The risk of taxing carried interests

Dustin Klinger

Although associated most often with hedge funds and private equity, carried interests are also a common element in major real estate development structures. Lobbyists for the real estate investment and development industry, like NAIOP, are concerned that capital gains treatment for carried interests will be a tempting political trading chip, potentially raising developers’ net taxes without visibly increasing tax rates. If these incentive payments are re‑defined as ordinary taxable income, the result could be a big tax bite for project promoters and developers, some with existing projects waiting to pay off.

Critics argue that by being patient, and effectively trading a portion of future returns for lower ordinary management fees from investors, those who benefit from successful carried interests have made a low‑tax gain without ever paying tax on the original investment. In effect, they buy some equity with their efforts and work, but that compensation is not taxed. Then, if the investment succeeds, the entire carried interest is treated as an investment return.  

As with most tax issues, conflicting results and anecdotes often bury the actual legal rule. Many legitimate deals support the speculative-risk argument for continued capital gains investment treatment for carried interests, but the risk is high that a developer will get nothing. Clear examples abound in which the numbers worked into a carried interest agreement were blatantly favorable, were given in place of income-taxable management fees, and practically guaranteed a future payout without risk. Those overreaching examples may be what make carried interests an attractive political target in the budget fight. 

Watching how current and future transactions are structured to account for the unknown changes in the wind will be interesting. Rather than fight the tide and the growing media images of carried interests as special insider loopholes, perhaps a middle ground would be to declare or recognize some risk-adjusted value of the interest at the outset, as taxable income, and have investment capital gain treatment on the growth, or on the loss if a project fails. Without compromise, the whole system could end up treated as ordinary income, which is simplistic but makes a good political sound bite.

Dustin Klinger is partner in the Vancouver office of Miller Nash LLP. He can be reached at 360.699.4771 or Dustin.Klinger@millernash.com.

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