The Truth about Carried Interest

In previous years, legislation passed the U.S. House to treat carried interest compensation as ordinary income instead of taxing it at the capital gains rate. To date, the U.S. Senate has been hesitant to change the tax treatment of carried interests. However, with comprehensive tax reform possibly on the table in the 113th Congress, both chambers could view a change in the tax treatment of carried interests as a way to offset the cost of lowering general tax rates or of increasing the perceived fairness of the tax system.

The proposals to restructure the way carried interests are taxed appear to be largely based on flawed assumptions. For example, some lawmakers believe that the majority of those who receive carried interests are Wall Street hedge fund or private equity fund high rollers. This is not the case. Real estate accounts for almost 50% of the 2.5 million partnerships in the United States. In reality, the proposed tax hike on carried interests would be an increase on a substantial amount of real estate activity in an already volatile and recovering sector of the economy.

What Are Carried Interests?

Many partnerships (including real estate) are organized with general partners, who contribute their expertise (and, in some cases, capital) and limited partners who contribute capital in the form of money and/or property to the enterprise. Generally, any profits of the partnership are divided among the limited partners. A common practice, however, is to provide additional incentive for the general partner to perform well by sharing some of the profits above a certain “hurdle” rate with him or her through a “carried interest,” even when the general partner contributed little or no capital to the enterprise. The general partner’s profits interest is “carried” with the property until the property is sold, which can be years after the enterprise is formed and limited partners have received profit distributions.

During the time the property is held, the general partner receives compensation through management fees that are taxed as ordinary income. The limited partners can receive both ordinary income from operations and capital gains from any profits generated during the year. When the property is sold, the limited partners receive their profits distribution (the earnings on the capital they invested) as capital gains. If the venture is successful, the general partner then also receives the value of any carried interest as capital gains income. This partnership structure has been a huge success, giving investors and entrepreneurs in many industries the tools needed to create and grow businesses, build shopping centers, launch technology companies, and create millions of jobs.

Effect of Changing the Tax Treatment

It is unclear how much revenue the government could generate by changing the taxation of carried interests. Some tax policy experts believe that talented entrepreneurs would simply find other ways to structure new ventures to avoid the higher tax. Others argue that some deals that now make economic sense would simply not be done in the future, since a higher tax would increase the hurdle rate of return. Moreover, Congress itself seems torn on how to approach the issue, with some proponents of changing the tax rules urging that certain industries, such as real estate and venture capital, be exempt from the change. Such an approach would likely reduce any possible revenue raised by a significant amount. Other policy makers argue that the change should be made prospective only, which would also likely reduce any new revenue by a large amount.

Carried Interest Taxation Should Not Be Changed

The National Association of REALTORS® believes the current-law treatment of carried interests helps better align real estate managers’ interests with those of investors, and the existing policy has played an important role in economic development and job creation. Changing the tax treatment to increase the rate of tax on general partners would decrease potential rates of return on successful ventures and raise the hurdle rate, resulting in fewer ventures being funded, and less economic growth and job creation.