Real Estate Groups Warn That Carried Interest Tax Could Harm Recovery

"Opponents Say Commercial Real Estate Investors Will Unfairly Get Lumped In With Hedge Fund Managers Under Tax Changes Awaiting Senate Consideration."


"Legislation changing the tax treatment of so-called carried-interest income by investment partnerships will result in tax hikes that could discourage commercial real estate ventures from making investments -- and possibly put the brakes to a fledgling recovery in real estate, CRE trade groups warned this week.

Invoking the law of unintended consequences, industry leaders said real estate limited-liability corporations (LLCs) and limited partnerships (LPs) would see significant tax increases under the legislation -- even though Congress is mostly targeting hedge funds and private equity funds in trying to cope with a skyrocketing budget deficit and ongoing public chagrin over Wall Street's perceived influence over lawmakers.

In passing the "American Jobs and Closing Tax Loopholes Act" (HR 4213) by a vote of 215-204 on May 28, the House of Representatives adopted the changes on carried interest, the portion of a fund’s investment gains taken as compensation by the fund's managers. The Senate is expected to take up the measure when it returns to session next week.

The bill would change the treatment of carried-interest income, which is currently taxed at the capital gains rate of 15%. Under the new law, carried interest would be treated as a mixture of ordinary income, which can be taxed at a rate of up to 35%, and capital gains.

For three years beginning in 2011, 50% of carried interest would be taxed as capital gain and 50% as ordinary income. After 2013, the percentage of carried interest taxed as capital gains would fall to 25%, with 75% treated as ordinary income.

Opponents did succeed in delaying the date the legislation would take effect until Jan. 1, 2011. And Congress has been down this road before. This is the third time in three years the House has voted to raise the tax, and previous efforts have stalled in the Senate.

The legislation is an attempt to end what proponents in Congress have characterize as a tax break for wealthy executives of hedge funds, private equity funds and venture-capital investment funds, who have allegedly used IRS loopholes to lower their tax liability on tens of billions in investment profits annually.

However, that's not the view of more than a dozen CRE trade groups representing the spectrum of commercial property types. Those groups, which have vigorously lobbied Congress in a coordinated effort to oppose the legislation, include such organizations as NAIOP, The Commercial Real Estate Development Association; the American Hotel & Lodging Association, the American Seniors Housing Association, Building Owners and Managers Association International (BOMA), the CRE Finance Council, the International Council of Shopping Centers (ICSC), the National Multi Housing Council and Real Estate Roundtable.

Opponents argue that the real estate industry, and by extension, the overall economy, will suffer collateral damage in what is essentially a political battle between Congress and Wall Street.

While NAIOP supports Congress in going after fund managers who haven't paid their fair share, changes in tax policy typically apply broadly to legal entities structured as LLCs and LPs, not selectively targeted types of investors, James V. Camp, chairman of legislative affairs for the Southern California chapter of NAIOP, tells the Advisor.

"We wanted them to go after the hedge funds, to go after the bad Wall Street guys, but not to take the real estate industry down with the ship," Camp said. "For whatever reason, [Congress] couldn’t or didn’t want to come up with a really creative way to go after who they were trying to go after."

"We’re just a casualty of war in this zest and zeal to penalize the evil Wall Street guys," Camp said.

While much of the public believes the carried interest tax proposal is aimed at leveling the playing field on tax inequities between average workers on Main Street and wealthy hedge fund managers on Wall Street, the proposal "will actually hurt the commercial real estate industry, job creation and economic development in communities across the U.S.," BOMA International said in a statement.

"Real estate is a long-term, risk-based investment which is regularly structured as a partnership, and therefore often involves a carried interest," noted BOMA International Chair James A. Peck, who is also senior director of asset services for CB Richard Ellis. "The passage of the bill by the Senate would result in fewer jobs, fewer economic development projects, fewer small investors lifting our economy into recovery and less tax income at the local level."

The carried-interest measure is problematic because almost every piece of real estate is owned in an LLC or an LP, Camp said. While successful investments typically pay a premium to the investment manager as a reward for taking the calculated financial risk, "this law basically eliminates the capital gains treatment on investment income and treats it as ordinary income," Camp said.

Real estate investors and developers would pay more taxes and see narrower margins, reducing their ability and incentive to make risk-based investments, Camp said. Higher taxes will also continue to hold down property pricing, as profit-pinched investors won't be able to afford to pay as much for office, industrial, multifamily and other properties, Camp said.

"With the commercial real estate market and our economy in the condition it’s in, the last thing we need now is a major tax increase on our industry. Prices have already gone down around 45% and there’s $2 trillion in commercial real estate mortgages expiring before 2013," Camp said.

NAIOP National President Thomas J. Bisacquino said in a statement that the House passed the bill "without the full consideration of the resulting harmful impact to one of the largest contributors to the nation's GDP."

Mounting an especially vigorous and organized lobbying effort is the International Council of Shopping Centers, which represents 60,000 mostly retail members. The ICSC said lobbying the Senate before next week is the last chance to stop the tax increase, the ICSC said in a policy document on its Web site.

"Because of the tremendous lobbying efforts you have generated, numerous senators from both parties have expressed concern with the tax increase and its effect on real estate," ICSC said.

The ICSC said about 48% of all partnership entities are real estate partnerships. Although no precise financial impact on real estate is available, the ICSC claimed in its materials that some real estate partnerships could see a 150% increase in their taxes. An ICSC issues brief from last year estimated economic loss due to the "crowding out of economically viable projects" at between $15 billion and $20 billion annually."