Many in Congress want to change the tax treatment of carried interest compensation from capital gains to ordinary income. A “carried interest” (also known as a “promoted interest” or a “promote” in the real estate industry) is a financial interest in the long-term capital gain of a development. The “carried interest” is given to a general partner (GP), usually the developer, by the limited partners (LPs), the investors in the partnership. It is paid if the property is sold at a profit that exceeds the agreed-upon returns to the investors, and is designed to give the developer a stake in the venture’s ultimate success. This serves to align the interests of the GP with the investors by allowing the GP to share in the “upside” of the real estate venture. It also serves to compensate the GP for the substantial risks taken during development of the project and during the period prior to sale of the property. A carried interest has traditionally been treated as a capital gain, subject to favorable capital gains rates.
Beginning in 2008, there have been efforts in Congress to change the tax treatment of carried interest from capital gains to ordinary income. Supporters of the legislation described it as eliminating a loophole used by Wall Street private equity and hedge fund managers to avoid taxes. However, the proposed partnership tax law change would disproportionately impact the real estate industry since real estate partnerships comprise over 46 percent of all partnerships and many use a carried interest component in structuring development ventures. Such a change would result in a dramatic tax increase on real estate partnerships using carried interest.
Comprehensive tax reform discussion drafts introduced in both the House and Senate have eliminated capital gains treatment for carried interests. In addition, there have been efforts outside of tax reform to use the revenue from eliminating capital gains treatment for carried interest for a number of other purposes. Importantly, then-House Ways and Means Committee Chairman Dave Camp in his reform plan introduced in the 113th Congress would have taxed most carried interests at ordinary income rates, but would have exempted real estate partnerships.
NAIOP opposes a change in the tax treatment of carried interest that would result in an increase in tax rates from capital gains to ordinary income rates. These proposals ignore the very real risks undertaken by general partners in real estate development, and treats carried interest income as if it were guaranteed salary. Reducing incentives for entrepreneurs to undertake the risks inherent in development would have a pronounced negative impact on the real estate industry, and would limit the flow of investment capital to the real estate industry.
While attempts to change the tax treatment of carried interest compensation have been unsuccessful thus far, it will be a major point of contention in comprehensive tax reform discussions beginning in 2017.