A plan to eliminate carried interest is moving forward as part of the Biden administration’s ambitious $6 trillion plan to build infrastructure and expand social benefits for families earning less than $400,000. While the measure presumably would raise between $7 billion and $14 billion in tax revenue over 10 years, it also would end a partnership structure many consider critical to the financing of private real estate developers and to their ultimate reward for taking risk.

Carried interest, commonly known as the “promote,” is the share of profits that accrue to a developer after the return thresholds of limited partner investors are met. In other words, it’s what developers get after certain other investors are paid, typically upon a project’s disposition or refinancing. Traditionally, carried interest has been taxed at the capital gains rate, which is currently 20 percent. But lawmakers in the Senate and House have introduced bills that would recharacterize carried interest as regular income, which could double the tax rate for developers in such partnerships.

The elimination of carried interest not only would jeopardize the real estate partnership structure but also would disincentivize entrepreneurial investments in both vibrant communities and underserved neighborhoods in need of a catalyst, real estate experts say. In short, developers would be much more hesitant to perform a range of time-consuming and expensive pre-development activities. Consequently, the number of projects driven by private developers could plummet. “It’s safe to say that if you cannot be compensated properly for risk taking in development, then eventually, you’re going to avoid it and look for opportunities that provide the best return for your time and capital,” said Trish Blasi, founder of Borghese Investments, a commercial real estate developer and advisor based in Aventura, Florida. “Maybe you’ll choose opportunities that aren’t as beneficial to communities, like trading stocks. That’s concerning because the process of development and redevelopment is critical to our economy and communities across the country.”

Congress’ push to end carried interest is just one piece of the Biden administration’s tax reform plan, which on the whole would impact the commercial real estate industry dramatically. Generally targeted at annual earners of $1 million and framed as reforming policies that unfairly benefit the rich, Biden’s proposal seeks to eliminate the step-up basis for inherited properties, to gut like-kind exchanges and to double the capital gains tax rate, among others. To date, the plan to eliminate carried interest is the only proposal that is part of legislation before both chambers of Congress, though a discussion draft to amend the step-up basis is circulating among lawmakers.

Some consider carried interest the “sweat equity” that developers commit to a prospective deal. Among other pre-construction work, developers must identify properties and negotiate contracts; conduct title reviews, property surveys and environmental and stormwater evaluations; and obtain entitlements. Developers also must prepare architectural designs, secure contractors and issue debt, which may require personal guaranties.

Depending on the number of complicating characteristics, including a project’s size and its location, the pre-development process can take several years and cost millions. Only at the end of that work are investors brought in as limited partners. “Anyone can invest in a project once all the plans are done, but to get from an idea to a project that’s financeable, it takes a long time and involves a lot of risk,” said David Bramble, managing partner for commercial real estate development and investment firm MCB Real Estate. “And in particular, if you’re trying to do a development in an underserved area, no investors want to touch it until everything is buttoned up.”

Among other projects, Bramble spearheaded Yard 56, a mixed-use project in East Baltimore on the site of a former paint factory and across the street from the Johns Hopkins Bayview Medical Center. The factory closed in 2006 and had become a target for arsonists and vandals. Hazardous contamination was also a concern. MCB Real Estate acquired the property in 2014, and it took four years to fully complete the pre-development work before construction began. In addition to the removal of asbestos and routine planning, MCB Real Estate lined up Brownfield, New Markets and Enterprise Zone Contribution tax credits. Yard 56’s first phase, a 90,0000-square-foot neighborhood center, opened in 2020. A second phase will include medical office, apartments and additional retail.

While developers typically receive fees for development and other services, the real reward can be several more years away. But a return is hardly guaranteed. Unforeseen delays, lawsuits and other hiccups can diminish or wipe out the carried interest, Bramble adds.

Over the past several years, some lawmakers repeatedly have looked at reforming carried interest, says ICSC Global Public Policy vice president of tax policy Phillips Hinch. Those efforts, like this one, largely have been sold as closing a lucrative tax loophole that unfairly benefits the general partners of hedge funds. But the conflation of real estate developers with hedge fund managers is misleading, experts say. Taxpayers and lawmakers alike are largely unfamiliar with how some shopping centers, apartment communities, offices and other projects are created. “Real estate development is not like getting lucky on a trade and making $100 million,” Bramble said. “It’s slow and plodding. It takes a lot of capital and upfront risk.”

While past carried interest-elimination proposals have struggled to gain traction, massive deficit outlays during the pandemic, the Biden administration’s enormous spending plans and a compulsion to create more tax fairness are fueling anticipation that more progressive tax reform in the current Congress is possible.

ICSC has been working closely with a number of other commercial real estate organizations in Washington, D.C., on the carried interest issue. The Real Estate Roundtable president and CEO Jeffrey DeBoer suggested that beyond influencing future development, the elimination of carried interest more immediately could impact existing partnerships. That’s because the developer suddenly would be paying a higher tax rate than the limited partners, and as a result, the economic interests of the two parties no longer would be aligned. “Members of Congress need to understand that this is not going to affect different industries in the same way,” he said on a recent Marcus & Millichap webcast. “To continue to provide opportunities in real estate to people who haven’t had them in the past or who don’t have the money or balance sheet to do development themselves, we need to keep laws like this on the books.”

Indeed, if Congress does away with carried interest, it’s likely that only the most deep-pocketed developers will pursue meaningful projects, Hinch states. “Developers that have a couple of hundred million dollars can create a shopping center on their own, and there’s no question that they will get capital gains tax treatment when they sell it,” he said. “But the bills in Congress are saying that if developers bring in outside investors, now suddenly they have ordinary income upon disposition. It’s not a logical argument.”