Tax Changes Affecting Real Estate Investing

On Friday, May 28, 2010, the House of Representatives passed the American Jobs and Closing Tax Loopholes Act of 2010 (the “Act”). It is not certain when the Senate will consider the legislation. One of the changes with this new act, is the ordinary income treatment for carried interest. The proposed legislation would treat part or all of a partnership’s carried interest as regular income, as opposed to a capital gain. The legislation is primarily aimed at private equity funds and venture capitalists, but would have a huge knock-on effect on commercial real estate since many property investments are structured as LPs and LLCs. Carried interest is the portion of the venture profits paid to general partners of such structures after the property has been sold, separate from the fees the general partners earn for managing the property.

The measure is now in the Senate, where it is expected to be modified. This modification decreases the amount of carried interest that is recharacterized as ordinary income from 75 percent to 65 percent and increases the amount treated as capital gains from 25 percent to 35 percent in taxable years beginning after December 12, 2012. The change further decreases the amount of carried interest that is recharacterized as ordinary income to 55 percent and increases the amount treated as capital gains to 45 percent for gain or loss attributable to the sale of an asset which is held for 7 or more years.

Please keep in mind that eventhough most of the focus has been geared to investment funds, it impact goes beyond that. For example, it is expected to dramatically change the taxation of developers in the typical real estate operating partnership. As currently drafted, the rules may curtail the ability of real estate developers to use tax depreciation and other losses from the property and would accelerate tax on certain transfers of the Carried
Interest.

The Act is intended to be effective immediately after enactment, with income for the year of enactment allocated between the pre- and post-enactment portions of the tax year.