Part I of this article addressed the nature of the problem being discussed in Congress and in the press, particularly as regards the impact carried interest legislation designed to curb perceived abuses with respect to hedge funds will have on real estate. This second part addresses what may be some carve-outs to those effects and distinctions between hundred-million-dollar corporate type deals and the more average real estate “back-end interests.”
The Effect on Real Estate Deals: The Institutional Deal
In the written discussions, the case is made that the development of apartment housing, to take one example, will suffer because developers in structuring their so-called “promote” will now have to pay ordinary tax on their gain. Where the promoter is structuring a deal with passive investors, and gets a 25% profits interest (sometimes called a “back-end interest” to reflect either or both that the gain is made on the sale and/or the interest is payable only after the return of capital plus some minimum return on that capital), whether the higher tax rate will prove a disincentive to deal-making is speculative. However, there are some good reasons to expect the structuring of investments by these promoters (ones using institutional investor equity, and where the developer is the moving force, puts the deal together and finds the equity investor, usually an institution, pension fund, endowment etc.) to change because of the carried interest rules.
Take the fund manager who usually takes a carried interest, along with perhaps his local operating partner, and who has an equity investor as a joint venture partner contributing more than 50% of the required capital contributions. With carried interest legislation, that manager may find his old joint venture equity investment partner (pension, endowment and other institutional investors) less attractive if his partnership interest gain would be taxed at ordinary income rates. The carried interest legislation would then encourage partnership managers to self-finance their equity and to borrow all investor funds (thereby taking them outside the “for services partner” rules).
But it may not be practicable to replace equity capital with loans from independent lenders. The investor (whether called a lender or not) needs to receive equity-like returns on the loan. A partnership’s general partner might be able to obtain debt financing only if the investor would be able to achieve those returns by means of the loan agreements providing profit participation features. In that event, the lender’s upside participation rights might need to be limited so that the loan could not be recharacterized by the IRS as equity for tax purposes. A reasonable maximum limit on the participating lender’s internal rate of return would help avoid recharacterization as equity but might not be exciting for such a lender. Furthermore, control of decision making or intrusion into management, especially with respect to major decisions, might be characterized as involving equity, bringing back the entire panoply of carried interest rules.
The Effect on Real Estate Deals: The Non-Institutional Transaction
Institutional deals may (or may not) comprise a majority of real estate investment and development transactions, but they certainly occupy 90% of the discussion on the effects of carried interest legislation. Let’s take a look at the impact on the more common deal going on in every Texas market as well as around the USA. And whether, unlike the institutional illustrations, there may be ways to avoid the entire problem.
A Real World Illustration
Joan (the daughter of famed Texas investor Lemur Huntress), Renata (a fashion impresario), Maria (an actress and film producer and daughter of legendary vulture fund manager Tremail Pidgeon), and Renee (the restaurateur), entrepreneurs all, have on advice from a top commercial brokerage firm which learned of the seller’s need to unload , entered into an option agreement giving them the right to acquire a 90-acre tract on the edge of town in one of the fastest growing areas in Texas. The property would be a major mixed use development consisting of apartments, offices, commercial retail, and condominiums to be developed over a 10-year time span. The partners have all done well in various ventures ranging from real estate development to fashion lines, retail franchises, jewelry sales and venture capital and definitely know their ways around a deal.
However, they no longer have the patience or time to be dealing with all the details of the development, including the major entrepreneurial decisions needing to be made—the best mix, the concept, the execution, finding and negotiating financing, choosing the team members, the architects, sub-managers, coming up with a marketing plan, and the like.
Joan has a good friend, Montserrat, who happens to have spent the last few years working in the Pidgeon companies and was successful in bringing to market the 500 Gentry Vacation homes in a previously run down area of town known as The Cannery. Montserrat, despite being groomed for a Pidgeon leadership position, is ready to take on a challenge with a big upside reward. Her recent bonuses provide her with funds to pay her mortgage, but she is looking for far more than a development fee. The partners agree that Montserrat is the one.
Heavy negotiations ensue, covering monthly management fees, staffing, employment/management agreement matters such as termination, term, and most importantly, the profits interest Montserrat is to receive, including a myriad of issues regarding how it is calculated, minimum pricing, time thresholds, effects of partnership decisions to bring in joint venture partners, to sell parcels to others, the consequences of various financing terms on measurement of profits and assorted definitional elements. Additionally, and as we shall see below, after much discussion and energetic debate, everyone has agreed on the decision-making process by which the important issues are to be decided—Montserrat is to call the shots. Impressed by Montserrat’s vision for the development, the partners agree that a 20% profits interest, putting her on a par with Joan, Renata, Maria, and Renee after the return of all capital plus 8% per annum, is generous but fair.
On the eve of signing the partnership agreement, Montserrat, over Camparis and soda with her accountant, Luca Pacioli, learns of the recent passage of the 2013 Jobs Bill with its (Max) Baucus bill provisions covering carried interests. Quickly analyzing the compensation arrangements in light of the preliminary spread sheets for the 10-year development against the offer which just came from the Pidgeon companies, Luca quickly calculates that if Montserrat’s partnership interest is taxed at ordinary income rates because the interest is an ISPI (see below) she will do far better at Pidgeon.
Montserrat gives the news to Renata, who after conveying it to the others, calls the broker who pulls the plug on the option. The seller enters into a deal with Texas oilman turned real estate developer Whit Shue, who turns the site into a ranchette subdivision, storage facility and film studios while assessing other sizzling development concepts. None of them sell, leading to foreclosure and the site being transformed into the local neighborhood trash dump when Whit’s lender turns out to have loaded up heavily on Spanish bonds, gets tied up in litigation, and gets taken over by the FDIC.
But did it have to end this way? Only if Montserrat failed to hear the rest of what Luca was telling her about “investment partnerships.” And in fact, good listener as always, her conference call with Renata, Joan, Renee, and Maria took a decidedly different turn.
The Open Door
The most recent proposal pending in Congress (the combined 2012 Jobs Bill and the Baucus bill), which as the most evolved form of legislation is more than likely to be treated at some point, does not apply to interests held by service partners in all partnerships regardless of the underlying business conducted by the partnership, but rather is limited to interests in “investment partnerships.” These are called “investment services partnership interests” or “ISPIs”.
For these purposes, an “investment partnership” would be defined as follows:
A partnership . . . if the majority of its assets are investment-type assets (certain securities, real estate, interests in partnerships, commodities, cash or cash equivalents, or derivative contracts with respect to those assets), but only if over half of the partnership’s contributed capital is from partners in whose hands the interests constitute property held for the production of income.
The rules covering these ISPIs are extraordinarily complex, addressing net income attributable to such interests (treating it as ordinary income regardless of the character of the income, e.g., as capital gain, at the partnership level; the applicability of self-employment taxes to them; the deferral of losses otherwise applicable; and the creation of a “qualified capital exception” to treatment as an ISPI. Further, the bill applies the conversion-to-ordinary income rate for individuals only on the “applicable percentage”, which can range between 50% and 75%, the more favorable rate being applicable with respect to gains on disposition of an asset held more than five years and disposition of the ISPI itself if held for more than five years (and attributable to assets likewise held for more than five years). It gets far more complicated.
But Luca also knew from the above definition that more than half of the contributed capital of the partnership must be attributable to contributions by one or more persons in whose hands the partnership’s interests constitute property held for the production of income (as opposed to held as part of a trade or business). The purpose is presumably to limit ordinary income treatment to cases where the carry is earned primarily on capital from passive investors.
These provisions are a significant change from prior proposals, at least as concern our non-institutional deals. The legislation is now aimed at more specifically targeting the carried interest provision at partnerships like hedge funds, private equity funds, larger real estate partnerships, venture capital funds, and the like. Two of the hallmarks of such investment partnerships are a predominance of investment assets and a capital base that derives primarily from passive investors. The requirement that a majority of the partnership’s assets must be “investment-type” assets obviously focuses on the first of these characteristics. Although the concept of holding a partnership interest “for the production of income” is not clearly defined in the budget proposal or the tax law generally, the requirement that over half of the partnership’s contributed capital must derive from partners holding their interests in this manner would seem to be aimed at identifying partnerships with a predominantly passive investor base.
Based on that, Luca told Montserrat to talk to the partners, reopen the hard fought victories she had won over control and decision-making, and see an experienced non-institutional thinking real estate lawyer to rework the partnership agreement along the lines he discussed.
And so it was done, the city gained a beautiful development, all the partners made a lot of money, Montserrat earned capital gain treatment, and Luca and the attorney made a relatively small but very reasonable fee for the value added and having saved the project.