Under present law, capital gain classified as a carried interest is taxed like any other capital gain, at a 15% rate. Under changes proposed in legislation recently approved by the House of Representatives, that tax rate could climb to 35%^.1 Among other impacts, this change would generate a 133% tax increase on carried interest income, thereby impeding the financing of future multifamily developments and undermining the underwriting of established deals.  These effects would result in lost jobs and economic benefits from future development, as well as foregone property tax revenues for state and local governments.

In particular, increasing the tax on carried interest would²:

• Reduce property tax revenues to state and local governments by $1.2 billion per year — $242 million of which would be allocable to multifamily rental property
  
• Result in the loss of more than 18,000 jobs in 2010 and 33,000 jobs in 2011 due to reduced multifamily rental housing construction

What is Carried Interest?

The use of partnerships and other pass-thru entities is common in the home building industry and the construction sector generally. These entity types provide a useful way to organize — for particular development projects — the hundreds of thousands of home builders and subcontractors who work in thousands of local markets across the country.  This is particularly true for multifamily rental housing development.

In a common arrangement, a multifamily builder/developer performs the role of the general partner and outside investors act as limited partners, who provide much of the initial equity financing. Typically, the general partner receives a developer’s fee (and possibly subsequent fees for owning and operating the property) and the limited partners receive a specified rate of return on their investment. Any residual profits are split between the multifamily builder/developer/property owner and the investors as defined by the partnership agreement. Of course, the particulars differ depending on the nature of the project, the types of developers, and the role of outside investors.

In many cases, the developer’s share of the residual profit, if it is realized (uncertain at the time of the deal), is classified as a “carried interest ,” which is an allocation of profit that as a share of total profit exceeds the share of the developer’s initial equity investment in the project^.3 The carry can be ordinary income or capital gain, but the current policy debate is limited to a carried interest that is due to a capital gain at the partnership level. Carried interest that is paid as ordinary income is unaffected by the proposals being debated in Congress. Capital gain typically arises in such arrangements through the sale of a tangible, depreciable asset that is held for more than one year. For example, this situation would include a building that was constructed, owned and operated for a period of time and then sold to other investors.

As a simple example, if a multifamily developer, acting as the general partner, provides 5% of the equity financing for a project (with the remaining 95% provided by the limited partners) and receives 10% of all capital gains distributed, then the 10% distributed to the multifamily developer is a carried interest for the purpose of the Congressional proposals under consideration (because 10% — the gain distribution share — is greater than 5% — the initial equity contribution). 

Table 1 illustrates this in more detail for a hypothetical partnership with $100 million in initial equity financing ($95 million from outside interests, and $5 million from the multifamily developer), a 10% preferred return for the limited partners, and a 50%-50% division of residual profit. Under this example, the developer’s capital gain income is a carried interest (portion in excess of 5% — the initial equity stake) and would be subject to additional tax under existing proposals. View Table 1 here.

Economic Purpose of Carried Interest

Putting aside the tax issues, the carried interest in the above multifamily development example serves two important economic purposes. First, it provides an incentive for the multifamily developer and property owner to control costs and operate the property efficiently in order to generate a profit for the outside investors. This incentive makes the investment more attractive for investors, helping to attract investment for multifamily projects, particularly those in higher risk environments, such as economically-distressed areas.

Second, the carried interest transfers business risks associated with the development project to the multifamily builder and owner, who may be more familiar with market conditions and in better position to manage the risks. These risks include changes in administrative expenses, local regulations and, of course, local market conditions, which is of particular importance given the existing weakness in many local housing markets. Further, a multifamily developer may assume additional risk by making additional guarantees to the outside investors.

For example, the developer can guarantee the completion of the project, or the servicing of debt used to finance the project. Carried interest allows multifamily builders to be compensated for making these guarantees and assuming the risks. Hence, partnerships with carried interest mechanisms are excellent financial arrangements for allowing multifamily developers and outside investors to share business risks efficiently. 

Proposed Change to the Taxation of Carried Interest

The carried interest proposal in H.R. 4213 requires all capital gains income distributed as part of a carried interest allocable to a partnership to be treated as ordinary income, taxable at a tax rate of up to 35%. Under present law and practice, such carried interest gains income is taxed at the long-term capital gains tax rate of 15%. The change proposed in the legislation represents a sharp break with established tax law and practice associated with partnerships and other pass-thru entities, since  it would redefine the nature of the income (i.e. capital gain) from how it arises (sales of a capital asset) to how and to whom the income is distributed. The legislation also would subject the newly-defined ordinary income to applicable self-employment taxes. The proposed tax policy change would be effective for sales or dispositions of capital assets after December 31, 2009.

The Joint Committee on Taxation estimates the proposal would raise $24.6 billion over ten years for the Federal government, with a significant share of that tax revenue arising from the construction and real sector.⁴Other industries that would be affected include the energy sector, venture capital, and the hedge fund industry.

The Economic Impact of Modifying the Taxation of Carried Interest

Increasing the tax on carried interest for the real estate sector results in a transfer of tax revenue from state and local governments to the Federal government.  

IRS and Census data for the multifamily industry shows that on average, 25.2% of partnerships’ income due to a capital gain is structured as a carried interest to the general partner. The after-tax change for investment return is 23.5%. Using these estimates, we calculate that multifamily properties affected by the proposed change would fall in price by about 5.9%. Assuming an average seven-year hold of properties, we believe 20.25% of current properties would be affected by the proposed tax change.

With these facts, we estimate an estimated annual reduction of state and local property taxes of $242 million — or $2.42 billion over ten years — for the multifamily sector. Using the same method, we estimate a reduction of state and local property taxes due to commercial real estate equal to $966 million per year. Thus, the total amount of property taxes lost to state and local governments due to the increase in carried interest taxation for the real estate sector is approximately $1.2 billion per year^.5

The proposal also will eliminate projects in the future by decreasing the after-tax return, thus causing the projects to be abandoned. Using the NAHB forecast for non-condominium multifamily starts, we estimate the following declines in multifamily rental construction and associated economic benefits due to the proposed increase of carried interest taxation.  For example, in 2011 the change in the taxation of carried interest would eliminate more than 33,000 jobs.

Conclusion

This article presents estimates of some of the economic consequences of changing the taxation of capital gain to ordinary income when the gain is due to a carried interest. These impacts include $1.2 billion of lost state and local property taxes per year (due to the real estate sector) and more than 18,000 jobs in 2010, and 33,000 jobs in 2011 due to reduced multifamily development.  It is clear that increasing the tax rate on capital gain structured as a carried interest would result in lost jobs and development, and a transfer of revenues from state and local governments to the federal government. 

More fundamentally, the change in the tax treatment of a capital gain, as determined by how it is allocated to the owners of the property, would harm the ability of developers and investors to efficiently allocate the risk of real estate development and reduce the flow of investment available for multifamily construction.

² This article is a summary of a longer research paper, “Increasing the Tax on Carried Interest: An Economic Impact Analysis.”  That paper covers the methodology and assumptions and will be published in Housing Economics.

³ Note that technically, this definition describes both promoted and carried interests. A “promote” is often used to refer to any share of profit allocation greater than the initial equity stake, and a “carry” is a type of promote for which there is little or no equity stake. However, in the current debate, the term “carried interest” now captures all of these scenarios.

⁴ Joint Committee on Taxation. JCX-59-09. December 7, 2009.

⁵ The longer version of this paper provides state-level impacts. [ return to top ]