As lawmakers in Washington mull legislation that will affect the tax treatment of carried interest, a standard form of compensation for general partners in limited partnerships and limited liability corporations, commercial real estate pros are debating whether the legislation makes sense and how much of an impact it will have, should it come to pass.
The proposed legislation would treat part or all of a partnership’s carried interest as regular income, as opposed to a capital gain. The legislation is primarily aimed at private equity funds and venture capitalists, but would have a huge knock-on effect on commercial real estate since many property investments are structured as LPs and LLCs. Carried interest is the portion of the venture profits paid to general partners of such structures after the property has been sold, separate from the fees the general partners earn for managing the property.
For example, if the partnership buys a regional mall for $100 million in 2010 and sells it for $130 million in 2017, the general partners would get a share of the $30 million upside, which would then be taxed as carried interest.
If the legislation passes, the tax rate on carried interest would rise from the current 15 percent to 35 percent—the current highest income tax rate. However, should President Obama go through with the plan to let Bush-era tax cuts expire in 2011, the tax rate would be even higher—39.6 percent. Many industry trade groups, including ICSC, have made the case that higher taxes on carried interest would make real estate transactions less attractive and derail the nascent recovery in the commercial real estate market.
But brokers, tax lawyers and economists say that while the legislation will alter investments in real estate partnerships, it will not have an Armageddon-like effect on the industry as a whole.
“Partnerships, historically, have invested significantly in real estate and it certainly has the potential to impact the flow of capital into real estate through partnerships,” says Sam Chandan, global chief economist and executive vice president with Real Capital Analytics, a New York City-based research firm. “But these partnerships are one contributor to overall investment. There are certainly other channels through which we would see private funds being invested in real estate.”
While many industry insiders are against the tax increase in principal because they say it would disrupt investment both in real estate and in the overall economy, they feel the trade groups might be overstating the danger. The bill, HR 4213, the “American Jobs and Closing Tax Loopholes Act”, passed the House of Representatives in mid May. The expectation is that the Senate will consider the legislation in the coming weeks with the goal of getting a final bill to President Obama’s desk before July 4. By that time, the wording of the law may yet change many times, says Gary Kaplan, a partner with Greenberg Glusker, a Los Angeles-based law firm. Senators are reportedly discussing limiting the carried interest tax rate for assets held longer than seven years to 31 percent. Assets held for a shorter period would be taxed at 33 percent.
Even if the bill passes as is, by the time it becomes effective, the commercial real estate market should be back to a normal level of activity, adds Hessam Nadji, managing director of research services with Marcus & Millichap Real Estate Investment Services, an Encino, Calif.-based brokerage firm. If the legislation is passed, it would be applicable starting in 2011. But industry sources say it will be at least until 2012 or 2013 before the Internal Revenue Service will be able to adapt the measure and start applying it in real life. If that is indeed the case, the industry will have some time to continue its recovery and adjust for the law’s enactment.
In addition, commercial real estate professionals have historically been adept at finding new ways to structure deals when old ones cease to work, Nadji says. One potential alternative to a limited partnership, according to Kaplan, would be a so-called subchapter S corporation, which has only a limited number of shareholders.
Subchapter S corporations do not pay federal income taxes. Instead, the income earned by the corporation gets divided among its shareholders based on their share in the corporation and the shareholders are taxed through their personal income tax returns. The general partner in a Subchapter S corporation gets a share of the stock and, by extension, a share of the profits. The reason such structure have not been used much in real estate is because they are less flexible than limited partnerships. For example, losses that are greater than the original investment in the corporation cannot be deducted.
That’s not to say that the legislation, in its current form, won’t have an impact on investment in real estate, especially on the smaller deals, Nadji and others note. General partners in real estate partnerships, unlike those in deals involving hedge funds and private equity firms, focus on long-term returns and have to put in a significant amount of work to deliver results on strategies such as redevelopment. In the past two years, as real estate investment became more risky, many newly formed partnerships have eliminated property acquisition and disposition fees that have historically been paid to real estate fund managers, says Jeff Hanson, president and CEO of Grubb & Ellis Equity Advisors, Grubb & Ellis’ investment subsidiary.
Fund managers still get asset management fees, but those tend to be just small enough to allow the managers to break even. At the current moment, most of their returns come in the form of carried interest, according to Hanson. In his view, if the government starts taxing carried interest at 39.6 percent instead of 15 percent, it will take away the incentive for many managers to participate in new transactions.
“On a carried interest basis, the day you close the deal your interest is valued at zero until you do something for the property that’s going to turn a profit in the future,” says Rich Walter, president of Faris Lee Investments. “Many of these deals don’t work out. [If the legislation passes], potentially the economics of those deals will change.”
This will be particularly true for deals under $5 million, which won’t have economies of scale to justify the higher transaction costs, according to Nadji. But the legislation will also affect institutional players who often form joint ventures with private capital and venture capital outside the real estate sector. That will be detrimental to the economy since venture capital often funds new businesses and spurs innovation.
“It will mean lower returns” across the board, Nadji says.