Carried InterestOctober 10, 2007Taxation Committee Federal Issues CommitteeThe following is for study only and has NOT been approved by the Board of Directors.Issue: Should C.A.R., in conjunction with NAR, oppose changes to the tax code that would tax carried interest at normal income rates instead of capital gain rates?
Action: Action is requested at this time to due to pending legislation
Options: 1. Support 2.Oppose 3.Neutral 4.Not Real Estate Related 5.Other
Status/Summary: When the Democrats took over Congress, one of their first moves was to establish PAYGO rules. This meant that any reforms had to be revenue neutral, or increase revenue. This has presented some challenges for Congress as they attempt to reform programs and the tax code. One of the largest obstacles has been reforming the Alternative Minimum Tax (AMT). Eliminating the AMT is projected to cost the government 1.2 trillion dollars over ten years. Therefore, finding offsets for a program of this magnitude is difficult at best.There have been numerous proposals surrounding AMT reform that have been floated. They include a 1-year patch that adjusts the income threshold for AMT based on inflation, a 2-year patch, a permanent change that would exempt any person making under $125,000/year ($250,000/year for couples) from AMT, and an all-out elimination of the AMT.In order to enact AMT and other tax reforms, Congress, and specifically Ways and Means Chairman Rangel (D-NY), have been looking for ways to offset the losses of revenue without having to raise overall tax rates. One option that they have focused on is the practice of carried interest. Attention became focused on carried interest partially due to a private equity firm, Blackstone, having an IPO and announcing the extraordinarilylarge amounts of profits that Blackstone was able to realize using carried interest. This prompted Congress to examine the practice of carried interest and whether or not it should continue at capital gain rates or be changed to normalincome rates, which is what current legislation is attempting to do.The House has introduced H.R. 2834, which is currently in the House Ways & Means Committee with 23 cosponsors. H.R. 2834 would eliminate taxing carried interest at capital gain rates (currently 15%) and instead tax them at the standard income rates (currently up to 35%). The Senate has introduced S. 1624, which is currently in the Senate Committee on Finance with four (4) cosponsors. S. 1624 currently focuses on private equity groups and does not specifically include real estate carried interest in the language of the bill, but it is expected that this will be amended in the future to include realestate and mirror H.R. 2834.Both the House and Senate have held hearings concerning changes to carried interest. While there are some questions concerning what the fallout of this tax change would be, many in Congress seemdetermined to focus on the revenue from this tax change as the main vehicle to help pay for AMT reform.Background: Under most real estate partnerships when a private equity partnership is developed there are two categories of participants. There is the general partner (GP) and the limited partner(s) (LP). The LPs are the ones who contribute the capital to fund the projects. The GP either puts up a small (usually 1-2%) amount of capital, or none, but handles the financial dealings of the partnership and brings their expertise and experience to the project. This includes finding the property, taking care of the leasing, paying the taxes, and more. They are not simply day-to-day property managers, but handle all the financial aspects of the partnership and the property.When that property is sold, the profits are divided, primarily among the LPs.However, there is a common practice in partnerships, including real estate partnerships, that gives the GP a portion of the profits. This is separate from his annual management fee which covers his salary and overhead. This part of the profit is known as carried interest. The carried interest (which can be up to 20% of the profit from the investment) is part of the setup of the partnership and is done to give the GP an incentive to push for the success of the partnership venture and is a return on their “sweat equity”. Under the current system, the profits realized by the GP and the LPs are taxed at capital gain rates (currently 15%).Pro: The money that is collected from the changes to carried interest will help offset the changes to the AMT. Reforming the AMT is a major goal of this Congress and they will find offsets, even if it means squeezing blood from a stone. Previous ideas on how to offset reforming the AMT have often focused on a dramatic reduction in the mortgage interest deduction. If carried interest tax changes are enacted to offset the AMT, it could potentially take pressure off of Congress and stop them from considering ending other tax breaks, such as: mortgage interest deduction, deductions applying to second homes, deducting state and local taxes (which includes property tax), and the deduction of interest from home equity lines of credit.Con: There is a fear that changing the tax code on carried interest will become a blight on real estate as an investment, especially is low economic and blighted areas. Oftenthese areas carry larger risks, but also can come with larger rewards if successful. The use of carried interest getting treated as capital gain has been a reward for entrepreneurs who are willing to take these risks and help revitalize depressed or blighted communities. They take great risks in these projects, often failing and taking losses, and therefore earn the reward when they make capital investments that succeed.These changes to how carried interest is taxed are also focused on those who put the sweat equity into these projects. The LPs who front only the capital, not the experience, expertise, or put in the time and effort of developing these projects will still get their profits taxed as capital gains. It is only the GP, who brought all of those skills and experience to the table that will have his share of the profits taxed as normal income.Impact on REALTORS®: Residential real estate sales agent and/or broker will not be directly affected by the proposal, as it applies only to real estate partnerships that have carried interests. However, real estate investment is typically held in partnership form. Not all real estate partnerships include general and limited partners, or carried interests for the general partners; but investments that are held in that form would be harmed by the change in tax code.By increasing the tax burden on these real estate partnerships, there is a fear that these tax changes could make real estate a less attractive investment. When the value of real estate investment is impaired, there is an indirect impact on all real estate.
NAR Policy: NAR opposes any proposal that would eliminate capital gains treatment for any carried interest of a real estate partnership.C.A.R. Policy: C.A.R. currently has no policy on carried interest.Should C.A.R., in conjunction with NAR, oppose changes to the tax code that would tax carried interest at normal income rates instead of capital gain rates?