One of the tax issues in play in the current round of deficit talks is the taxation of carried interest. A carried (or promoted) interest is a profits interest in a business deal that is larger as a share of the total return than the share of the initial equity investment. Under present law, if the income paid out as the carry is a capital gain, then the carry is taxed at capital gains tax rates (in general, up to 15%).
However, some critics, focusing on the hedge fund and private equity industries, have proposed taxing income due to a carry as ordinary income (up to tax rates as high as 35%) whether it originates as a capital gain or not. The claim is that because the return to the carry is out of proportion with the initial capital investment, the income is due to labor – not capital – and should be taxed at ordinary income tax rates.
Despite the focus on the financial sector, the use of carried interest is actually quite common in real estate. A builder/developer will typically gain a carried interest in partnership with outside limited partners, who will invest a significant share of the initial equity for a project. The builder provides also provides some equity, but additionally acts as the entrepreneur and takes more of the economic risk. The return to the carry reflects this risk premium, and thus allows shifting the risk away from the limited partners and attracting capital to the deal.
For projects yielding non-capital gain income (for example, in single-family development), the proposal to tax carried interest as ordinary income would have no impact. But it would have a large and harmful impact for multifamily developers.
For multifamily projects, the income due to a carry typically arises as profit from the sale of an apartment building, which is a depreciable, capital asset. As such, this profit originates as a capital gain. The proposal to tax carried interest would arbitrarily redefine such income as non-capital income and tax it at a higher rate.
During an earlier round of debate over this issue, NAHB published a paper analyzing the negative consequences that would arise if the tax treatment of carried interest was changed. The analysis found that by placing downward pressure on the prices of apartment buildings and other commercial real estate, the proposal would reduce state and local property tax revenues by more than $1 billion per year and would eliminate more than thirty thousand jobs in multifamily construction and development.
Given the ongoing weakness in the labor market and the potential for job creation in the multifamily sector, tax increases on apartment developers would be harmful for economic growth. It would be useful to keep these real economic consequences in mind, despite the media focus on the carried interest issue as only a financial sector concern.