Much has been written about the new tax code, known as Tax Cut and Jobs Act or TCJA, that was approved by Congress in late December 2017. However, I haven’t seen anything written about one particular unintended consequence of this new tax code. A consequence that is very relevant to real estate investing. The unfortunate truth is that the new tax code puts a wedge between real estate investors and real estate sponsors/developers based on how profits are taxed for each of the participants in the same deal. You might ask why this matters? Real Estate investing is not just about location. It’s also about timing.
Deal sponsors/developers make their money when their investors make profits, typically over a hurdle rate such as a preferred return. In real estate terms this is called the “promote” while Wall Street and the IRS call it the “carried interest.” Today, the new tax code has added nuance to how the promote is taxed, and it isn’t an altogether rosy picture.
Let’s examine what a real estate sponsor/developer/entrepreneur does. Real estate sponsors work to create value by repositioning real assets, typically through capital investment. Real estate sponsors earn sweat equity by first coming up with an idea, then creating a business plan by investing significant pursuit costs, time and often personal guarantees, and then by executing a plan of property development or renovation and leasing. Under the tax code, the sweat equity created by the real estate entrepreneur is lumped into the same category as the carried interest of Wall Street financial engineers.
Let’s say a sponsor raises equity to acquire a partially leased commercial property with the intent of creating value through a lease up. Suppose the lease up is successful and actually goes more quickly than expected – that’s good news, right? Suppose just a year after the acquisition of the property, it’s leased up, and the market is so frothy that an aggressive buyer makes a very attractive offer to purchase the entire property with a short contract period and will pay a premium for it, which would result in a return to investors beyond the original expectations? That’s really good news as well, isn’t it?
As an investor, I would be pushing for that profitable “bird in the hand.” scenario. However, most investors in syndicated deals do not have any major decision rights. Now contemplate what the sponsor’s reaction might be to this “bird in the hand” scenario? Under the new tax code, if the sponsor takes this attractive bird in the hand and sells, the sponsor will pay significantly more taxes than if they had waited another two years (for a three-year hold period) before selling for the same attractive price. Of course, this assumes that the same buyer exists two years later and nothing has changed.
Obviously, we know that the world doesn’t stand still and things change – not always for the better. This reminds me of a real story from the last cycle about a suburban Denver office building we renovated, leased and sold. I kept in touch with the leasing team who stayed on with the new owner. I was saddened to hear that within a few months after we sold the property, the largest tenant was shut down by the IRS for tax issues. There was no indication of problems looming, as that tenant had always paid rent promptly. Had we held on the property, we would have taken a big hit.
So why is this relevant now? The new tax code creates a misalignment of interests based on how the IRS will look at timing for capital gains tax treatment. Although, the new tax code continues to allow investors to benefit from long-term capital gains for deals held for more than one year from project completion, the new code requires that deals be held for at least three years for the sponsor/developer to have its promote taxed at the same long-term capital tax rate. If it is less than three years, the promote will be taxed as ordinary income, which equates to about twice the tax rate of capital gains. There are many smart tax experts out there who are trying to figure out how to work around the three-year carried interest requirement, but so far there doesn’t seem to be a clean way to do so. For example, on March 1, 2018, the IRS issued clarifying guidance that it will not allow taxpayers to avoid the three-year holding period by using a pass-through entity (such as an “S” Corp).
Since I’m neither a tax attorney, accountant, nor partisan, you might be wondering why am I bringing up this topic? My focus is alignment of interests. Although deal sponsors/developers want what is in the best interest of their investor, it also is human nature to make decisions based on self-interest. Thus the new tax code may create real conflict of interest during this important two-year period.
What does it all mean? It’s possible that sponsors/developers will want to hold the deals longer at the risk and conflict to their investors, (i.e., the investor may want out after only one or two years versus waiting for three). This tax code translates to significant tax liabilities to the real estate sponsors who create the value for their investors. Limited partner investors, especially in syndicated deals, are most at risk as they do not have major decision rights like large financial partners do.
I started my business over 20 years ago because of conflicts of interests I saw at that time in old limited partner deals where my family was invested. The decisions made between those with little or no skin in the game often conflicted with those with skin in the game – especially decisions related to whether or not to sell the property. I have worn both hats in my career – the sponsor/developer hat and the investor hat and in all deals where we are sponsor/developer, we also are a significant investor. When Kaufman Capital Partners invests or joint ventures with another developer/sponsor, we negotiate major decision rights and require sponsors to have a significant co-investment – something many financial partners don’t require.
So if you are considering doing real estate deals as an investor or as a sponsor, consider what your strategy will be for dealing with this wedge Congress has created. If you’re not sure about the next step, I encourage you to contact me to discuss how I believe you can protect yourself.