For those who question the relationship between shortsighted tax policy and the economy, consider the possible consequences of taxing carried interest.

The carried interest provision in both the president’s budget and in legislation before the House Ways and Means Committee would have a much broader reach than the hedge fund managers it targets. In its current form, it could wreak havoc on traditional real estate ventures, according to Stephen Breitstone, equity partner at Long Island-based Meltzer, Lippe, Goldstein & Breitstone, LLP.

The legislation is aimed at “carried interests,” which is the right to receive a designated share of the profits of a partnership as compensation for managing or otherwise providing services to the partnership. It is considered part of the compensation for the managers, and is in addition to any investments they may have in the partnership.

The proposal would convert all income derived from partnership-taxed entities to be taxed as ordinary income, rather than at the capital gains rate. Although the bill is described as closing a tax loophole, it could have a devastating effect on an already beleaguered industry.

“The legislation changes the laws of nature with effect to real estate partnerships,” said Breitstone. “Typically, someone puts in money and someone else creates the deal. The people that create the deal are usually getting a bigger partnership interest after the money is paid. This is because they’re taking bigger risks. Whatever risk capital they put in at an earlier stage before they bring in the outside investor is subordinated to passive investors, and in exchange they get bigger backend participation.”

“You could argue that real estate has tax-favored characteristics, and it does,” he added. “Going out and developing real estate is a very risky thing. Without these [incentives], it is questionable whether people would take the necessary risks that make it possible to create housing stock.”

As an example of what tax law can do to affect real estate, Breistone pointed to the Tax Reform Act of 1986. “When the passive law rules were enacted as part of 1986 law, they cut the ability of passive investors to use tax losses from real estate to offset other income,” he said. “This decreased the flow of income to real estate and caused the real estate meltdown of the late ’80s and early ’90s, and eventually precipitated the S&L crisis.”

And the current situation has similar characteristics, according to Breitstone. “We’re in a major real estate downturn already, and to pull the rug out from under the treatment that is historically awarded to real estate developers would further accelerate that decline,” he said. “We’re in a particularly vulnerable point in the business cycle to do something like this.”

The only way around this is for the real estate developer to use borrowed funds to do the deal, he noted.

“The carried interest rules apply if you bring in investors as equity partners, but if you go out and borrow the money, they don’t apply and you’re entitled to the capital gain treatment,” he said. “But this creates a massive incentive to engage in much more highly leveraged capital structures, which is exactly the opposite of what we should be doing. We already are suffering a credit hangover, and on top of that these deals won’t happen because you can’t even borrow now.”

Those in favor of the proposal think they are reining in wealthy investors on Wall Street, Breitstone observed. “But they’re casting a much broader net and will stifle a lot of activities we want to encourage,” he said.

We’ve been warned.

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