Paper Potential Changes to the Taxation of Carried Interests in Commercial Real Estate

This paper examines the impact of increasing the tax rate applied to carried (or promoted) interests in the context of U.S. commercial real estate investing. Under current tax law, this disproportionate share of cash flow distributions is typically taxed at the capital-gain tax rate rather than at the ordinary-income tax rate. This carried interest “loophole” remains a contentious political issue. The literature is divided; some advance arguments for taxing carried interest at ordinary income rates, while other research defends the current tax treatment. However, no research of which we are aware has attempted to quantify the benefit of this favorable tax treatment to commercial real estate investors, especially general partners. We attempt to fill this gap in the literature. Due to the complexities of the Tax Code, no closed-form solution is available; instead, a detailed financial model is constructed. The paper relies on two metrics to quantify the impacts of changing tax rates: the effective tax rate and arc elasticities. Our primary findings can be summarized as follows. The GP’s effective tax rate for the base case scenario is 12.32%, which is 4.75 percentage points lower than the LPs’ effective tax rate of 17.07%. However, if the GP’s “pure” carried interest is taxed at a 40% instead of 23.8%, the GP’s effective tax rate increases by 6.85 percentage points to 19.17%. The average arc elasticities of after-tax returns with respect to changes in the assumed capital gains rates are greater – in absolute value – for the LPs than for the GP. In other words, efforts to increase the capital gains rate to something approaching the ordinary-income rates would be more detrimental to the after-tax returns of the LPs than the GP. Should new legislation produce an increase in the capital gains rate, myopic LPs and/or GPs might favor increasing leverage and/or investing in riskier properties to offset the negative effects of legislative action.

Read the Working Paper