Vijay Yadlapati, NATIONAL ASSOCIATION OF REALTORS® Associate
Commercial Policy Representative
As NAR’s Commercial Policy Representative, Vijay monitors and analyzes federal legislative and
regulatory developments in order to shape the direction of today’s policies. Additionally, Vijay lobbies
the U.S. Congress and federal regulatory agencies to ensure that the interests of the commercial real
estate industry are addressed.
The Real Truth About Carried Interest
What's the Issue?
In previous years, legislation passed the U.S. House to treat carried interest compensation as ordinary income instead of taxing it at
the capital gains rate. To date, the U.S. Senate has been hesitant to
change the tax treatment of carried interests. However, with comprehensive tax reform possibly on the table in the 113th Congress,
both chambers could view a change in the tax treatment of carried
interests as a way to offset the cost of lowering general tax rates or
of increasing the perceived fairness of the tax system.
The proposals to restructure the way carried interests are taxed
appear to be largely based on flawed assumptions. For example,
some lawmakers believe that the majority of those who receive carried interests are Wall Street hedge fund or private equity fund high
rollers. This is not the case. Real estate accounts for almost 50 percent of the 2. 5 million partnerships in the United States. In reality,
the proposed tax increase on carried interests would be an increase
on a substantial amount of real estate activity in an already volatile
and recovering sector of the economy.
What Are Carried Interests?
Many partnerships (including real estate) are organized with general partners who contribute their expertise (and, in some cases,
capital), and limited partners who contribute capital in the form of
money and/or property to the enterprise. Generally, any profits of
the partnership are divided among the limited partners. A common
practice, however, is to provide additional incentive for the general partner to perform well by sharing some of the profits above a
certain “hurdle” rate with him or her through a “carried interest,”
even when the general partner contributed little or no capital to the
enterprise. The general partner’s profits interest is “carried” with the
property until the property is sold, which can be a number of years
after the enterprise is formed and limited partners have received
During the time the property is held, the general partner receives
compensation through management fees that are taxed as ordinary
income. The limited partners can receive both ordinary income
from operations and capital gains from any profits generated during the year. When the property is sold, the limited partners receive
their profits distribution (the earnings on the capital they invested)
as capital gains. If the venture is successful, the general partner
then also receives the value of any carried interest as capital gains
income. This partnership structure has been a huge success, giving investors and entrepreneurs in many industries the tools to create and grow businesses, build shopping centers, found technology
companies, and create millions of jobs.
Effect of Changing the Tax Treatment
It is unclear how much revenue the government could generate by
changing the taxation of carried interests. Some tax policy experts
believe that talented entrepreneurs would simply find other ways
to structure new ventures to avoid the higher tax. Others argue that
some deals that now make economic sense would simply not be
done in the future, since a higher tax would increase the hurdle rate
of return. Moreover, Congress itself seems torn on how to approach
the issue, with some proponents of changing the tax rules urging
that certain industries, such as real estate and venture capital, be
exempt from the change. Such an approach would likely reduce any
possible revenue raised by a significant amount. Other policy makers argue that the change should be made prospective only, which
would also likely reduce any new revenue by a large amount.
Carried Interest Taxation Should Not Be Changed
NAR believes that the current-law treatment of carried interests
helps better align real estate managers’ interests with those of investors and has played an important role in economic development and
job creation. Changing the tax treatment to increase the rate of tax
on general partners would decrease potential rates of return on successful ventures and raise the hurdle rate, resulting in fewer ventures being funded, and less economic growth and job creation.