Changes to Tax on Carried Interests Would Lead to Conflicts of Interest

In music, some notes are held longer than others, and the basic notation system is easily understood. For example, a half note is half as long as a whole note. A quarter note is half as long as a half note. An eighth note is half as long as a quarter note, and so forth.

Sometimes, a composer wants to hold a particular note longer than it otherwise would be based upon the note. Enter the fermata. A fermata above a note indicates that the note is to be held longer than the duration indicated by the note value. The typical fermata is a symbol above the musical stave, which looks much like an upside-down letter U with a dot in the middle (musicians also call fermatas "birds' eyes").

Sometimes, fermatas may look like an upside-down V with a dot in it, indicating the performer should hold the note only slightly longer. Rarely, fermatas look like a three-sided square open on the bottom, with a dot in the middle, indicating the performer should hold the note much longer.

Despite these fermata options, the "bird's eye" version is the most common. And generally, the performer decides how long to hold the note to convey the desired musical message. In an orchestra, the conductor decides how long all the musicians must hold a fermata.

Politicians are touting a new tax proposal they claim would "close the carried interest loophole." The tax proposal wouldn't eliminate carried interests as implied—it would only extend the holding period from three to five years for a fund manager to be eligible for long-term capital gains treatment on their carried interest upon sale. This holding period contrasts with the one-year holding period rank and file investors must hold their investments to be eligible for long-term capital gains treatment upon sale.

Functionally, this carried interest tax proposal would require the conductor told a fermata five times as long as the orchestra musicians to create the same musical effect. Such a rule would create tension between the orchestra, which might be eager to move on in the piece, and the conductor, who would be penalized if they did so.

This article discusses carried interests, how they are taxed, and how, if passed, the proposed changes to the taxation of carried interest would affect real estate fund investors.

What is a Carried Interest?

Private equity and hedge fund managers who run funds and rich people who own them aren’t the only people who benefit from the current tax laws on carried interests. For instance, an increasing number of investors are retirement funds. According to a January 10, 2022 Wall Street Journal article – roughly $480 Billion in state and local government pension funds are invested in private equity funds. Those pension funds are ultimately owned by ordinary, middle-class workers who are saving for retirement.

Carried interests also are common in real estate funds. While sophisticated ultra-high net worth managers manage some real estate funds, many managers, particularly new ones, are not wealthy. And although many real estate funds require that owners be accredited (generally with a net worth over $1 million), with crowdfunding and other newer securities law exemptions, interests in those funds have become available to nearly everyone.

For the remainder of this article, I’m going to discuss real estate as a fund asset, but much of the discussion is equally applicable to funds that hold other types of assets.

One way managers make money from putting together investments is a “carried interest.” To incentivize managers to manage the investment well, they receive a percentage of the gain when the real estate is sold. The manager doesn’t receive its payment unless the investment is successful. That's because the manager usually gets paid only after the investors get all their money back plus a guaranteed "preferred" return similar to interest.

Because a manager may never receive a dime from its carried interest, it has no value at the beginning of the investment. It's speculative whether a fund manager will ever benefit from its carried interests. A carried interest might be viewed as a bet on the success of the investment. Once a gambling bet is made, there is no value until the bet pays out.

How are Carried Interests Currently Taxed?

A carried interest has no value when the fund manager receives it, so it is given a tax basis of zero. Therefore, any amount the manager receives later on account of the carried interest traditionally has been treated as a capital gain.

Tax law distinguishes capital gains based on how long the investor owned the property. If the investor owned the property for more than one year, it is a "long-term capital gain." Gains on property held for less time are called "short-term capital gains."

Short-term capital gains are taxed at the same rates as regular income. But long-term capital gains are taxed at lower tax rates. Taxing long-term capital gains at a lower rate incentivizes people to save money and make investments.

Some view lower long-term capital gains rates as an attempt to adjust taxes for inflation. If someone buys a property for $100,000 and sells it for $165,000 six months after buying it, the cost of living has changed little between the purchase and sale. So, the $65,000 gain reflects an increase in real value (nominal value adjusted for inflation) to the investor.

But if an investor invested $100,000 in a property in June 2002, the equivalent value in June 2022 adjusted for the Consumer Price Index would be $164,708.73. Selling the property at $200,000 after that twenty-year hold period would show a nominal gain of 100 percent while the real value of the investment is essentially unchanged. Some would say that the lower long-term capital gain rate would help compensate for phantom changes in asset value.

Regarding carried interests, under the TCJA, passed in 2017, if the real estate is held for three years, any payment the manager receives from its carried interest is treated as a long-term capital gain. The manager pays taxes at ordinary income rates if the property is held for less than three years. Before the TCJA, fund managers’ carried interests received long-term capital gains treatment after a one-year holding period. However, TCJA didn’t change long-term capital gains treatment for real estate fund investors -- they remain subject to the one-year rule.

Disparate Treatment Creates Conflicts of Interest

Now, unless property is held for three years to receive long-term capital gains treatment, gains on carried interests are treated the same as all other manager income. Since fund investors must hold their interests for only one year to receive long-term capital gains treatment, the manager's and investors' interests aren't aligned during the second and third years a real estate investment is held.

This disparity creates a conflict of interest for investors, who might want to sell for a favorable price in years two or three, and fund managers, who benefit from holding the investment longer – even if the value doesn’t increase.

To eliminate this conflict of interest, fund managers may change their fee structures to level the playing field with investors. With managers disincentivized from waiting until the property is sold to receive their compensation, managers may reduce their carried interest and seek to receive increased annual asset management fees or require higher upfront fees. And without a carried interest, managers may be less focused on the long-term increase in real estate value. Instead, the focus may be on income from the investment.

Real estate investment held primarily for current income rather than long-term gain may be managed differently. Since maintenance and capital expenditures can reduce the cash available to distribute as investor income, there is less incentive for owners not to make repairs or improvements.

How the Proposed Change Might Affect Tenants

There are two ways to increase current cash flow for a property managed for income rather than long-term gain–increase income or reduce expenses. Since rental rates are affected by supply and demand, a fund manager is limited on how much they can increase rental rates. It may be easier to reduce expenses by cutting amenities and deferring maintenance – resulting in a less desirable living environment for tenants.

Lengthening the hold period for long-term capital gains treatment of carried interests might cause fund managers to delay sales. Owners frequently make significant when they buy a property (and have financing) or when preparing to sell a property (in hopes of a higher sale price). So, incentivizing extended real estate hold periods will likely reduce capital improvements on properties, affecting property condition and ultimately, tenants.

Conclusion

Fermatas prescribe how long a note is to be held. If the musicians in an orchestra hold a fermata for different lengths of time than the conductor prescribes, cacophony can result. The larger the discrepancy between lengths of time the fermata is held, the greater the cacophony. The purpose of the fermata – the musical message – is lost.

Similarly, increasing the discrepancy between the long-term capital gain treatment of investor gains and manager carried interests will increase the conflict of interest between investors and fund managers. In the end, the losers aren’t the fund managers – it’s the investors.

As with many tax initiatives, fund managers are likely to change their compensation structure to minimize those conflicts and also minimize the additional tax burden any tax law change imposes. So, as with the disparate length fermatas harms the musical message, the goal of changing the taxation of carried interests – raising more tax dollars – may not be as effective as hoped.

© 2022 by Elizabeth A. Whitman

Any references clients and their legal situations have been modified to protect client confidentiality.

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