It seems regulators across the globe cannot stop causing trouble for the real estate investment management industry, even if most of the time it is unintentional.
In the UK, the new global lease accounting rules, which may result in shorter lease terms that might impact property valuations, is one example. The Organisation for Economic Co-operation and Development's (OECD) Base Erosion and Profit Shifting initiative, which may make it more expensive to finance real estate deals, is another.
The latest initiative to see property managers draw the shortest straw is the proposed changes to the taxation of carried interest.
Only carry from funds undertaking long-term investment activity will enjoy capital gains tax treatment, the UK government said in December. This should have been good news for managers, but how “long-term investment activity” is defined has been a source of uncertainty. Consultation on the proposals is expected to be clarified by Chancellor George Osborne in his forthcoming budget in March.
Current thinking puts private equity and venture capital in one bucket which UK tax authorities deem as long-term investment, but real estate has seemingly, and not for the first time, been forgotten. A large number of real estate fund managers will find their carry is taxed as trading income, at around 48 percent, compared to the more favorable capital gains treatment of 28 percent.
Without delving into the minutiae of the draft tax legislation, any investment held for four years or longer will benefit from the lower tax rate. Anything held for three years and under will be taxed as income. That is clearly a problem for opportunistic and value-added players which can have holding periods of less than three years for investments.
The method to calculate how long an investment has been held will use an average investment holding period, rather than on an individual investment basis. This is intended to neutralize the effect of early investment exits made for reasons beyond a fund manager's control where the original intention was to hold the asset for the long term. But, the average holding period of a fund's investments is calculated by reference to both the value of its investments and the holding period for those investments, meaning that if a fund exits a high-cost investment early, its average holding period could be disproportionally skewed.
However, the UK government believes that the periods above will allow most funds' investment strategies to fall clearly on the side of income or capital. But the rules are quite clear that a holding period of less than 36 months still does not prevent investors from getting capital treatment if appropriate. There are certain caveats and carve-outs available to real estate fund managers in order to gain similar exemptions to the private equity and venture capital industries. Yet, the computations required to justify the more favorable treatment are complicated, tax lawyers told PERE . Not only is it a time-consuming task, but also a costly one, as the complex UK tax code will require fund managers to hire legal and tax advisors to get it right.
While UK-based fund managers may take the time to go through the rigmarole, global fund managers with a UK footprint may not, to the detriment of their executives.
The lawyers said it is likely that UK-based professionals working for global firms headquartered elsewhere will be more hard done-by than their counterparts at locally-based firms. This creates a risk that these groups will lose good UK-based workers if they do not do the compliance work needed to mitigate the imbalance.
One of the biggest challenges for real estate fund managers is how to hire and retain the best talent. UK tax authorities may have not considered the country's real estate executives, but global property fund managers should follow closely the proposed changes to the taxation of carry if they are to demonstrate they are not guilty of the same oversight.