Why should real estate people give a darn if John Paulson, Ray Dalio or Carl Icahn get taxed at ordinary income rates on their half-billion dollar plus carried interests?

Well, actually they shouldn’t—that is, if only Congress and the Administration could agree that treating hedge fund managers as subject to ordinary income tax rates on their regular annual compensation should not be applicable as well to real estate deals.

The Problem

Differentiating hedge funds from real estate deals has some real economic foundation, but so far, no one has been able to present a satisfactory theoretical principle on which the distinction could be founded. The real estate industry has not been able to surmount the problem and has been left to argue merely on the basis of bad consequences which would follow. As a result, the old smells like, tastes like, and walks-like-a-duck-rule means that both real estate partnerships and hedge funds are treated identically under the various carried interest taxation rules which have been put into the hopper.

But as you read this article, keep in mind that the discussion about “applicability to real estate” has a decidedly institutional bent, meaning that the popular press is somewhat out of touch with the real world of real estate deals. What may be the same treatment of hedge funds and real estate partnerships may mean the same treatment of hedge funds and large deals founded by a general partner promoter whose investors are the same passive types as hedge fund investors. Bear in mind, as will be seen later in this article, that the consequences for deals this and other offices have been doing for decades may be quite different, and with proper structuring, may preserve the current system.

No one can see why the CEO of a Fortune 500 corporation making $10 million or $50 million (however one thinks of his or her worth or relative multiples to apply to executive compensation) is taxed on that amount at ordinary income tax rates because it is salary, whereas Ray Dalio’s $3.9 billion clocked for 2011 as the effective CEO of the Bridgewater Associates hedge fund or James Simons’ $2.1 billion as effective CEO of Renaissance Technologies Corp. gets capital gain treatment on their take of the annual returns made by the fund.

When the rule is fashioned which turns those gains into ordinary income as opposed to capital gains treatment, it captures as well the real estate deal guy who puts no money into the deal but gets a piece of the action in the form of a partnership or LLC interest, after the return of capital to the money partners plus perhaps some minimal return on their investment, such as, for example, a “preferential return” of say 8% to 10%.

The real estate industry’s best case for differentiation seems to be based on the importance of the real estate industry, and all the horribles (a lessening of affordable housing and the like) that follow upon real estate deals not getting done. This is unlikely to work. So we are left with a rule designed to capture Carl Icahn being applied to the neighborhood development deal. We shall see in an example below how that will work to make things difficult for almost every bread and butter real estate deal.

Witness the following critique published by the National Multi-Housing Council:

Real estate partnerships-and many of the 618,000 workers and 17 million Americans who rely on our industry to provide them with safe, decent affordable housing-will be very adversely affected by such a change. Some estimates indicated that approximately one-quarter of the legislation’s impact would have been on the real estate industry alone.

A “carried interest” (or “promote”) has been a fundamental part of real estate partnerships for decades. Investing partners grant this interest to the general partners to recognize the value these partners bring to the venture as well as the risks (recourse debt, litigation risks, responsibilities for cost overruns, etc.) they take.

Current tax law, which treats carried interest as a capital gain, is the proper treatment of this income because carried interest represents a return on an underlying long-term capital asset, as well as risk and entrepreneurial activity. Extending ordinary income treatment to this revenue is inappropriate. In addition, any fees that a general partner receives that represent payment for operations and management activities are already properly taxed as ordinary income.

The proposed change in the taxation of carried interest would impose the most sweeping and potentially most disruptive new tax on real estate since the Tax Reform Act of 1986, which contained the passive loss limitation rules.

Not only is such a tax law change inappropriate, it will also have numerous unintended consequences, including exacerbating the nation’s affordable housing shortage. If enacted, changes in the taxation of carried interests could affect whether a new development is financially viable. It will be particularly damaging to properties located in under-developed areas and could prevent much of the proposed new affordable housing from being built.

True enough. But not enough people in Congress understand the problem to have been convinced. And in fairness to them, there is nothing supportable in the argument. A carried interest could be defined as something pertaining to stock funds only, but so long as it is defined simply as a profit interest received in exchange for services, real estate cannot be excluded any more than Mississippi or one or another minority can be excluded from legislation because its application would be economically detrimental to them and even to the nation’s economy. We are therefore headed for a tax law change which will chop off both heads.

The Tax Issue

A carried interest is a share of any profits that partners receive as a bonus, which is intended as an incentive to make sure the deal performs well, despite not contributing borrowed or personal funds to the initial deal. It is often the backbone of real estate deals. A real world example will be covered in Part II of this article.

Typically, in hedge funds, the amount of a carried interest comes out to around 20-25% of the fund’s annual profit. A carried interest is meant to serve as the primary source of income for the general partner of a hedge fund. However, before receiving its profit interest, the general partner must ensure that all the initial capital that the limited partners contribute is returned along with some previously agreed upon rate of return.

The articles discussing carried interests do so in terms of general partners, but in real estate, the individual receiving a profits interest can well be the principals’ employee or chief operating officer type, who may be the promoter, but may in fact be a secondary figure. In either case, the profits interest is subordinated to the return of capital of the investors or money partners.

The genesis of the problem is that the Internal Revenue Code does not address how a partnership interest received in exchange for services, as opposed to in exchange for property, should be treated. If a person receives property in exchange for services, then the Code (Section 83) provides that the recipient is taxed on the fair market value of that property as soon as the grant is not subject to forfeiture. The essence of the problem is that Section 83 does not address whether, in this context, a partnership interest is property, or, if it is, how it is to be valued. The valuation of a profits interest based on the future of the enterprise would obviously be a monumental problem. Therefore, under current law, the issuance of a carried interest for services can be structured so as to be non-taxable. Under the Code , the rules look only to the granting or vesting of the interest to determine whether the service provider has received compensation.

The current position of the IRS and the Treasury Department, as reflected in proposed Regulations issued in 2005, is that, in keeping with the case law over three decades on the matter, it is appropriate to allow partnerships and service providers to value a partnership interest issued for services based on the liquidation value of the interest in certain circumstances. However, because the liquidation value generally is the amount that the holder of the interest would receive if, immediately after receiving the interest, the partnership sold all its assets and liquidated, the liquidation value of a profits interest typically will be zero.

Of greater significance in the context of the carried interest debate is that, under current law, once a service partner receives a profits interest in a partnership, income allocated to that partner retains the same character as the income earned by the partnership.

Therefore, when a partnership recognizes capital gain in connection with a transaction, the portion of such income allocated to the individual service partner is taxed at favorable capital gain rates. That is why Ray Dalio gets capital gain treatment on 3.9 billion, even though it sure looks like salary or bonus, and certainly is compensation for services rendered and in any case looks like unfair tax treatment.

The Fix

Most of the newspaper discussion assumes that somehow, magically, the compensation of a partnership interest granted to a promoter or other service provider will be treated as ordinary income. Not so fast.

If a partnership interest is held by the service provider, turning the profit interest to ordinary income has to be distinguished from the legitimate capital gain treatment afforded to investors acquiring like partnership interests. And is it ordinary income upon receipt, or only when distributions under the partnership are made? Or some combination of both? There is no single piece of legislation right now on the floor of Congress, but rather many proposals.

Proposals in recent years have addressed possible taxation at time of receipt (that however presents valuation problems, as noted above) combined with subsequent treatment of items of gain as under present law; treatment of income allocable to the interest as subject to ordinary income tax rates; and a “blended” rate by which 50% of the gains would still be subject to capital gains treatment. Whether it is 100% or 50% turns very much on the matter of who controls the Senate and House, assuming even that Congress gets to the point of bringing up the legislation, certainly not before January 2013. Likewise as to whether it will be retroactive or only applicable to partnership interests granted in exchange for services after the date of the legislation. Most legislative proposals do not provide for grandfathering in existing arrangements, and given the revenue needs which motivate the legislation, it is likely that this retroactive effect may remain.

Part II will address the practical impacts of the proposed carried interest legislation on typical deals real estate practitioners work on, the newest legislative proposals, and whether there will be ways to structure those deals differently than in cases which are the subject of most of the discussion.