There is a storm brewing over the Obama administration’s and Congress’s plans to tax something called carried interest at a higher rate. Why? What’s carried interest? Should I care about this?
While the term “carried Interest” may sound like it has something to do with mortgages or other types of loans, it does not. It refers to an interest a real estate developer, as a partner in a real estate development project, may have in that project’s outcome.
For example, assume a developer, as a partner in a real estate partnership (as defined under the tax code), has an interest in that partnership based on services (in addition to any capital invested) he or she provides to it in steering the project from start to finish. To realize that gain:
First, the project has to be financially successful – always a risk in real estate development.
Second, such projects necessarily are multiyear in nature – the land has to be acquired, the improvements constructed then leased, and finally sale has to occur in a future year.
Thus, the developer’s interest in the project is carried through to the termination of the venture, and then distributed to him or her. Currently, this interest is treated as long-term capital gain and taxed at the lower 15% rate. Under the proposed changes, carried interest would be taxed as high as 39.6% - more than 2 and a half times the current rate.
What does this mean to those who don’t invest in, or develop, real estate? At least two things:
1. The developer’s carried interest, payable as it is on the backend, often is the impetus for putting in the years of effort and assuming the high degree of risk involved in creating real estate projects. The effort and risk remain unchanged, but the compensation will be greatly reduced by the tax bite; perhaps fatally skewing the risk/reward formula. This results in less development activity, in turn leading to an imbalance in supply and demand and, ultimately, higher residential and commercial rents.
2. The disincentivizing effect of the higher tax bite on investors and developers also has a dampening effect on the pricing of investment real estate, which in turn adversely impacts the economy in which it is an important component.
The subject is discussed in greater length at the following web sites:
There are no coincidences!
Copyright 2010 by the Falbey Institute for the Development of Real Estate
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