There is a major real estate tax battle bubbling and brewing in Washington DC. Some are saying it is as significant as the Tax Reform Act of 1986. If you are not old enough to remember that sweeping legislation, it ushered in a new era of complex tax rules, removing many of the then-sacred tax deductions enjoyed by the average person (back then credit card, car loans, and general consumer debt interest was deductible, just like home loan interest is today), introducing the passive loss limitation rules and other less than friendly tax concepts.
The new battle is over a business concept commonly known as “carried interest”. Many investment vehicles, regardless of industry, include a profit split that allows the promoter of the investment to participate in the profits of the investment. This promotional interest in the investment is referred to as the “carried interest”. It is intended to align the sponsors’ interests with those of the investors by providing a profit participation in the deal. The investment sponsor often receives both fees for services rendered which are taxed at ordinary income rates, and if they have an interest in the “back-end” of the deal or profits, they receive that profit interest as income that is taxed at a capital gain rate.
In 2007 Congress became increasingly alarmed at the apparent unfair tax treatment of the hedge funds and other investment managers who were receiving all of their income from sponsored investments as “carried interest” taxed at the beneficial capital gains rate. Little or none of their fees were packaged as ordinary income. To many, this seemed a fundamentally imbalanced result.
As is typical of Congress however, they never seem to be able to fix an identified problem with the accuracy and precision of a scalpel. The current proposed carried interest fix would impact not only the recognized problem, but all transactions with “carried interest” or promote incentives.
There are fundamental differences between the structure of a real estate investment and investments in other industries. Some real estate transactions need the benefits of the carried interest because of the significant length of time real estate transactions and developments take. Just as capital gains treatment is intended to provide some tax relief for long term investments, the taxation of the carried interest is intended to do the same. For a more complete discussion and history of the legislation, please see the National Multi Housing Council’s “Taxation of Promote Interest” at http://www.nmhc.org/Content/ContentList.cfm?NavID=389.
Various proposals from Congress have languished in committees. President Obama introduced his own carried interest legislation as part of his overall budget proposals. The Real Estate Law Blog reported today:
… both the House Ways and Means Committee and the Senate Finance Committee, along with their respective Chairs, Sander Levin and Max Baucus, have indicated a desire to pass as quickly as possible—but no later than May 31, 2010—a roughly $30 billion tax extenders package. As originally described, the tax extenders package was intended to address numerous areas, including individual tax relief, business tax relief, the extension of numerous expired energy incentives, disaster relief, community assistance, and a handful of miscellaneous provisions. Earlier this week, Rep. Levin announced that lawmakers are close to agreement on a provision that would phase in increased taxation on carried interests. (See http://relaw.typepad.com/real-estate-law-blog/2010/05/more-info-re-pending-carried-interest-legislation.html)
Congress is expected to vote on the proposal early next week. If you are a real estate investor, or ever hope to be one, you should weigh in on this policy changing, and bottom line impacting, legislation. Regardless of how you feel about the underlying issue, a far reaching change of this magnitude seems ill-timed and ill-conceived in light of the current anemic health of real estate and its import to the overall health of the national economy.
If you are an investor or sponsor of investments, what do you think of carried interest? Is it fair and reasonable, or simply a way to avoid taxes for savvy Wall Street investors? Share your thoughts and feelings through Comments.
Want to find out who your Congressional representatives are so you can weigh in?
http://www.congress.org/congressorg/directory/congdir.tt?command=congdir
Additional Resources for “Carried Interest”:
Taxation of Promote Interest
http://www.nmhc.org/Content/ContentList.cfm?NavID=389
Carried Interest Q&A
http://relaw.typepad.com/real-estate-law-blog/2010/05/qa-about-carried-interest.html
Legislation Ending Hedge Fund Managers Carried Interest Failed at Close of 2009
http://www.financialcrisisupdate.com/2010/01/legislation-ending-hedge-fund-managers-carried-interest-failed-at-close-of-2009.html
Monday, May 24, 2010 at 9:38AM 
