Tied to legislation that is known more for unemployment benefits, COBRA and Medicare, the House of Representatives recently passed a bill (Barrow-Aye, Kingston-No) that could have a negative effect on commercial real estate development. H.R. 4213, “American Jobs and Closing Tax Loopholes Act of 2010,”changes the way carried interest is taxed. Typically treated as long term capital gains, carried interest is taxed at 15%. The new code would treat it is as a mixture of capital gains and ordinary income. This could increase the tax rate to as much as 38.5%.
Carried interest is typically viewed as investment gains that are paid as compensation to managers of hedge and private equity funds, Congress’ assumed target for the legislation. Unfortunately, the change would also affect members of real estate ventures that are set up as limited partnerships (LPs) and limited-liability corporations (LLCs). According to the Real Estate Roundtable (www.rer.org), an industry policy group, real estate accounts for forty-six percent of these 2.5 million partnerships and totals $1.3 trillion in equity. This includes large portfolios, but most are one-and-two-owner organizations.
Carried interest in real estate ventures is usually paid to the general partner while incurring significant risk and liability inherent in real estate development. The general partner might be the single member of an LLC or small business owner. So, every mom-and-pop owner of strip malls, office buildings and warehouses could see their taxes increase by 150 percent at the time they decide to sell.
Go, No-Go Decisions
Tax consequences and exit strategy are key factors for developers. With profits already thin in the current economy, this new tax implication could be a deciding factor in whether or not a property is purchased or land is improved. This is especially true for smaller development partnerships that could not pass on the potential increased costs to its equity partners. Just like choosing between bonds or stocks based on their potential return, developers have a targeted return and a certain amount of risk they are willing to take.
Reduced new investment and construction equals a continued drag on commercial real estate values and the economy in general. The Real Estate Roundtable states this change in taxes on real estate partnership capital would cause an annual $15-$20 billion economy-wide loss in economic income. It could also reduce entrepreneurs’ interest in pursuing real estate development.
At the time of writing this article, it is still being considered in the Senate. Though similar proposals failed in 2007 and 2009, many are concerned that it has a chance to pass this term. There are already attempts by both parties to water down the amount and timing of the increases.
All of the national commercial real estate associations are opposed to the bill and are lobbying hard against it as they believe it threatens the industry and is an unintentional target of the legislation.
Rex Benton is a Savannah Commercial Real Estate agent with NAI Savannah, the commercial division of Mopper-Stapen, Realtors and is a contributing columnist for "BiS-Business In Savannah" weekly business publication. www.naisavannah.com 912.358.5600 Office Retail Industrial Investment Real Estate