Carried Interest Taxation
Updated: January 11, 2010
The Issue · Position · Talking Points · Legislation · Resources
The Issue
On December 9, 2009, as part of legislation extending expiring tax provisions, the House of Representatives passed a provision to change the tax treatment of partnership carried interest from capital gains to ordinary income. If signed into law, this would result in a tax increase from the current capital gains tax rate of 15 percent to ordinary income rates as high as 35 percent on many real estate development partnerships and limited liability companies (LLCs) that utilize carried interest.
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. These risks include, among others, liability for debts of the partnership, partnership liabilities for environmental contamination, and liability for lawsuits.
Partnerships are the dominant business model used in real estate ventures, in great part because that structure provides flexibility in allocating the risks and potential rewards of a real estate deal, and carried and promoted interests have been a feature of the real estate development industry for decades. Many times in real estate development partnerships, the GP is also paid fees for performing services, which are taxed as ordinary income. The carried interest, which is given for entrepreneurial risk, is often hard to value at the time granted, and is not guaranteed income to the GP, has traditionally been taxed as a capital gains.
This is the third time a carried interest tax increase has been passed by the House of Representatives, having failed on the two prior occasions to pass the Senate. President Obama's 2010 fiscal budget also includes a similar carried interest tax increase to begin in 2011. The proposal is described by its supporters as intended to eliminate the capital gains treatment for carried interest paid to Wall Street private equity and hedge fund managers. However, the proposed change applies to all partnerships and LLCs and would thus have a disproportionate impact upon in real estate partnerships, which comprise over 46 percent of all partnerships. The sponsors have refused to narrow the proposal to exclude real estate.
The carried interest tax increase was included as a revenue raising measure to offset the costs of extending the expiring tax provisions with broad bipartisan support, including the NAIOP supported provisions for 15-year tenant improvement depreciation and expensing of brownfields remediation. It is estimated to raise $23.4 billion over the next ten years, according to Treasury estimates.
Position
NAIOP strongly opposes a tax increase on "carried interest" from capital gains rates to ordinary income rates. The proposal ignores the risks undertaken by general partners in real estate development, and treats carried interest compensation as if it were guaranteed income that is more like salary. By reducing the incentives for entrepreneurs to take the risks inherent in development projects, the change would have a pronounced negative impact on the real estate development industry. Changing the capital gains treatment of carried interest would also lessen the flow of investment capital to the real estate industry, further weakening this sector of our economy.
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 legislation 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.
Legislation
Resources
Contact:
Aquiles F. Suarez
Vice President for Government Affairs
(703) 904-7100 ext. 115
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