Real estate scores loophole to save loophole

Real estate is an industry constantly aggrieved. But few things have riled up its private equity honchos as much as talk of eliminating the tax break for carried interest.

Back when Barack Obama broached it, Blackstone head Stephen Schwarzman compared it to “when Hitler invaded Poland in 1939.” Schwarzman later apologized.

Last week, Senators Charles Schumer and Joe Manchin struck a surprise compromise for a spending bill that again includes increasing taxes on carried interest income.

In the real estate world, this was no small matter. The “promote” — the share of profits that developers and fund managers get from a project — is treated as carried interest, which is taxed as capital gains, not as ordinary income.

For high earners, that means Uncle Sam takes 23.8 percent rather than 37 percent. Along with depreciation and 1031 exchanges, it’s a major tax advantage that real estate has over other businesses.

But the carried interest tax loophole will not be eliminated altogether by the Democrats’ new plan, known as the Inflation Reduction Act of 2022. Instead, Schumer-Manchin just asks real estate players to hold assets a bit longer to continue enjoying the lower rate: three years instead of one. For assets that are not property, the holding period would be raised to five years from three.

In real estate, three years is not a long time to hold an asset.

“It’s not the final nail of the coffin for real estate,” said Stuart Saft, a real estate attorney at Holland & Knight, in something of an understatement.

The Republican tax plan signed by President Donald Trump in December 2017 increased the holding period to three years from one for investors to receive the lower tax rate, but provided a workaround for real estate: Property sales could be classified as a “1231 gain” rather than a capital gain.

The new plan could treat those 1231 gains as short-term capital gains, subjecting them to higher taxes, according to real estate attorneys.

“The three-year holding period now has more of a bite than it did before,” said Stephen Land, the chair of Duval & Stachenfeld’s tax practice.

The other big change, Land said, is when the three-year holding period starts. Under the previous rule, it was thought to begin when a venture or fund was created. But under the new bill, the count doesn’t start until the fund or venture has acquired nearly all of its assets. For a ground-up real estate project, the developer might not be able to start the clock on the three-year period until the project is nearly finished.

“If you start a new venture and you issue carried interest and you start development, but it takes two years to complete the project, it’s only at that point that the three-year holding period starts,” said Land. “When you add that to the two-year development period, you effectively have five years.”

There’s another concern for real estate. Developers often pitch their projects to smaller investors by noting that they have a stake in the effort. The Schumer-Manchin plan would weaken that alignment of interests. Developers or managers would have an incentive to hold an asset until the sale qualifies for a lower tax rate, while their investors would not — and might push to unload it sooner.

Max Sharkansky of Miami-based Trion Properties said a tax hike could also have consequences for young investors, who tend to sell relatively quickly and put the profits into new projects. Schumer-Manchin would discourage that by taxing short-term gains more.

“This is a huge tax hike. It’s not like 1 or 2 percent,” said Sharkansky. “You have a higher tax rate, you have less capital to put to work.”

The proposal is hardly a done deal. Democratic Sen. Kyrsten Sinema, who wields the crucial 50th vote in the upper chamber, remains undecided.

Private equity, a major target of the bill, will likely lobby aggressively for changes. The Wall Street Journal recently reported that 28 of the top executives at five of the largest public private equity firms earned about $760 million in carried interest last year.

“As our economy faces serious headwinds, Washington should not move forward with a new tax on the private capital that is helping local employers survive and grow,” said Drew Maloney, president and CEO of the American Investment Council, a private equity lobbying group, in a statement.

Bill Ackman, a prominent hedge fund manager, has diverged from the industry consensus and expressed his support for changes to the tax.

“The carried interest loophole is a stain on the tax code,” Ackman said in a tweet. “It does not help small businesses, pension funds, other investors in hedge funds or private equity and everyone in the industry knows it.”

He added, “It is an embarrassment and it should end now.”