Taxation of Promote Interests (Carried Interest)

 Taxation of Carried Interest
Background     NMHC/NAA Position     Current Status 

Background

In 2007, the House of Representatives initiated an effort to rein in the high-flying hedge fund managers by proposing to eliminate capital gains treatment of carried interest and taxing it as regular income instead.  However, the reach of this proposal goes much further and, if enacted, will significantly reduce the ability to develop or rehab apartments across the nation.

Real estate partnerships—and many of the 550,000 workers and 16 million Americans who rely on our industry to provide them with safe, decent affordable housing—will be very adversely affected by such a change. Some estimates indicated that approximately one-quarter of the legislation’s impact would have been on the real estate industry alone.

A “carried interest” (or “promote”) has been a fundamental part of real estate partnerships for decades.  Investing partners grant this interest to the general partners to recognize the value these partners bring to the venture as well as the risks (recourse debt, litigation risks, responsibilities for cost overruns, etc.) they take. 

Current tax law, which treats carried interest as a capital gain, is the proper treatment of this income because carried interest represents a return on an underlying long-term capital asset, as well as risk and entrepreneurial activity.  Extending ordinary income treatment to this revenue is inappropriate.  In addition, any fees that a general partner receives that represent payment for operations and management activities are already properly taxed as ordinary income. 

The proposed change in the taxation of carried interest would impose the most sweeping and potentially most disruptive new tax on real estate since the Tax Reform Act of 1986, which contained the passive loss limitation rules. 

Not only is such a tax law change inappropriate, it will also have numerous unintended consequences, including exacerbating the nation’s affordable housing shortage.  If enacted, changes in the taxation of carried interests could affect whether a new development is financially viable.  It will be particularly damaging to properties located in under-developed areas and could prevent much of the proposed new affordable housing from being built. 

For these reasons, both the U.S. Conference of Mayors and the National Association of Counties have passed resolutions urging Congress to maintain the current law-capital gains treatment of “carried interest” used by real estate partnerships, noting that any change would bring extremely negative consequences to "main streets" throughout the country.

Finally, some in Congress see the tax revenue generated by the carried interest proposal as a way to offset the cost of other tax changes, such as changes in the alternative minimum tax.  Enacting a bad tax law, such as carried interest, merely to gain revenue to make other tax changes, is not an appropriate view of tax policy, which demands that each tax proposal be judged on its individual merits.

NMHC/NAA Position

NMHC/NAA strongly oppose proposals to change the current law governing the tax treatment of carried interests. A carried interest or "promote,” which has been a fundamental part of real estate investment partnerships for decades, is an interest in the long-term capital gain of the partnership when it sells its property. Investing partners grant this interest to the general partners as an incentive for increasing the value of the underlying asset. The distribution of funds when a partnership is terminated come from the sale of capital assets, making capital gains, which recognizes the long-term nature of real estate investing, the proper tax treatment for carried interests.   

Current Status

Senate leaders have tabled, for now, a bill extending several popular tax credits (including some of interest to apartment firms) that is partially paid for by increasing the tax rate on "carried interest" or a developer's "promote." The House passed its tax extenders bill (H.R 4123), with a carried interest tax increase, in late May.

On June 24, the Senate failed for a third time to secure the 60 votes needed to move the measure forward even after scaling the package down from adding roughly $100 billion to the deficit to just $35 billion.   As part of those changes, Senator Max Baucus (D-MT) twice modified the carried interest proposal to try to make it more palatable to real estate partnerships.

The latest Senate iteration would have taxed 75% of a carried interest at ordinary income rates and 25% at capital gains rates as of 2011.  A carried interest attributable to assets held for at least five years would have been taxed at a 50-50 split.  The language was also modified to exempt family partnerships who allocate carried interests on a pro-rata basis from the tax law change.  Those partnerships would have continued to be taxed at capital gains levels. 

Under the House bill, effective January 1, 2011, 50 percent of a carried interest will be taxed at ordinary rates and 50 percent will be taxed at capital gains rates.  After January 1, 2013, 75 percent of carried interest would be taxed at ordinary income tax rates, and 25 percent at capital gains rates.  Both House and Senate bills would be imposed on all existing and new partnerships.  The bill also subjects carried interest to the self-employment tax. The Joint Committee on Taxation said the change is expected to raise $17.7 billion in new revenues over 10 years.

The tax law change has the support of the Obama Administration, which included a version of the proposal in its FY10 budget recommendations. 

NMHC/NAA remain vigilant as the Senate could take up the extenders bill again in the fall, and carried interest remains a possible "pay for" for other forthcoming legislation.

Relevant Committees

• Senate Finance
• House Ways and Means
• Joint Committee on Taxation

Key Legislative, Regulatory and Court Action

• Introduced December 7, 2009
• Sponsor: Charles Rangel (D-NY)
• Passed by the House of Representatives on May 28, 2010.

Contact Information

Matthew Berger
Vice President of Tax
NMHC/NAA Joint Legislative Program
202/974-2362
mberger@nmhc.org 

Last Updated:  June 2010