Taxation of Promote Interests (Carried Interest)
In 2007, the House of Representatives initiated an effort to rein in high-flying hedge fund managers by proposing to eliminate capital gains treatment of carried interest and instead tax it as regular income. 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.
Such a change will adversely affect real estate partnerships—and many of the industry’s 686,000 workers as well as the 17 million American households who rely on our industry to provide them with safe, decent apartment homes. At a time when Harvard University Joint Center for Housing Studies estimates that the nation already faces a three million unit shortage of affordable rental housing, increasing the tax rate on long-term capital gains will discourage real estate partnerships from investing in new construction. Furthermore, such a reduction will translate into fewer construction, maintenance, on-site employee and service provider jobs at a time when our economy is struggling under the weight of an abnormally high unemployment rate.
A “carried interest,” also called a “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 they take. Such risks include responsibility for recourse debt, litigation risks and cost overruns, to name a few.
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 beyond exacerbating the nation’s affordable housing shortage. If enacted, changes in the taxation of carried interest 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, in 2010, both the U.S. Conference of Mayors and the National Association of Counties passed resolutions opposing this proposal as it relates to real estate partnerships and urged Congress to maintain the current law-capital gains treatment of “carried interest,” 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 to the alternative minimum tax or tax reform more generally. Enacting a bad tax law, such as changing the taxation of carried interest, merely to gain revenue to make other tax changes, is a distorted view of tax policy, which demands that each tax proposal be judged on its individual merits.
NMHC/NAA strongly oppose proposals to treat carried interest as ordinary income instead of as a capital gain. Carried interest has been a fundamental part of real estate investment partnerships for decades and represents 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 interest.
Policymakers have considered legislation to change the tax treatment of carried interest since 2007, but despite passing the House in 2010, the proposal never made it through the Senate. Modifications to carried interest, however, could be on the table in the future in one of several ways. First and foremost, President Obama continues to offer the proposal as a way to fund the cost of other initiatives, meaning it could reemerge as part of deficit reduction and talk reform talks during either the lame duck session of Congress or in early 2013. Second, it is noteworthy that at 15 percent, capital gains tax rates are at historic lows. Should Congress fail to extend the 15 percent tax rate on capital gains, which is set to expire at the end of 2012, capital gains and carried interest would be taxed at 20 percent. Furthermore, in the longer term, there is a material possibility that Congress could consider tax reform proposals that may result in higher capital gains tax rates and perhaps a capital gains tax rate that is set equal to the top rate on ordinary income. Should Congress conform rates on capital gains and ordinary income, carried interest would effectively be taken off the table as an issue, albeit in a manner that does not single out the real estate industry. At this point, NMHC/NAA are working to ensure policymakers understand the devastating and disproportionate impact that any modification to the tax treatment of carried interest would have on multifamily housing.
Last Updated: November 2012
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