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NREI Readers Write

Reforming Carried Interest

Many people are proposing a change in the tax law such that all carried interest is taxed as ordinary income. Their primary justification is that they claim carried interest is created by labor alone and if there is no risk of capital why should there be capital gains treatment.

All labor should be taxed the same way. This is a powerful argument that I agree with. The problem I have is that there are different types of carried interest and for those types that do require the risk of capital, their justification is not true.

In the real estate industry single property partnerships typically require the general partner to risk very significant amounts of money for the front end costs. This capital is risked prior to the formation and funding of the partnership entity. The person or firm that later becomes the general partner has to pay for all the legal fees, earnest money, engineering and financial due diligence, mortgage costs, etc. These costs amount to $100,000s.

They have to be ready to fund the down payment, if the minimum amount of sales of partnership units does not allow the escrow to be broken, prior to the closing of the property acquisition. This could amount to millions of dollars. It is typical that all this money is refunded to the general partner once all the partnership units are sold. So at that point the general partner has all their money back but no return on that money other than their carried interest position.

How can anyone say that this type of carried interest is just fee for service, labor, like a policeman, teacher or lawyer? This type of carried interest, like all legitimate capital gains, requires the risk of capital. The general partner has the cancelled checks to prove they risked capital in the acquisition of the property. It is typical for the partnership to be formed after the intial due diligence is done as there are significant legal costs to form the partnership and do a securities offering so that one can have partnership units to sell.

Since no partnership exists at the time of the initial due diligence who else but the general partner could possibbily pay these costs. Up until the time the escrow is broken from the sale of the minimum amount of partnership units , many things could go wrong with the deal and the acquisiton process stops. If that happens only the general partner looses all the money risked.

The proposed chanegs do not allow for grandfathering of old deals done ten years ago. Surely there will be a new deal structures with some of the capital left in, so that the future deals will still allow the general partner to pay capital gains. Old deals cannot be resturtured.

Real estate is a very capital intensive business. In any city or town in the US , the majority of commercial real estate is not large enough for institutional investors, public REITs etc. It is suitable for the small entrepreneurs, the backbone of America.

All we did was follow the rules, take risks, create jobs and become successful. Now many years later we are told our taxes should triple on past deals we have not sold, justified by untrue statements. Many of the people making these statements know they are not true. If anyone says that in single property real estate partnerships, one of the largest forms of partnerships with carried interest, the general partner never risked a dime to obtain their carried interest, ask that person to explain how that is possible.

Th real estate lobbyist, like those for the hedge funds and private equity, are focused on defeating any change to the carried interest tax. They do not differentiate between small property specific partnerships that require capital to be risked and large institutional blind pools that do not.

Most journalists and politicians have a one size fits all approach to carried interest as well. Everyone has their own sense of what is fair. For me the fair approach to carried interest tax is to have cap gains for those that risked capital and ordinary income for those that didn't.

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