Carried Interest Taxation

A "carried interest", also known as a "promoted interest" or a "promote" in the real estate industry, is a financial interest in the long-term capital gain of a development given to a general partner (GP), usually the developer, by the limited partners (LPs), the investors in the partnership. It is paid if the property is sold at a profit that exceeds the agreed upon returns to the investors, and is designed to give the developer a stake in the venture's ultimate success. This serves to align the interests of the GP with the investors by allowing the GP to share in the "upside" of the real estate venture, and to compensate the GP for the substantial risks taken during development of the project and during the period prior to sale of the property. Carried interest has traditionally been treated as capital gains income taxed at favorable capital gains rates.

The
Issue

A "carried interest", also known as a "promoted interest" or a "promote" in the real estate industry, is a financial interest in the long-term capital gain of a development given to a general partner (GP), usually the developer, by the limited partners (LPs), the investors in the partnership. It is paid if the property is sold at a profit that exceeds the agreed upon returns to the investors, and is designed to give the developer a stake in the venture's ultimate success. This serves to align the interests of the GP with the investors by allowing the GP to share in the "upside" of the real estate venture, and to compensate the GP for the substantial risks taken during development of the project and during the period prior to sale of the property. Carried interest has traditionally been treated as capital gains income taxed at favorable capital gains rates.

Beginning in 2008 and continuing over the last several years, there have been efforts in Congress to change the tax treatment of carried interest from capital gains to ordinary income.  Supporters of the legislation described it as eliminating a loophole used by Wall Street private equity and hedge fund managers to avoid taxes.  However, the proposed partnership tax law change would disproportionately impact the real estate industry since real estate partnerships comprise over 46 percent of all partnerships and many use a carried interest component in structuring development ventures. The legislation would have more than doubled the tax rate on real estate partnership carried interest, from what was then a capital gains tax rate of 15% to nearly 35% in ordinary income rates.  The Obama Administration strongly backed the efforts, and the carried interest tax hike passed the House of Representatives on three different occasions, but ultimately was defeated in the Senate. 

Position

NAIOP opposes a tax increase on "carried interest" from capital gains rates to ordinary income rates that is intended solely as a revenue-raising measure or as a punitive attack on certain industries.   The proposal ignores the very real risks undertaken by general partners in real estate development, and treats carried interest income as if it were guaranteed salary.  Reducing incentives for entrepreneurs to undertake the risks inherent in development would have a pronounced negative impact on the real estate industry, and would lessen the flow of investment capital to the real estate industry.  Any such fundamental change to partnership law should only be undertaken in the context of overall comprehensive tax reform where the total impact of changes on commercial real estate can be balanced.

Status

A change in the character of carried interest compensation from capital gains to ordinary income was not included in the legislation signed by President Obama on January 2, 2013, which avoided the major impact of the so-called “fiscal cliff.” However, capital gains tax rates were increased from 15% to 20% for certain taxpayers, resulting in an increase in carried interest as in other capital gains income.  Supporters of eliminating capital gains treatment for carried interest intend to pursue the effort in the 113th Congress in connection with any deficit reduction measures. 

Talking
Points

  • Return for Risk: a carried interest is given by the limited partners in a real estate partnership to the general partner (usually the developer) in return for the risks taken by that partner during the project. A general partner will often personally guarantee construction completion of the project, as well as payment of all debts of the partnership. In addition, the general partner is at risk for all partnership liabilities such as environmental contamination and other lawsuits.
  • Not Guaranteed Income: carried interest is not guaranteed salary income to the general partner. Fees for services received by the general partner are already taxed as ordinary income. A carried interest oftentimes cannot even be valued at the time it is granted since its payment is contingent upon the ultimate success of the project. This makes it more in the nature of a long-term risk investment that should treated as capital gains.
  • Creation of Capital Assets: real estate development, unlike other industries where carried interests are used, results in the creation of a tangible, capital asset - a shopping mall in a community, an office building, a housing project, or an industrial development. The carried interest is given for the risks taken in the creation of this capital asset, which also gives rise to jobs and results in an increased tax base for the community. To increase the tax on carried interest for all partnerships, without regard to the underlying investment or its impact upon a community, would be shortsighted.
  • Undermines economic activity and job creation: a tax increase on carried interest would undermine entrepreneurial activity in the real estate development industry, and in other areas of the economy where risk-taking is needed. If the willingness to take development risk is reduced by much higher taxes on the ultimate return, then many job-creating development projects will simply not be undertaken.
  • Decreases investment in real estate: increasing the tax rate on carried interest for real estate partnerships would adversely impact the flow of capital to real estate deals. Such a move would disrupt the investment relationship between entrepreneurs and their capital finance partners. If such a change were to take place, many general partners would demand a different compensation structure at the beginning in order to justify undertaking the risks of development, thereby making the investment less attractive to investors.
  • Retroactive: the carried interest provision does not contained transition rules but rather represents a retroactive tax increase that applies to any structures that have a carried interest or promoted interest component.