Carried Interest Taxation
Updated: June 8, 2009
The Issue · Position · Talking Points · Legislation · Resources
The Issue
President Obama’s budget plan contains a proposal to increase the taxation of carried interests from the current capital gains rate of 15% to much higher ordinary income rates, currently as high as 35%. Earlier attempts to eliminate capital gains treatment for carried interest were originally directed at private equity and hedge fund managers, whose large compensation packages had garnered unfavorable media attention. However, the proposed changes would affect all partnerships and thus have a disproportionate impact upon in real estate partnerships, which comprise over 46% of all partnerships. Because taxation of limited liability companies (LLCs) is governed by the same provisions of the tax code, the tax increase would also apply to LLCs.
A “carried interest” (also known as a “promoted interest”, “promote”, or a “carry”) , is a financial interest in the future appreciation of a real estate development project often given by limited partners (LPs) to the general partner (GP) in the venture. Partnerships are widely 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. In addition to the fees paid to a GP for services such as leasing and project management, the LPs, who are the investors in a real estate partnership, will often give the GP in charge of overall management an interest in the future appreciation of the project. This “carried interest” 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 risks taken during development of the project and during the period prior to a disposition of the property. These risks include, among others, partnership liabilities for environmental contamination as well as lawsuits. The fee income the GP receives for services is 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.
In June of 2007, Representative Sander Levin (D-MI), a senior member of the House Ways and Means Committee, introduced H.R 2834 to change the treatment of carried interest compensation, taxing it at ordinary income rates instead of at capital gains rates. The legislation became part of larger tax bills and was passed twice by the House of Representatives, before failing in the Senate under threat of a veto by President Bush. As a candidate, Barack Obama supported increasing the tax rate on carried interest, and included the provision among his budget proposals to Congress sent in February 2009. The White House proposal is estimated to raise approximately $23.9 billion over ten years and would take effect beginning in 2011. Shortly thereafter, on April 3, Sander Levin reintroduced legislation to change the tax treatment of carried interest to ordinary income from capital gains (H.R. 1935).
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
- Carried interest is compensation given by investors to a general partner for the entrepreneurial risk taken by that partner. The carried interest is contingent upon the ultimate success of the project, oftentimes cannot be valued at the time it is granted, and is not guaranteed income to the general partner. Therefore, it is not like salary as some have claimed, but more in the nature of a long-term risk investment that should treated as capital gains.
- A general partner is at risk for more than capital contributions made to the partnership, which is the risk taken by the limited partners. 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.
- 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.
- 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.
- 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.
Legislation
Resources
Contact:
Aquiles F. Suarez
Vice President for Government Affairs
(703) 904-7100 ext. 115
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