New Tax Reform Carried Interest Rules Could Put CRE Investors at Odds with Developers

September 21, 2018

It was somewhat of a surprise in the final legislation President Donald J. Trump signed into law in late 2017 when the carried interest rules, also known as “promote” in the real estate community, were left mostly intact.

Earlier versions of Trump’s tax reform proposal called for taxing all carried interest at ordinary income rates, prompting a massive lobbying campaign by alarmed real estate developers, private equity executives and hedge fund managers, The New York Times has reported.

But the final bill signed into law had one MAJOR change.

To get capital gains tax rates on a promoted interest, investments must be held for 3 years instead of 1.

For investments sold before 3 years, gains are taxed at ordinary individual income rates of as much as 37%.

Why this change matters

That 17-point spread is a big deal for real estate developers and hedge funds, who sometimes flip investments in just a year or two when certain performance targets are met, when “waterfall” payments kick in or when an attractive buyout offer comes along.

The new rules may put investors who fund deals at odds with the developers who have carried interest in a project: the money side might want to sell as soon as a good buyout deal comes along, while the “promote” side gets hit with taxes that are almost double (37% vs. 20%) if they sell within 3 years.

In a nutshell, the “promote” is a partnership interest that entitles a partner to cash distributions that are not commensurate with how capital was contributed to the deal.

“The unfortunate truth is that the new tax code puts a wedge between real estate investors and real estate sponsors/developers based on how profits are taxed for each of the participants in the same deal,” Craig Kaufman of Atlanta-based real estate investment firm Kaufman Capital Partners wrote in a recent blog post. “Real estate investing is not just about location. It’s also about timing.”

The origin of carried interest

Carried interest dates to at least the 1600s when Venetian merchants paid ship captains a portion of the value of the cargo they carried, which gave them an “interest” in getting porcelain, silk and grain safely to its destination, Lynnley Browning wrote in a recent article published by Bloomberg.

Four centuries later, the same promoted interest compensation model is still strong with real estate developers, private equity and hedge fund managers.

The capital gains loophole

A few decades ago, a so-called “capital gains loophole” was created, and critics including billionaire investor Warren Buffett have argued that it should be closed because capital gains are essentially the same as ordinary income that’s taxed at the higher rate.

The “Oracle of Omaha” has said he pays a lower tax rate than his secretary and most other people in his office, thanks mostly to the capital gains tax rate. Buffett, whose net worth is $83 billion according to Forbes, makes most of his money from investment gains.

Gary Cohn, a former Goldman Sachs executive who helped push the tax legislation through as Trump’s top economic advisor, said that they tried to close the loophole on carried interest, but couldn’t get support for it because of intense lobbying by the financial industry.

“We would have cut carried interest. We tried probably 25 times,” Cohn said in December, according to CNBC.

“We hit opposition in that big white building with the dome at the other end of Pennsylvania Avenue every time we tried,” he said, referring to Congress. Cohn resigned in March, in part over a dispute with Trump over tariffs, The New York Times reported.

This past year is the most active that the American Investment Council has been since 2012 when former Bain Capital executive Mitt Romney ran for president and the industry came under scrutiny, CEO Mike Sommers told The New York Times. The council lobbies on behalf of private equity companies, which invest a half a trillion dollars into the US each year.

“The private equity, venture capital and real estate industries won on carried interest because they stressed the critical role that long-term investment plays in the US economy, and they pushed all the right levers along the way,” Ken Spain, a Washington-based consultant who has worked with the private equity industry on tax issues, said in The New York Times after Trump signed the tax reform law.

Just hold longer?

For real estate, private equity and hedge fund managers who rarely trade out of deals in under 3 years, the changes in Trump’s tax reform law are a moot point.

But for those who depend on fast appreciation and quick flips, the new 3-year hold provision in Trump’s Tax Cuts and Jobs Act may force firms to rethink their acquisition strategy and investment philosophy, according to National Real Estate Investor.

To be sure, capital gains taxes are just one component of whether and when to exit an investment. Numerous other considerations such as deal price, waterfall payments and the risk of degradation of other terms in the future should also be taken into account.

The difficulty is going to be navigating the conflicting desires of investors and those with the “promote” interest.

Imagine a sponsor who raises equity to buy a half-empty building that is quickly leased up and repositioned within a year or two. A buyer comes along and makes an attractive offer. The investor will likely want to take that deal, but if he does, the sponsor with the “promote” interest will have to pay significantly higher taxes on the carried interest for falling short of the 3-year hold.

“The new tax code creates a misalignment of interests based on how the IRS will look at timing for capital gains tax treatment,” Kaufman of Kaufman Capital Partners wrote in the recent blog post. “Limited partner investors, especially in syndicated deals, are most at risk as they do not have major decision rights like large financial partners do.”

Other ways to adapt

Investors have many unanswered questions about the nuances of the new carried interest rules and how they will be applied.

For example, Miles Weiss of Bloomberg reported in February that hedge funds were in a “wild rush” to create thousands of new S-corporations in the belief that the 3-year hold period on carried interest paid to a corporation rather than an individual doesn’t apply and thus would exempt them. Weeks later, the US Department of Treasury and the Internal Revenue Service issued guidance that declared S-corps are subject to the 3-year hold period, too.

It may be several years until investors and companies who have interpreted the new tax code a certain way face challenges and then appeal in Tax Court, which will set new precedents.

In the meantime, investors are looking for other ways to adapt.

Some developers may try to roll their carried interest into the new ownership entity if the buyer is willing to do so. However, doing that could expose the buyer to legal or financial risk that they wouldn’t have if they created their own new limited liability company (LLC) or other ownership entity.

Developers looking to pay the lowest capital gains tax may simply have to hold an investment for the full 3 years. A CPA and legal counsel should review the pluses and minuses of all deal terms to help you make an informed decision.

Bottom line

Trump’s tax reform law requires a 3-year hold period on promoted interest to get the lower capital gains tax rate on the investment.

That may put investors in deals at odds with developers who hold a “promote” interest because investors sometimes want to flip assets quickly, which would force the developer to pay higher capital gains taxes.

Developers must carefully consider these factors at the front end of deals and should ensure their financial models account for longer hold periods if they want to pay the lowest capital gains tax.

Got a question about the implications of the new carried interest rules on an existing or upcoming real estate project? Contact Jeff Winland, tax partner and Aprio’s resident expert in this field.

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