receive as part of their compensation package for overseeing a property owned by private real estate partnerships.

The current law allows these managers to pay tax on their carried interest income at the 15 percent capital gains rate, rather than the tax rate associated with ordinary income which could be as high as 35 percent for high-income individuals. The 15 percent rate will rise to 20 percent next year when the Bush administration’s tax cuts expire. The House measure would subject 75 percent of carried interest to the regular personal income tax rate, which will rise to 39.6 percent next year, from the current 35 percent. The bill would create an effective tax rate of 38.5 percent, including a 3.8 percent self-employment tax, in 2013. With no tax change, the effective tax rate would be 23.8 percent, including the self-employment tax in 2013. That compares with a current total rate of 18.8 percent.

There are many negative consequences for the real estate industry. It would more than double the effective tax rate for managers, which could reduce the amount of private equity that would normally fund real estate transactions. This would devalue real estate as an investment vehicle, causing a ripple effect in the economy. The potential risks would be loss of jobs, fewer new developments and an increase in default rates on commercial mortgages. Neighborhoods would suffer as there would be little incentive to build or invest new capital. The result would be the opposite of what the bill was supposed to accomplish. Tax revenues would actually decline dramatically as investors moved their equity out of real estate and into other investment vehicles.

Anyone familiar with the real estate bust of 1986-1990’s, will recall that the elements that contributed to the decline of the real estate market were not, all market driven, but mostly government related.

In January of 1986, Congress put into effect changes in the tax laws that altered real estate investing overnight. The Tax Reform Act of 1986 eliminated many of the tax advantages of traditional ownership and syndication. What followed was a tumbling of values which rippled through the real estate industry with devastating consequences.  A record number of foreclosures took place, straining banks and bankrupting scores of investors.

The Tax Reform Act of 1986 crippled the real estate industry. It increased the capital gains tax rate from 20 percent to 33 percent. The passive loss limitation restricted the deduction of real estate losses against regular income. A longer tax write-off period for depreciating real estate from 19 years to 31.5 years was enforced and the 175 percent declining balance write-off method was eliminated.

These changes contributed to the deterioration of the industry by ending the incentives that made real estate an attractive investment. These changes resulted in decreasing the value of real estate and caused the market to decline.

Once again, tax reform is high on the government’s list of priorities. It is critical for real estate professionals to understand how it can affect the ownership of real estate. While radical changes would be catastrophic, any change could cause a ripple effect that would unsettle the delicate balance between boom and bust.

The focus of any change in the current tax system must be to not discriminate against real estate investing and ownership. In addition, whatever changes do take place must come with an extensive transition period to take into account that real estate is not a liquid asset. Any thing that might affect its values must come with ample timing to protect the value and not tip the market further into further decline.

Any potential changes could diminish values and lead to catastrophic consequences. The mere discussion of possible modifications are already causing skittishness in the marketplace. The recovery of the real estate market would be unpredictable. It would be too late to shift investment dollars to other assets classes without an impending loss in values. There would be a halt of cash flow to real estate, causing values to be more depressed.

We must mobilize now, to halt the most certain demise for the real estate market.

(Adelaide Polsinelli is a 25-year investment sales specialist. She is the associate vice president of investments at Marcus & Millichap Real Estate Investment. She can be contacted at [email protected])