The city’s real estate investment market could suffer a jolt just as it appears to be improving if a proposal in Congress to raise the tax on carried interest is adopted real estate industry members say.
Carried interest is the cut that managers of an investment take from the profits of that venture for their own compensation. The House of Representatives approved a bill at the end of May called The American Jobs and Closing Tax Loopholes Act that would raise the tax on that income.
The legislation package includes provisions to cut taxes for businesses and extend insurance and healthcare benefits for unemployed workers but seeks to help pay for its $127 billion cost is a provision to significantly raise the assessment on carried interest, which is currently taxes at the capital gains rate but would now be treated as ordinary income under the bill.
An announcement released with the legislation said that the higher rate would "close tax loopholes for wealthy investment fund managers and foreign operations of multinational companies."
Real estate experts say that while the bill’s language appears aimed at curbing Wall Street avarice, it would be real estate that bears the brunt of the tax hike.
"Real estate makes up nearly 50 percent of all partnerships in America," Jeff DeBoer, president of the Real Estate Roundtable, an industry-lobbying group, wrote on the congressional blog The Hill last week. "It is not a tax on hedge funds that tangentially affects real estate; it is a real estate tax hike that tangentially affects hedge, venture capital and private equity."
Deboer added that the bill is "more than anything, a tax on real estate partnerships large and small."
Many real estate investments are structured in a way that would be impacted by the legislation if it is adopted. In the city, partnerships and joint ventures are often used to acquire real estate assets, especially sizeable deals that would be difficult for one entity to finance single-handedly. Landlords abound in Manhattan expert at finding investment opportunities and managing them but who rely on deep-pocketed partners such as pension funds to put down the bulk of the equity.
Other landlords like Tishman Speyer and Blackstone raise vast pools of cash from a host of investors and then channel the money into deals of their choosing.
In both cases, the managers in the deals divert returns from the investment to pay back an arranged return for their partners or investors, but then share in a cut, often 20 percent or more, of the profits from there.
Currently those proceeds are assessed at the capital gains rate of 15 percent, a tax that is expected to rise to 20 percent next year when President Bush-era cuts are scheduled to sunset. Under the House’s bill, that tax would skyrocket to almost 40 percent because the carried interest that the investment managers receive would be treated as ordinary income.
"This is going to discourage deals because the drivers of a lot of real estate investment are real estate operators who are working to earn sweat equity and this tax eats substantially our of their profits," said Steve Spinola, president of the city real estate association, REBNY.
"You discourage deals when people won’t get the economic benefit of their effort and time and that’s going to take money out of not just real estate, but the economy in general."
Robert Knakal, an executive at the real estate sales brokerage firm Massey Knakal, said that he has had two owners approach him in recent weeks with plans to sell before the year is out because they are fearful of having to pay the higher assessment if the legislation is passed.
"Whenever you add a tax to an activity, you will produce less of that activity so you may see an uptick now, but this will be bad for sales volumes next year if the bill passes," Knakal said.
Knakal felt that the higher tax rate would particularly hurt new development because those types of projects usually require higher returns to compensate for their higher level of risk.
"This could diminish profits and remove the incentive for new buildings, which we’re going to need at some point when the economy begins to turn around," Knakal said.
Howard Landsberg, a partner at the accounting firm Weiser, said that the bill could change real estate investment management into a business that asks for fees rather than a percentage cut.
But Landsberg also said he saw the industry shifting in that direction anyway due to the economic downturn and the drop in real estate prices.
According to Landsberg, investors have to take a longer-term approach to investment in order to earn returns because rents have fallen and real estate appreciation appears to be flat, or only gradually on the rise. The market conditions appear to have left little room to pay generous returns to a passive equity partner or investors in a real estate fund and then split the further profits.
"The managers in a real estate partnership would prefer to shift to a fee structure in order to guarantee their own income during the tougher times," Landsberg said.
Currently, the future of the carried interest tax hike rests in whether the Senate and the House can agree on the bill. The Senate has proposed a competing version that is similar but would essentially charge a lower rate than the House’s plan, somewhere around 30 percent.
Picture: Howard Landsberg, WeiserMazars