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.
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. 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.
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.
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. 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 a
Source: NAHB.org