How the carried interest controversy can affect investors in real estate

Much has been written in recent months regarding the carried interest controversy as it applies to venture capitalists and hedge fund managers. Less attention has been paid as to how it can affect investors in real estate. The term carried interest is not defined by the Internal Revenue Code or the regulations. It is usually defined as a right to receive a specified share of profits of a partnership without contributing any money or property to the partnership. Essentially it's a profit interest in a partnership for services rendered. In investment partnerships the usual carried right is a 20% profits interest by the managers who set up various deals. In rental real estate partnerships it can go even higher. The carried interest when paid out in the form of partnership distributions is taxed based on the type of income the partnership earns. Most investment funds earn long-term capital gains so the managers are taxed primarily at a 15% tax rate. The controversy arises since managers are being taxed at a favorable capital gains rate of 15% instead of the income being treated as compensation which is taxed at 35% plus Social Security and Medicare taxes. This can lead to a decided advantage in rental real estate partnerships as well. Most rental real estate investments are in partnerships. Partnerships are flow through entities, so the character of its income will be passed through to its partners and taxed as if the partner earned the income individually. Net operating income from rental real estate operations will be taxed to the managers as ordinary income However, the lion's share of profits in rental real estate results from capital gains generated upon the sale of property which will be taxed at 15% on all property held by the partnership for more than one year. The portion of the gain attributable to depreciation taken on the property is taxed at 25%; however, that is usually a small percentage of the gain. The controversy over this issue stems from the tax benefits. Since the carried interest appears to be compensation for services, it is taxed more favorably then other forms of compensation for similar service. Recently comprehensive tax reform was proposed to change how a carried interest is taxed. The bill proposed that the distributive share of partnership income should be treated as compensation subject to ordinary income tax rates, to the extent the income is attributable to a substantial amount of investment activity services contributed to a partnership for a profits interest in the partnership. This would apply if a partnership interest is received for any of the following activities: 1) Advise in connection with investing, purchasing or selling any specified asset 2) Managing, acquiring or disposing of any specified assets, and 3) Arranging financing with respect to acquired specified assets. Under this proposal, any rental income and capital gain received by a manager who receives only a profits interest in exchange for services would be treated as compensation. In addition, gains derived from the sale of real estate related to a profits interest will also be treated as compensation income. Rental income is already taxed at ordinary income rates however; if gains derived from the sale of real estate were treated as compensation, a manager might not be able to offset rental losses from other rental activities against it. As of this writing, this proposal has not become law and it does not appear that it will become law during 2008. A proposed regulation will allow a partnership interest to be treated as property for Section 83. Under this proposal, a partnership and managers can elect to report as compensation income the fair market value of the partnership interest determined on the day it is received. This will allow the partner who makes this election to freeze the compensation at the value date, and any gain upon the subsequent sale of the real estate will be taxed at capital gains rates. In conclusion, the issue of carried interest is one that will be in the forefront for the foreseeable future. As always, one should consult with their tax advisor when involved with partnership transactions. Sandy Klein is a partner at Shanholt Glassman Klein Kramer & Company, New York, N.Y.