From ICSC Website

U.S. lawmakers introduced legislation yesterday that would increase taxes on the percent of the profits investors collect from the deals their firms complete. The proposals to increase taxes on so-called “carried interest” are part a of larger attempt to reform the U.S. financial sector, but could end up hurting the commercial real estate industry just as it is trying to emerge from the worst recession for decades.

Specifically, legislators want to reclassify “carried interest,” which is currently treated as capital gains and taxed at 15 percent. Instead, carried interest would be considered ordinary income, subjecting it to a top tax rate of 35 percent, plus the 2.9 percent Medicare tax. This is likely to rise to 39.6 percent next year. Furthermore, the 3.8 percent Medicare tax included as a last minute addition to the health care will be added on top in 2013. Limited partnerships and liability companies are so common in real estate that the impact would be wide, observers say.

Carried interest — sometimes referred to as “the carry” — refers to the share of profits general partners of such institutions receive as compensation. Typically, general partners also take management, construction or leasing fees, though that is already classified as ordinary income.

Congress initiated the carried tax increase back in 2007 as a way to target perceived excess and abuses within equity and hedge funds. Many in the real estate sector will be unintentionally swept up by the new legislation if it passes, opponents say. If carried interest is taxed as ordinary income, general partners will owe billions more in federal taxes annually. The equity at risk for higher taxation is a traditional part of compensation at real estate development and management companies (which are often partnerships) and also for individuals in private deals, observers say.

Critics point out that most limited partnership managers are not overseers of private equity and hedge funds with billion-dollar returns, but rather more-modest partnerships in which the general partners have a stake in the form of capital investment, sweat equity and reputation.

“Here’s what will happen if this bill becomes law,” said Betsy Laird, senior vice president at ICSC’s Washington office. “Real estate values will be depressed immediately, transaction volume will drop. Risk will get riskier and certain projects our members once may have undertaken will no longer make economic sense.”

Lee H. Wagman, vice chairman of Los Angeles–based CityView, also takes a dim view of the proposal. “The proposal to reclassify “carried interest” as ordinary income instead of capital gains is tantamount to a tax increase on limited partnerships which will be a significant disincentive to take the kind of entrepreneurial risks that have been the hallmark of our industry. By dampening the motivation of real estate developers to undertake new deals, we will put a drag on one of the few robust job-creating sectors in the economy,” he said. “The proposal also makes what I believe is a false comparison between real estate partnerships, where the general partner assumes significant risks in providing things like loan guarantees, upfront risk capital, and carve outs to non-recourse provisions, and the typical private equity structure where the carried interest is much less of a reward for taking on these risks and capital obligations, if at all.”

The House vote on the measure is planned for Tuesday, with the Senate vote due May 28.

The timing could not be worse, says Michael P. Kercheval, president and CEO of ICSC. “Imposing this tax burden would be devastating at a moment when the retail real estate industry, one of the U.S. economy’s biggest drivers, is recovering after the recession,” he said. “ICSC is doing all it can to make legislators aware of the unforeseen consequences of this provision.”

Compiled by the staff of Shopping Centers Today. © May 21, 2010 International Council of Shopping Centers.

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