MultiFamily Market Outlook - 12/20/2007 (Plain Text Version)

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In this issue:
Tax Update: Proposed Tax Law Change Would Affect Some Multifamily Developers
Second Consecutive Strong Month for Starts
Inflation Outpaces Rents
Forecast: Greater Threat of Recession
Multifamily Stocks Drop Dramatically

Tax Update: Proposed Tax Law Change Would Affect Some Multifamily Developers

For the multifamily housing sector, the most important emerging tax issue in 2007 concerned the taxation of carried interest, especially as found in partnerships formed to finance multifamily projects. Under present law, capital gains classified as carried interest are taxed like any other capital gain, at 15%. Under changes recently proposed by Congress, that tax rate could climb to 35%. Among other effects, that change would generate a huge 133% tax increase on carried interest income, and make the financing and operation of certain multifamily properties much less efficient. The National Association of Home Builders is strongly opposing these proposed tax changes, and is working to inform Congress of its negative consequences for the multifamily sector.

What is a Carried Interest?

Partnerships are common in the residential building industry. They provide a useful way to organize the hundreds of thousands of builders and subcontractors who work in thousands of local markets across the country.

In a common form of multifamily housing partnerships, a builder/developer performs the role of the general partner, and outside investors act as limited partners, providing 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 (e.g. 10%). Any residual profits are split between the multifamily builder/developer/property owner and the investors. The developer’s share of this residual profit is in many cases classified as a “carried interest” for tax purposes.¹ Specifically, capital gain distributed to the general partner is a carried interest when it is greater (as a percentage of the partnership’s income) than the share of total equity provided by that partner. ²

For example, if a multifamily builder, 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 builder is a carried interest for the purpose of the Congressional proposals under consideration. The following table 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 builder), a 10% preferred return for the limited partners, and a 50%-50% split on residual profit. Under this example, the builder’s capital gain income is a carried interest.

Assumptions: Project yields 20% return over time period; All income is capital gains at partnership level; LPs receive first 10% return; Residual gains beyond first 10% are split 50% each to GP and LPs; Partners face ordinary income tax rate of 35%

Economic Purpose of the 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. This also makes the investment more attractive for outside investors, and helps multifamily projects attract investment dollars.

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 a better position to manage the risks. These risks include: changes in administrative expenses, local regulations, and of course local market conditions – 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 the risks efficiently.

Proposed Change to the Taxation of Carried Interest

H.R. 3996, a bill approved in November 2007 by the House of Representatives to curb the growth of the Alternative Minimum Tax [AMT], contains a provision that would hurt multifamily partnerships with carried interests by increasing the effective tax rate on these partnerships.³ The carried interest provision is used to offset reduced taxes for the federal government that result from a proposed one-year AMT fix, plus extending some expiring tax provisions such as the state and local sales tax deduction.

The carried interest proposal in H.R. 3996 requires all capital gains income distributed as part of a carried or promoted 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-through entities.

Proponents of the proposal make two policy claims in defense. The first is that carried interest is, in some cases, compensation for services (i.e. multifamily property management) that is in other cases classified as ordinary income for tax purposes. The press and some members of Congress have focused on the example of hedge fund and private equity fund managers in this regard. They argue that fund managers, who typically have little equity stake in the funds they manage, are improperly claiming capital gains treatment by claiming income as a carried interest. It is important that policymakers understand the distinction between multifamily property owners and hedge fund managers, and realize the negative impacts this proposal could have on multifamily development.

NAHB’s Arguments against the Proposed Tax Change

The claims made by proponents of the change are not consistent with carried interest as it arises in the context of multifamily development partnerships. Requiring that all, or even part, of the gains return from a carried interest be taxed at ordinary income rates (irrespective of the nature of the investment or the investment period) ignores the fact that, in the case of a multifamily developer this income is paid as a return for a risky long-term investment that the developer undertakes when agreeing to develop and own the multifamily property. This is properly classified as a capital gain and should be taxed as such. The comparison to hedge fund managers is misleading because fees for particular services performed by the multifamily developer, such as developer fees, are already taxed as ordinary income.

If enacted, this new tax treatment for some kinds of partnership income would disrupt the relationship between multifamily builders and investors. This, in turn, would affect the flow of investment dollars into the multifamily sector—ultimately resulting in higher rents, fewer jobs in the multifamily sector, and reduced community development.

Federal Budget Considerations

As noted earlier, the underlying motivation for the proposed change in the way carried interest is taxes is as a way to pay for a fix to the AMT problem. In the 110th Congress, pay-as-you-go, or “PAYGO” rules require tax and mandatory spending proposals be paid for over a ten-year time horizon.⁴ Economists at the Joint Committee on Taxation and Congressional Budget Office are charged with determining whether or not a particular proposal is, in fact, “budget neutral” according to this criterion.

These economists estimate that changing the taxation of carried interest would raise approximately $26 billion over ten years. Given the cost of a one-year AMT patch ($51 billion) and extending expiring tax provisions ($21 billion), let alone the cost of permanent AMT repeal (perhaps $1 trillion) over that period, the risk that a provision that would increase taxes on carried interest in multifamily partnerships will be included in future tax bills is quite real.

How Has NAHB Addressed the Issue?

Immediately following the introduction of the carried interest tax change proposals, NAHB organized with other real estate industry organizations to gauge the full implications of the legislation and establish a joint strategy for advocacy on Capitol Hill. A key part of this strategy was educating members of Congress that their proposed legislation went far beyond affecting hedge fund managers on Wall Street and would, in fact, undermine one of the central financing mechanisms for real estate development—including multifamily housing. Over the past six months, these groups sent joint letters to Congress, submitted joint testimony before both the House Ways and Means and Senate Finance Committees, and met with nearly every member of these two committees. NAHB’s Multifamily members were specifically enlisted to help take the message to specific members of Congress. NAHB also has worked to publicize the wide-ranging impact of the legislation and the importance of protecting the benefits that multifamily and other types of residential development bring to local economies across the country.

In December, the Senate overwhelmingly approved an AMT patch that did not contain the carried interest provision (or any other provision to offset the lost tax revenue), so it now appears that Congress will not modify the way a multifamily developer’s carried interest is taxed in 2007. However, the proposal is likely to be discussed again in 2008, when a permanent solution to AMT will be debated, and the search for items to offset the lost tax revenue intensifies. NAHB will continue to track this issue, and advocate in favor of multifamily builders, developers, and property owners during 2008.

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1. In most cases, the home builder also invested a certain amount of equity in the partnership, so the “carried interest” is technically a “promoted interest,” Nonetheless, the Congressional proposals under consideration would affect both carried and promoted interests.
2. Note that carried interest is a term used commonly in the industry. The tax proposal described in this article only affects a subset of all arrangements commonly labeled as carried interests. In particular, the carried interest must be paid as a capital gain for the tax proposal to be a concern.
3. Under present law, the number of taxpayers expected to pay AMT will increase from more than four million in tax year 2006 to more than twenty-two million in 2007. This is due to a lack of inflation indexing and the reduced tax liability produced by the 2001 and 2003 tax cuts (without a corresponding change in the AMT. The “patch” will provide a one-year inflation fix preventing this forecasted jump in the number of AMT-payers.
4. Interestingly, discretionary spending programs (annual appropriations for defense, environment, education, etc – in practice, non-entitlement spending programs) are not subject to these PAYGO rules.