My colleague, Paul Comeaux, prepared the following brief Q&A about pending changes to the way "carried interest" is taxed. I thought it was worth sharing:
Q. What is the issue?
A. Congress is considering passing a law changing the way that “carried interests” are taxed.
Q. What is a “carried interest”?
A. A “carried interest” is the share of profits from a successful partnership that is paid to the partnership’s manager. It is money the manager gets not as a return on money invested, but rather based on the profitability of the partnership.
Q. Who is the main target of this potential change in the tax law?
A. Managers of hedge funds. Managers of hedge funds typically get paid a percentage of the profits that they earn for investors. (Usually 20%.) Right now, this profit generally is taxed at capital gains rates. The expected legislation would change this—profits paid to the managers will be taxed at ordinary income rates.
Q. Why do we care?
A. The change in tax law could hit real estate partnerships. For example, say Alfie wants to buy an old shopping center, lease it up, and sell it. He finds an investor who will put up the money—Alfie is bringing his real estate expertise, but no money. He tells the investor, “When we start making money, you’ll get your money back first, with a preferred return. Then, we split profits after that 50/50.” Right now, Alfie’s profit generally is taxed as capital gains. If the expected legislation passes, Alfie’s profits would be taxed as ordinary income.
Q. Can we see the current bill? Will real estate partnerships be carved out?
A. There is no final version of a bill to look at. This legislation will likely be added to the tax extender bill. Nobody knows if there will be carveouts or compromises for real estate transaction.
Q. When will this be up for a vote?
A. Possibly before the end of this month.
Q. Is the real estate industry concerned?
A. Yes. According to a recent alert sent by the International Council of Shopping Centers to its members:
- This proposal would be the largest tax increase on real estate since the 1986 Tax Reform Act.
- Commercial real estate has been unfairly swept up in this carried interest campaign. We were not the intended target. It was introduced to curb the excesses and abuses of the hedge funds.
- Unlike hedge fund and private equity firms, commercial real estate uses carried interest as the return for taking on the tremendous risks and liabilities associated with real estate development projects, such as environmental concerns, lawsuits, operational shortfalls, construction delays and loan guaranties.
- If the carried interest provision is retroactive like the House version, the change in tax treatment would effectively devalue all existing properties that are held by partnerships. A sudden devaluation is exactly what happened in the Tax Reform Act of 1986, which caused the meltdown in commercial real estate shortly after that legislation took effect.
- Hedge funds can move their investment vehicles off shore. Commercial real estate developers in your state can't move their investment off shore because real estate is local.
The ICSC offers more information on this issue at http://www.icsc.org/government/news_events.php |