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. The “carried interest” is 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. It also serves 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.

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. The “carried interest” is 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. It also serves 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.

Efforts to change the taxation of carried interest began in 2008. Supporters of legislation to tax carried interests at ordinary income rates described it as eliminating a loophole used by Wall Street private equity and hedge fund managers to avoid taxes. However, the change would also disproportionately impact the real estate industry since real estate partnerships comprise a large number of partnerships and many use a carried interest component in structuring development ventures.

In order to address concerns regarding hedge funds characterizing service income (taxed as ordinary income rates) as carried interests (taxed at lower capital gains rates), the Tax Cuts and Jobs Act of 2017 imposed a three-year holding period before a carried interest could be afforded tax treatment as a capital gain. Despite this change, H.R. 1068, “The Carried Interest Fairness Act of 2021” has been introduced in Congress to eliminate capital gains tax treatment for carried interests. The Biden Administration has also included a provision to eliminate capital gains treatment for carried interests in its American Families Plan, presented to Congress on May 28, 2021.

Position

NAIOP opposes a change in the tax treatment of carried interest that would result in an increase in tax rates from capital gains to ordinary income rates. These proposals ignore the changes already made in law requiring a three-year holding period for carried interests to be afforded capital gains tax treatment.

Status

Carried interest taxation is a part of the current congressional debate over President Biden’s “American Families Plan” proposal debate.

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: 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.

Resources

June 29, 2021 Real Estate Industry Letter on Carried Interest 

H.R.1068 - Carried Interest Fairness Act of 2021

Tax Cuts and Jobs Act

July 2011 Carried Interest Advertisement

May 19, 2010 Industry Letter to Congress

October 16, 2009 Industry Letter to All Members of the U.S. House of Representatives opposing a carried interest tax increase

Industry Advertisement in Roll Call opposing carried interest tax increase

Contact

Aquiles Suarez
Senior Vice President for Government Affairs
703-904-7100, ext. 115