PROPOSED CHANGES TO TAXATION OF CARRIED INTERESTS

The Inflation Reduction Act of 2022 promises big changes to how America responds to global warming, aka climate change. But if enacted in its current form, it will also change how real estate sponsors and hedge fund managers are taxed on carried interests.

A “carried interest” or “promote” is what the sponsor gets for putting the deal together. In a typical hedge fund, the manager receives a 2% annual management fee plus 20% of the profits. In the syndication of an apartment building, the deal sponsor might receive 30% of the profits after investors have received a preferred return of 7% and all their money back. The 20% of the hedge fund manager and the 30% of the real estate sponsor are the “carried interest.”

For many years gains from carried interests were taxed as capital gains rather than ordinary income. This favorable tax treatment attracted widespread criticism, from Warren Buffett among others, and is often referred to derisively as the “carried interest loophole.”

As described here, section 1061 was added to the Internal Revenue Code to close, or at least narrow, the loophole. Under section 1061, gains from carried interests generally are treated as ordinary income if the interest is held less than three years. But in a loophole within a loophole, capital gain was preserved for most real estate syndications by excluding from section 1061 gains from the sale of property used in a trade or business, such as the ownership and operation of an apartment building.

The Inflation Reduction Act of 2022 includes two important changes to section 1061. One, the three year holding period will be extended to five years. Two, the exception for property used in a trade or business will be eliminated.

As someone famous once said, one man’s loophole is another man’s castle (or something like that). For many real estate sponsors, the carried interest is the primary source of income: annual management fees pay the bills, but the carried interest sends the kids to college. Increasing the tax rate on the carried interest by 20 percentage points or more is not trivial.

The capital gain rate is still available if the property is held for five years, but many real estate projects contemplate shorter holding periods.

If the changes are enacted in their current form, I expect sponsors will adjust the economic deal with investors. Most likely, we will see the carried interest percentage increase from around 30% to around 50%, at least for transactions where the holding period will be less than five years. For that matter, we will probably see longer holding periods for both hedge funds and real estate, as the market adjusts.

Senator Sinema of Arizona is a longtime fan of the carried interest loophole and hasn’t yet weighed in on the Inflation Reduction Act. You can bet she’s getting lots of phone calls as we speak.

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