What Carried Interest Means to the Real Estate Industry

It seems the dirtiest of phrases among the current administration when discussing tax reform is the partner “carried interest.” The administration even goes as far as calling it a tax loophole. However, in context related to the real estate industry, I struggle to define it as anything different than an incentive to promote development and jobs.

A “carried interest,” also known as a “promoted interest,” is a financial interest provided to managers or developers as an incentive to aid/maximize performance of a partnership’s assets and/or investments.

According to real estate industry sources, the administration’s current aim is to remove the perceived tax benefit to hedge fund managers who receive these carried interests. The administration believes that hedge fund managers receive these interests for performing ordinary services, and therefore, should not enjoy the lower capital gain tax rates generated by the investments they manage. However, the proposed legislation would affect more partners and partnerships than the intended hedge funds.

Many real estate partnerships allow for the developer to receive a portion of profits from the property once agreed-upon returns to the investors are met. These profits to the developer would also fall victim to the proposed legislation, essentially reducing the returns to the developer by as much as 20% (ordinary tax rate 35% less capital gain tax rate 15%). With this reduction in upside return for the developer, one could only presume that if this legislation was enacted, the typical real estate deal structure would have to change significantly. These changes would probably include a lower “guaranteed” rate of return to investors. The reduction of the real estate investment and development incentives would have significant negative impact on the real estate industry, including reducing the availability of investment capital, effectively reducing development and, consequently, the jobs created associated with such developments.

While the carried interest legislation currently appears stalled and moved to the back burner of tax reform, the chance of revival in the future seems probable. Hopefully for the real estate market, developers and real estate investors, future legislation will exempt the real estate industry from this additional tax and the lawmakers will hit their intended target without the significant collateral damage that the current legislation would create.

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