New Legislation Affecting Commercial Real Estate

The Association for Corporate Growth (ACG) is closely monitoring two items of legislation that are presently making their way through the U.S. Congress.  Those two items are financial reform legislation and legislation to increase the tax on carried interest.  Because these legislative items are likewise significant to those in the commercial real estate sector, they have been examined below from the CRE industry’s point of view.

Financial Reform Legislation

Since the advent of the “Great Recession,” Congress has focused a significant amount of attention on how it could have been prevented.  No doubt, there were a lot of contributing factors to the recession.  Consequently, Congress’ proposals to prevent a similar recession are wide-ranging.  Among many other provisions in Congress’ financial reform legislation, one would impose risk retention requirements on lenders and securitizers (that is, companies that buy individual mortgages from lenders to combine them into securities for sale to investors).

Risk retention requirements would compel many companies that make loans or sell mortgage-backed securities to retain at least 5% of the credit risk.  In other words, if bad loans are wrapped up into a mortgage-backed security, companies could no longer transfer all of the risk of default in the underlying loans to the purchasers of the mortgage-back security.  Instead, upon a lender’s sale of a loan to a securitizer, the lender would retain an interest in the loan.  In this manner, the lender would continue to share some of the risk of default on the loan.  In addition, upon a securitizer’s sale of a mortgage-backed security, the securitizer would retain an interest in the mortgage-backed security.  In this manner, the securitizer would continue to share some of the risk of default on the loans backing up the mortgage-backed security.  The rationale for these risk retention requirements is that if lenders and securitizers have “skin in the game,” they will be less likely to tolerate unsound lending practices.  Congress hopes that risk retention requirements will reduce the possibility of another subprime mortgage crisis like the one that the nation just endured.

However, if risk retention requirements are imposed, banks will not be able to securitize as many loans.   In turn, if banks cannot make as many loans, real estate purchasers will not have as much access to credit.  Some real estate and bank associations claim that this will unduly stifle the growth of the economy.  However, others in the industry welcome risk retention as an opportunity to demonstrate their commitment to sound lending practices.

In any event, the conventional wisdom is that risk retention requirements will be included in the enacted version of the financial reform legislation.  Proponents of financial reform legislation hope that the president will sign it into law by July 2010.

Legislation to Increase the Tax on Carried Interest
The House of Representatives has passed and the Senate is expected to pass this week, the “American Jobs and Closing Tax Loopholes Act.” The bill is primarily a spending bill with respect to employment but it contains a number of tax provisions designed to raise revenue.  Of the tax provisions, the one that is of most concern to the real estate industry will raise the tax rate on interests in partnerships and LLCs that are referred to as “carried interests.”  
In general, carried interests are interests that receive a share of the profits of the partnership but which are not contingent upon a proportionate capital contribution to the partnership by the partner.  For 2011, assuming ordinary and capital gains rates go to 20% and 39.6%, respectively, the new blended rate on carried interests will be approximately 31.25% and by 2013, possibly as high as 36%.  These rates will apply to earnings that currently enjoy the favorable capital gains rate of 15%.

Carried interests have long been a standard method of forming a real estate partnership because they allow the developer to share in the upside of the venture without having to make a front-end capital contribution.  This legislation is likely to have a significant impact upon that structure.

Although the change in tax treatment was first proposed in 2007, it had not been enacted previously due to heavy lobbying by the securities and real estate industry. Compensation structures in the financial sector have come under increasing scrutiny recently, however, and this revenue-raising provision also serves as an offset to the cost of certain tax extenders Congress has been pressured to enact.  The legislation will apply to any business in partnership or LLC form if the carried interest holder provides services managing or advising with respect to securities, real estate held for rental or investment, or interests in other partnerships.

If passed, the new rates will take effect January 1, 2011, with no grandfathering for existing partnership interests.  Therefore, if a partnership or LLC were about to liquidate or incorporate in preparation for an IPO, for example, or if it were about to sell capital assets at a gain, it should consider whether that transaction should be accomplished in 2010 to avoid being taxed under the new law.