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.
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.
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.