Sen. Tammy Baldwin (D-Wis.) and Rep. Bill Pascrell (D-N.J.) last week introduced the Carried Interest Fairness Act of 2019, which would impose a major tax increase on real estate by generally requiring carried interest to be classified as ordinary income rather than a capital gain.
A carried (or promoted) interest is a profits interest in a business deal that is larger as a share of the total return than the share of the initial equity investment. Under present law, if the income paid out as the carry is a capital gain, then the carry is taxed at capital gains tax rates (in general, up to 23.8%).
NAHB opposes changes to the taxation of carried interest because it would have a significant negative impact on the multifamily housing industry and on the bottom lines of companies that participate in real estate investment partnerships.
Despite the focus on the financial sector, the use of carried interest is actually quite common in real estate. A builder/developer will typically gain a carried interest in partnership with outside limited partners, who will invest a significant share of the initial equity for a project. The builder also provides some equity, but additionally acts as the entrepreneur and takes more of the economic risk. The return to the carry reflects this risk premium, and thus allows shifting the risk away from the limited partners and attracting capital to the deal.
For multifamily projects, the income due to a carry typically arises as profit from the sale of an apartment building, which is a depreciable, capital asset. As such, this profit originates as a capital gain. The proposal to tax carried interest would redefine such income as non-capital income and tax it at a higher rate.
The effect of such a change would be to place downward pressure on the prices of apartment buildings and other commercial real estate, which would reduce local property tax revenue and could result in the elimination of tens of thousands of jobs in multifamily construction and development.
This bill would require partnerships to classify all partnership income as ordinary income and specifically includes real estate held for rental or investment. Some partnerships may be excluded from this legislation if 75% or more of the capital of the partnership is attributable to qualified capital interests. Qualified capital interests generally include the fair market value of any money or other property contributed to the partnership.
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