Friday Letter A taxing problem

A bill in the House could change the way carried interest from real estate partnerships is taxed in the US. Does it have any chance of passing? 

The US Congress is technically still on its summer break through the Labor Day weekend at the beginning of September. But as the politicians prepare to leave the barbeques and glad-handing behind and return to the District, plans are already afoot to discuss an issue on the minds of plenty of private equity and private equity real estate investment pros: potential changes in US tax law affecting carried interest in partnerships.

This week, Rep. Charlie Rangel, a New York Democrat and chair of the Ways and Means Committee, announced hearings on “fairness and equity in the tax code,” which are scheduled for September 6. The speaker line-up has not been announced, but one of the topics to be discussed is the “tax treatment of investment fund mangers.”

A bill known as Levin-Rangel that is currently before the House could dramatically change the way partnership interests are taxed. Introduced by 14 House members, the bill would tax fund interests held by partners actively involved with the assets—providing valuation, advisory services, asset management or arranging financing, among other things—as ordinary income at 35 percent, rather than the 15 percent capital gains rate. The impact on private real estate funds, from GPs to local operating partners who get a piece of the carry, would be obvious.

The question is, will the bill become law?

While a number of Democratic Presidential candidates and House members have come out in favor of some sort of tax law reform, plenty of high-profile Democratic senators, including Sen. Charles Schumer, of New York, and Sen. John Kerry, from Massachusetts, have questioned a similar bill in the Senate. (That bill, however, would only change the tax on publicly traded private equity firms.)

On the other side of the aisle, Republicans have, perhaps predictably, come out squarely against any change in the rules. Earlier this month, President George W. Bush said he would be “very, very hesitant” to raise taxes on private equity. Some tax experts who have spoken with PERE say they question just how much momentum the bill has at this point.

In any case, anti-tax lobbyists in Washington have been gearing up for a fight on behalf of fund managers. In addition to the recent creation of the Private Equity Council, it is reported that Fortress Investment Group, The Blackstone Group and Kohlberg Kravis Roberts have all hired lobbyists as more attention is directed towards the asset class and its big returns. In an early August interview with DC newspaper Politico, anti-tax activist Grover Norquist summed up what could easily be the industry’s party line when it comes to the tax increase. “The sponsors thought this was mugging the richest guy in town and no one else would care,” he said. “But this is an attack on the idea of partnerships.”

As for whether or not that “attack” is successful, some answers could come to the surface in the House next week. Even with a largely Democratic Congress, the bill could be facing an uphill battle to get passed in both chambers. But, much to the chagrin of market players, that battle could go on for some time. In any case, the upcoming hearings will likely shed some light on which way the political winds in Washington are blowing.