Real estate is a constantly injured industry. But few things have pissed off its private equity moguls more than talk of eliminating tax relief for deferred interest.
Back when Barack Obama addressed it, Blackstone chief 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 a tax hike on deferred interest income.
In the world of real estate, this was no small feat. “Promotion” – the share of profits that developers and fund managers make from a project – is treated as deferred interest, which is taxed as capital gains, not ordinary income.
For high earners, this means that Uncle Sam takes 23.8% instead of 37%. Along with 1031 depreciation and exchanges, this is a major tax advantage that real estate has over other businesses.
But the carried-interest tax loophole won’t be completely closed by the Democrats’ new plan, known as the Cut Inflation Act of 2022. Instead, Schumer-Manchin is simply asking players to real estate to hold assets a little longer to continue to benefit from the lower rate: three years instead of one. For assets that are not property, the holding period would be increased to five years instead of three.
In real estate, three years is not a long time to own a property.
“This is not the final nail in the coffin for real estate,” said Stuart Saft, real estate attorney at Holland & Knight, in a sort of understatement.
The Republican tax plan signed by President Donald Trump in December 2017 increased the holding period from one to three years for investors to receive the lower tax rate, but provided a workaround for real estate: sales of properties could be classified as a “1231 gain” rather than a capital gain.
The new plan could treat those 1,231 gains as short-term capital gains, subjecting them to higher taxes, according to real estate lawyers.
“The three-year holding period is now more biting than before,” said Stephen Land, president of Duval & Stachenfeld’s tax practice.
The other big change, Land said, concerns the start of the three-year detention period. According to the previous rule, it was thought to start when a company or a fund was created. But under the new bill, the count does not begin until the fund or company has acquired substantially all of its assets. For a basic real estate project, the developer may not be able to start the clock on the three-year period until the project is nearly complete.
“If you’re starting a new business and you’re raising interest and you’re starting development, but it takes two years to complete the project, only then is the holding period of three years starts,” Land said. “When you add that to the two-year development period, you effectively have five years.”
There is another real estate concern. Developers often pitch their projects to small investors noting that they have a stake in the effort. The Schumer-Manchin plan would weaken this alignment of interests. Developers or managers would have an incentive to hold an asset until the sale qualified for a lower tax rate, while their investors would not – and might push to offload 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 invest the profits in new projects. Schumer-Manchin would discourage this by taxing short-term gains more.
“It’s a huge tax hike. It’s not like 1 or 2 percent,” Sharkansky said. “You have a higher tax rate, you have less capital to put to work.”
The proposal is far from complete. Democratic Senator Kyrsten Sinema, who holds the crucial 50th upper house vote, remains undecided.
Private equity, a major target of the bill, is likely to push aggressively for changes. The Wall Street Journal recently reported that 28 top executives at five of the largest public private equity firms earned about $760 million in deferred interest last year.
“As our economy faces serious headwinds, Washington should not move forward with a new tax on private capital that helps local employers survive and grow,” said Drew Maloney, president and chief executive of the American Investment Council, a private equity lobby group, in a report.
Bill Ackman, a prominent hedge fund manager, deviated from the industry consensus and expressed support for the tax changes.
“The carried interest loophole is a stain on the tax code,” Ackman said in a tweet. “It doesn’t help small businesses, pension funds, other hedge fund or private equity investors and everyone in the industry knows that.”
He added: “It’s embarrassing and it should end now.”