Keep your eyes on the Congressional proposal to increase taxes on partnerships commonly used by private-equity and hedge-fund firms. Legislators are positioning the increase as a way to ensure fairness by making the rich moguls of Wall Street pay more taxes. But because the proposal would also tax real estate partnerships, industry advocates say it could also quash the entrepreneurial spirit that drives the real estate industry.

In late June, U.S. Rep. Sander Levin (D-MI) introduced a bill that would treat income received by partners for performing investment management services as ordinary income.

Current rules allow certain partnership profits, called carried interest, to be taxed at the capital gains rate of 15%. Under the proposal, carried interest would be taxed as ordinary income, increasing the rate to as much as 35%.

To understand what's at stake, think of a basic real estate partnership and its general partner who's responsible for managing the partnership for the benefit of all the limited partners. Usually, the general partner is compensated with both fees and a share of the partnership profits. Those profits are typically “carried” with the partnership until the partnership property is sold.

In the proposed legislation, the tax rate on the profits carried with the partnership would increase from the current 15% rate to whatever rate the general partner's ordinary income is taxed. And that could be the maximum rate of 35%.

Industry advocates, however, say carried interest should be taxed at the lower rate to reward general partners for their risk-taking. “This issue is really about entrepreneurship,” says Steve Renna, senior vice president and counsel of the Real Estate Roundtable, a trade group in Washington, D.C.

“General partners take risks, and people who take risks to employ capital and develop it into a productive asset won't do that unless the returns are worth the risks,” continues Renna. “The Levin bills says you can be an entrepreneur, but you're going to get taxed at ordinary income rates because we see you as a service provider. The bottom line is, what's the impact of that on entrepreneurs?”

Real threat or trial balloon?

Real estate groups, private equity firms and hedge funds aren't the only interests voicing opposition to the proposed increase. “We're strongly opposed to the Levin bill because this is the first shot over the bow on capital gains taxes,” says Ashley Miller, a tax lobbyist for the U.S. Chamber of Commerce.

Whether the proposed tax increase is truly a threat or just a trial balloon isn't clear. Levin described it as a way to “raise questions” about the proper tax treatment for carried interest income.

The communications director for the House Ways and Means Committee, Matthew Beck, also paints the bill as a conversation starter. “It's a foundation for discussion on how to construct a fair and equitable tax code,” Beck says. “We're interested in the discussion that'll take place.”

That hedging hasn't placated real estate advocates. “I think it's very serious,” says Renna of the Real Estate Roundtable. “Congressman Levin describes this bill as an idea we need to explore in Congress, so call it a trial balloon, but sometimes trial balloons gain a little altitude.”

“We look at everything as a possibility,” agrees Mary Trupo, spokesperson for the National Association of Realtors in Washington, D.C. “It could turn out to be the quickest bill ever passed in the history of Congress.”

‘Clumsy’ fix to real problem

There are signs, however, that may not happen. Though the U.S. Senate Finance Committee held a hearing on the proposal on July 31, a hearing in the House that was also scheduled for late July was postponed until September.

“Legislators realized this was moving way too fast and needed to be slowed down,” says Trupo. “We believe Congress stepping back and taking more time to explore the issue is a positive for the real estate industry.”

But Renna says sometimes a delay is just a delay. “The House Ways and Means Committee postponed its hearings, but it's adamant about having them. “I take no comfort that the hearings got pushed off.”

That means Renna will continue to fight the legislation, though he admits that protecting real estate partnerships when they're yoked to ostentatiously wealthy Wall Street dealmakers makes his job more challenging.

“This isn't about kittens and puppies,” Renna concludes. “Private equity and hedge funds have an image problem. Some have chosen to display their wealth in very extravagant ways. That's drawn the attention of lawmakers. A legitimate issue is being raised, but Congress isn't proposing taxing an industry but a component of partnership that's used by many different industries. It's handling this issue in a very clumsy way and using a not very well-reasoned approach.”

G.M. Filisko is a reporter and attorney based in Chicago who writes regularly on legal and real estate issues. She can be contacted at gabifil@rcn.com.