Cash and carry

If Washington increases the tax on carried interest, private real estate investors and REITs could take a big hit. By Aaron Lovell

Private equity real estate is an asset class that isn't used to being in the spotlight. Like their cousins in the LBO space, the recent unwelcome publicity— brought on by big deals and even bigger birthday parties—has brought scrutiny from newspaper editorial pages, men's magazines, cable TV pundits and, perhaps most alarming of all to investors, regulators in Washington, DC.

Two bills have been introduced in Congress that would drastically change the regulatory landscape for private equity investors in the US. Days before the initial public offering of The Blackstone Group, the Senate Finance Committee put forth a bill proposing a change to the tax code for publicly traded partnerships that manage financial assets.

But the vast majority of private equity real estate investors are losing sleep over a different bill: the far-reaching House bill—H.R. 2834—unveiled around the same time as the “Blackstone Bill.”

Similar to the Senate bill, this legislation would tax the carried interest generated by general partners as ordinary income at 35 percent—not the 15 percent capital gains rate.

Introduced by 14 House members, the bill would tax carried interest for any partnership at a higher rate: Similar to the Senate bill, this legislation would tax the carried interest generated by general partners as ordinary income at 35 percent—not the 15 percent capital gains rate.

Tax experts say the legislation, known in the District as the Levin-Rangel bill, could have a significant impact on private real estate funds, from GPs to local operating partners who get a piece of the carry.

Using the example of a partnership where one party brings the capital and another party contributes the expertise, Michael Frankel, global tax leader at Ernst and Young, says the law attempts to “say the sweat-equity partner is a glorified employee of the money partner.”

Charlie Temkin, a tax director at Deloitte, also says the effects could be far reaching. “It just permeates real estate where transactions are done as partnerships,” he says. “When you start recharacterizing the basic operating rules—that creates a lot of waves that bounce around.”

While the legislation was designed not to affect LPs— their passive stakes will still be considered capital gains—the law also has some provisions for real estate investments trusts. Experts say the new law will not recharacterize REITs for purposes of applying the REIT gross income test—the test to qualify as a REIT structure.

However, the new law will apply to REITs if the vehicle is receiving capital gains for actively managing assets in, say, a joint venture with a large LP: The back-end interest from that partnership would be considered income rather than capital gains.

In the past, REITs could pay the capital gains tax on the interest or pay out a capital gains dividend to investors. Frankel points out that this is one part of Levin-Rangel that trickles down to affect everyday investors.

Tax experts predict the new law would create all manner of confusion as affected partners work to determine the parameters of the new law and seek to minimize the impact of the legislation. “People will have to figure out the impact on existing deals and how to structure future deals,” Temkin says. “Whatever is enacted could be seen as the first round of legislation.”

The future of the legislation is unclear. The bill has the support of some heavy hitters in Congress, including Ways and Means Committee Chairman Charles Rangel, a Democrat from New York, and Financial Services Committee Chairman Barney Frank, a Democrat from Massachusetts. Many Democratic presidential candidates have come out in favor of the tax change, while, this August, President George W. Bush said he would be “very, very hesitant” when it came to raising taxes on private equity. The Treasury Department has also come out against the bill.

And attitudes in DC might be shifting in regards to the tax, no doubt helped by lobbying by the big New York firms and the recently established private equity trade association. Temkin points out that over the course of two Senate finance committee hearings, enthusiasm for the Senate bill seems to have cooled. “The extent of that [shift in attitude] may be coming as a surprise to people who were disposed to doing this.”

Still, real estate fund general partners feel the tax bill could have legs and aren't ruling it out completely. You can't blame them for feeling a bit nervous these days—the engine of their wealth creation is at stake.

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