No stone unturned

For the third time in three years, legislation to change current tax law governing treatment of carried interest in investment partnerships has reared its head.

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Reintroduced by Rep. Sander Levin (D-Mich.) on April 3, H.R.1935 targets the taxation of capital gains earned by hedge funds, private equity firms and venture capitalists. But, by its very nature, the proposal draws in multifamily developers’ so-called “promote fee,” or interest in the long-term capital gains of a real estate partnership that is earned when the partnership sells a property. The promote fee is an important component of real estate development partnerships and integral to how the country’s rental housing is created.

Under current proposed legislation, carried interest would be characterized as ordinary income and taxed at 35 percent (expected to rise to 39.6 percent by 2011), rather than at the current capital gains tax rate of 15 percent. It also would become subject to self- employment taxes — generally an additional 2.9 percent tax.

The NMHC successfully fended off previous attempts to change the law governing treatment of carried interest, including a bill introduced by Levin and Rep. Barney Frank (D-Mass.) in 2007 that passed the House as part of a larger tax package, but ultimately failed to make it through the Senate.

Another form of the carried interest tax change appeared the following year in the Alternative Minimum Tax Relief Act of 2008 (AMT), led by Ways and Means Committee Chairman Charles Rangel (D-NY), that gave temporary relief from the AMT and provided some mortgage debt provisions.

Thanks to the efforts of multifamily industry lobbyists, opposition from the Bush administration and a bi-partisan group of senators, the final AMT bill was enacted into law without the carried interest proposal.

This time around, the Obama administration has added fuel to the fire by including an even broader proposal to change the tax treatment of a profits interest in most partnerships in the President’s “Green Book”

FY10 budget recommendations and is pushing for those changes to go into effect in 2011. As written, Obama’s proposal would have an almost identically negative impact on the apartment industry as previously blocked versions, but will also have a significantly broader scope than the House bill because it would affect almost every other industry in which partnership structures are commonly used, says the NMHC.

The bad and the ugly
One of the more onerous aspects of the current version of the bill includes potentially subjecting the general partner’s heirs to both income and estate taxes if the carried interest is held by the general partner until death, because any unrealized carry, or promote, could possibly be considered “income in respect to a decedent” (IRD). With the potential for combined income and estate taxes to claim more than 100 percent of the value of inherited partnership interests, the impact on the industry could be profound if this IRD issue is not addressed in future versions of the proposal. In addition, the proposed tax change imposes strict liability penalties of 40 percent, if carried interest is under reported to the IRS.

The NMHC likens the bill’s potential impact on the multifamily industry to that of the 1986 Tax Reform Act. It would impose a multi- billion dollar tax increase on real estate, at a time when the industry is already experiencing a severe downturn. A tax increase on real estate entrepreneurs across the country of more than 133 percent would have a devastating impact on jobs, economic growth and the tax base. It would affect the pricing of all development transactions which, in turn, would have negative implications for capital flowing into real estate development. Some industry watchers estimate apartment development nationally could contract by one third, if the proposed legislation is implemented.

The changes also could reduce the appeal of real estate careers among people coming out of school, who could decide the potential return for general partners isn’t going to be significant enough for them to undertake the risks, while providing the limited partners with the level of returns that they need.

“Remember, the limited partners aren’t just looking at whether they’re going to invest in real estate deal A versus real estate deal B. A lot of times they are institutional investors looking at a number of investment options. If, because of the carried interest impact on the real estate deals that are out there, they find that they can’t get the levels of return they need from real estate, they may decide not to invest in real estate at all and, instead, go to other alternative investments.” said Jennifer Bonar Gray, vice president of tax for the National Multi Housing Council in Washington, D.C.

“One of my members did an analysis that showed he would need to receive, in order to come out on an equal level after taxes if this legislation passed, eight percent more in the promote just to break even. Obviously that eight percent has to come from somewhere because there’s only so much profit in a deal. So the limited partners may have to give up more of their profits. Again, this raises concerns, because they also need a certain level of return and might turn to another investment that provides it. The other option they might look at to get more returns from the deal would be to increase rents.

However, there is only so much rent increase that the market can absorb, so that is not always an option and, to the extent it is an option, obviously raises concerns for affordable housing,” she said.

Workforce housing on the horizon
In fact, exacerbation of the nation’s shortage of affordable housing is a likely unintended and troubling consequence of the legislation, says the multifamily lobbying group. “There already is a lack of affordable housing in this country that goes beyond Section 42 and Section 8,” said Gray.

“I’m talking about workforce housing — the challenge of finding housing in high-cost urban environments that a typical teacher or middle- income, blue-collar family can afford. One thing our industry is very concerned with is making sure those teachers and police officers can afford to live where they work. The last thing we need to do is force those workers who are so essential to communities to live two hours away and have to commute to the cities where they work.

“So that’s always a challenge. Obviously, there is a lot of competition for land and land prices are high, so developing housing where you can have the rents at a level that are affordable to those type of folks can be difficult. This proposed tax change will exacerbate that problem,” the multifamily tax expert said.

Unfair assumptions
“The Levin bill from 2007 and the new Levin bill from this year seem to be focused on a perceived fairness issue. If you read some of the documentation that Mr. Levin has put out, it really focuses on hedge fund managers and those types of folks and whether or not they’re paying the proper tax rate for the services they provide and the work they do,” said Gray.

How the real estate promote fee got lumped together with the carried interest paid to hedge fund managers in the proposed tax bill and looked at as a fee for services is a question NMHC lobbyists pose to legislators on Capitol Hill.

“They really are two separate issues and we want to assert this position of how real estate partnership interests should be taxed. We believe there is a misunderstanding of how the promote is used in real estate and how these real estate investments actually take place, such as the fact that they are very long term. Some don’t actually take place for years and others are decades long. I have a member whose deals would potentially be impacted by this and these were deals he went into literally decades ago — in the 1980s,” said Gray.

Risk versus compensation
In real estate partnerships, the general partners receive two kinds of income. One is a fee for development and/or management services, which rightfully are taxed as ordinary income, says the NMHC. The carry, or promote, is a share of the capital gains from the successful sale of a property and is payment for the developer’s investments in the project and entrepreneurial efforts. Currently, these capital gains are properly taxed at capital gains rates to both the general partner and the limited partners. This proposal would result in a bifurcation of that tax treatment by treating the exact same income as ordinary income to the general partner, but still as capital gains income to the limited partner, Gray said.

“Certainly there are some on the Hill who look at the promote as a fee for services performed and we think that shows a misunderstanding of how the promote structure is used in the real estate industry. The reason the limited partners are willing to provide the promote return to the general partners is in recognition of the risk that the general partners take that the limited partners are unable or unwilling to assume themselves,” said Gray.

Those risks include pre-construction funding, guaranteeing the construction budget and assumption of environmental risks. At the point when the general partners bring in the limited partners, generally the deal is baked and ready to go after receipt of the capital infusion. In many cases, the general partner will go after two or three deals and only have one that moves forward and that’s the type of risk taking and shouldering of upfront expenses that a limited partner just isn’t equipped to do, said Gray.

The NMHC is gathering data to provide analyses of how vital the promote structure is to apartment development across the country. A look at the apartments that went online in 2008 in Los Angeles County reveals that more than half of the apartments delivered last year were done using a promote structure.

“We are extremely active on the issue on the Hill. Additionally, we are beginning to see a heightened degree of interest from local governments that are beginning to understand the impact legislation like this could have on development and housing in their communities and on their tax base. To the extent there is less development, there is less tax base, and a lot of cities and local governments already are facing extreme budget challenges. When they look forward they can see the proposed federal tax change making their local problems worse,” said Gray.

Some in Congress are viewing the tax revenue generated by the carried interest proposal as a way to offset the cost of other tax changes, for instance, changes to the alternative minimum tax, as well as other costly legislation like healthcare reform. “So far there is no indication that the proposed carried interest tax change would be tacked on to a healthcare bill, although we continue to watch that debate closely. Tax bills rarely move as independent legislation in Congress. They tend to be grouped together into larger tax bills. The Levin bill passed the House in both 2007 and 2008 and, in both instances, it was part of a larger tax package — basically, it was used as a way to raise taxes to offset other tax provisions that lowered revenue. So our anticipation is that if this were to move this year or next, it would be part of a larger tax legislation package. At this time, however, it’s unclear as to when there might be a piece of tax legislation that moves that they may, or may not, want to attach this to,” said Gray.

The NMHC, however, is taking this legislation very seriously and calling for an immediate grassroots effort to educate Senate and House members about the bill’s potential adverse impact and to help them understand why the promote in a real estate transaction is a return for assumed risk rather than compensation for services rendered.