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Increasing the Tax on Carried Interest: An Economic Impact Analysis

Special Studies, January 6, 2010
By Robert Dietz, AVP Tax and Policy Issues
Economics and Housing Policy
National Association of Home Builders
Report available to the public as a courtesy of
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The taxation of capital gain due to a carried interest is an important issue for the real estate industry and particularly for the multifamily housing sector, both market-rate rental and Low-Income Housing Tax Credit. Under present law, capital gain classified as a carried interest is taxed like any other capital gain, at a 15% rate. Under changes proposed in legislation recently approved by the House of Representatives, that tax rate could climb to 35%.[1] Among other impacts, this change would generate a 133% tax increase on carried interest income, thereby impeding the financing of future multifamily developments and undermining the underwriting of established deals. These effects would result in lost jobs and economic benefits from future development, as well as foregone property tax revenues for state and local governments. This paper quantifies these impacts.

The data and calculations in this paper find that increasing the tax on carried interest would:

  • Reduce property tax revenues to state and local governments by $1.2 billion per year
  • $242 million allocable to multifamily rental property
  • Result in the loss of more than 18,000 jobs in 2010 and 33,000 jobs in 2011 due to reduced multifamily rental housing construction

What is Carried Interest?
The use of partnerships and other pass-thru entities is common in the home building industry and the construction sector generally. These entity types provide a useful way to organize – for particular development projects - the hundreds of thousands of home builders and subcontractors who work in thousands of local markets across the country.

In a common arrangement, a builder/developer performs the role of the general partner and outside investors act as limited partners, who provide much of the initial equity financing. Typically, the general partner receives a developer’s fee (and possibly subsequent fees for owning and operating the property) and the limited partners receive a specified rate of return on their investment. Any residual profits are split between the multifamily builder/developer/property owner and the investors as defined by the partnership agreement. Of course the particulars differ depending on the nature of the project, the types of developers, and the role of outside investors.

In many cases, the developer’s share of the residual profit, if it is realized (uncertain at the time of the deal), is classified as a “carried interest ,” which is an allocation of profit that as a share of total profit exceeds the share of the developer’s initial equity investment in the project.[2] The carry can be ordinary income or capital gain, but the current policy debate is limited to a carried interest that is due to a capital gain at the partnership level. Carried interest that is paid as ordinary income is unaffected by the proposals being debated in Congress. Capital gain typically arises in such arrangements through the sale of a tangible, depreciable asset that is held for more than one year. For example, this situation would include a building that was constructed, owned and operated for a period of time and then sold to other investors.

As a simple example, if a multifamily builder, acting as the general partner, provides 5% of the equity financing for a project (with the remaining 95% provided by the limited partners) and receives 10% of all capital gains distributed, then the 10% distributed to the multifamily builder is a carried interest for the purpose of the Congressional proposals under consideration (because 10% - the gain distribution share - is greater than 5% - the initial equity contribution).

Table 1 illustrates this in more detail for a hypothetical partnership with $100 million in initial equity financing ($95 million from outside interests, and $5 million from the home builder), a 10% preferred return for the limited partners, and a 50%-50% division of residual profit. Under this example, the home builder’s capital gain income is a carried interest (portion in excess of 5% - the initial equity stake) and would be subject to additional tax under existing proposals.

Table 1. Illustration of Partnership Income Distributions and Tax Consequences

Economic Purpose of Carried Interest
Putting aside the tax issues, the carried interest in the above multifamily development example serves two important economic purposes. First, it provides an incentive for the multifamily developer and property owner to control costs and operate the property efficiently in order to generate a profit for the outside investors. This incentive makes the investment more attractive for investors, helping to attract investment for multifamily projects, particularly those in higher risk environments, such as economically-distressed areas.

Second, the carried interest transfers business risks associated with the development project to the multifamily builder and owner, who may be more familiar with market conditions and in better position to manage the risks. These risks include changes in administrative expenses, local regulations, and of course local market conditions, which is of particular importance given the existing weakness in many local housing markets. Further, a multifamily developer may assume additional risk by making additional guarantees to the outside investors. For example, the developer can guarantee the completion of the project, or the servicing of debt used to finance the project.  Carried interest allows multifamily builders to be compensated for making these guarantees and assuming the risks. Hence, partnerships with carried interest mechanisms are excellent financial arrangements for allowing multifamily developers and outside investors to share business risks efficiently.

Proposed Change to the Taxation of Carried Interest
The carried interest proposal in H.R. 4213 requires all capital gains income distributed as part of a carried interest allocable to a partnership to be treated as ordinary income, taxable at a tax rate of up to 35%. Under present law and practice, such carried interest gains income is taxed at the long-term capital gains tax rate of 15%. The change proposed in the legislation represents a sharp break with established tax law and practice associated with partnerships and other pass-thru entities as it would redefine the nature of the income (i.e. capital gain) from how it arises (sales of a capital asset) to how and who the income is distributed. The legislation would also subject the newly-defined ordinary income to applicable self-employment taxes. The proposed tax policy change would be effective for sales or dispositions of capital assets after December 31, 2009.

The Joint Committee on Taxation estimates the proposal would raise $24.6 billion over ten years for the Federal government, with a significant share of that tax revenue arising from the construction and real sector.[3]  Other industries that would be affected include the energy sector, venture capital, and the hedge fund industry.

Douglas Holtz-Eakin (2007) analyzed an earlier version of the proposal, with a focus on its impacts for commercial real estate.[4]  His findings included $5 billion annually in increased tax payments allocable to commercial real estate and $15 to $20 billion in annual economic costs, with this estimate increasing for lost entrepreneurial talent, and unspecified lost jobs and wages in real estate development.

The Economic Impact of Modifying the Taxation of Carried Interest
This paper seeks to build on these previous estimates by quantifying the real estate impact of changing the tax treatment of carried interest. The analysis uses government data from the 2001 Residential Finance Survey (a part of the 2000 Census that contains information on the financing of owner-occupied and rental housing), the Internal Revenue Service Statistics of Income data, the Quarterly Summary of State and Local Government Tax Revenue, and the American Community Survey (ACS) data. The economic impacts estimated below are lost property tax revenues for state and local governments and lost general economic impacts of lost future development projects.

Lost State and Local Government Property Tax
Increasing the tax on carried interest for the real estate sector results in a transfer of tax revenue from state and local governments to the Federal government. To estimate this impact, it is first necessary to calculate the baseline amount of property tax paid by multifamily rental property and then estimate the reduction in the value of these properties that results from the increased federal tax burden.

The 2001 Residential Finance Survey (RFS) is the only source of data that can be used to estimate the aggregate value of the multifamily rental housing stock. The RFS provides the count of properties, and with these data the number of units can be estimated.[5] To generate an estimate for 2009, the stock is grown or “aged”, in terms of properties and units, by the percentage growth in the national multifamily stock as reported in the ACS from the end of 2000 to the end of 2008 (6.88%).

Table 2: Multifamily Rental Stock

The RFS also provides an estimate of the number of properties that represent recent construction (developments added in the previous year).

To determine the baseline property tax receipts, the aggregate value of the multifamily stock needs to be estimated. The RFS provides an average (mean) value per property by size of structure. Using these data, and the counts of properties, we can estimate aggregate values for 2001. Values for 2009 can be generated by growing the size of the stock, as reported above, plus increasing the average values by Moody’s Real Commercial Property Price Index – Apartments for the applicable time period (17.6%).

Table 3: Value of the Multifamily Rental Stock

Note that the aggregate values reported in the table above cross-checks well with an alternative approach. Using data from the 2001 RFS, it can be shown that the average value of the multifamily rental stock is equal to 11 to 12 times the sum of monthly rental gross receipts. Using the 2008 ACS, the value of total monthly rental receipts (approximately $32 billion), the 2001 RFS capitalization rate, and the Moody’s apartment price data series, yields an alternative estimate of $1.496 trillion for the value of the multifamily rental stock for 2009.

The 2001 RFS also reports average effective property tax rates for different elements of the housing stock. Using these data, it is possible to calculate the effective tax rate for the multifamily rental stock (1.27%). We assume that this rate has remained approximately the same for 2009. This suggests $20.1 billion in annual tax payments to state and local governments by multifamily rental properties. The Census of Governments reports, for 2009, approximately $428 billion in property tax revenue collections. Using 2008 ACS data, owner-occupied housing represents about $207 billion of this total, and single-family rental produces about $12 billion (for about 10.5 million housing units) for a total residential real estate total of about $240 billion of property tax revenues. The remainder of the $428 billion is paid by commercial and agriculture real estate owners.

With these estimates for the baseline multifamily rental stock, the effect of changing the tax on carried interest can be estimated. First, the share of multifamily rental stock income allocable to a carried interest needs to be calculated. According to 2007 IRS data for partnerships, 60.5% of income for the construction and real estate sectors is due to long-term capital gains (including section 1231 dispositions). The IRS data report that 21% of partnership income is passed-thru to the general partner.

However, as explained above, the gain portion of the carry will constitute a greater share for the general partner. Thus, we assume double the share reported (42%) to be that part of the gains that are passed-thru to the general partner. We believe this to be a conservative assumption, as in some deals up to 80% of the possible capital gain will be passed through to the general partner. Multiplying these yields, on average, 25.2% of partnerships’ income due to a capital gain structured as a carried interest to the general partner

The change in after-tax return given the tax policy change is 23.5%.[6]  If we employ an price elasticity of -1 with respect to a change in expected return (meaning a 1% decline in the rate of return decreases the asset price by 1% - a conservative assumption given that investment capital flows relatively easily to assets with the highest rates of return), then applying the after-tax change in return (23.5%) times the share of income due to the carry (25.2%) yields the estimated change in asset value (the price of the multifamily rental unit), or about 5.9%.

We now have a baseline effect on asset values for properties that would be affected due to the change in tax policy. To estimate the share of the tax base affected by the change in price, we assume that the average asset (multifamily building) is held for seven years before sale. Using the multifamily rental stock factor of recent construction from the RFS (2.89%), this yields 20.25% of current projects being eligible for a change in tax treatment and an impact that will be capitalized into the market value of the asset (excluding future projects, which are discussed below).

Now the reduced level of property taxes can be calculated. This is equal to the annual property tax due to multifamily rental properties ($20.1 billion) times the share of the stock affected (20.25%) times the change in the asset price (or assessed value) (5.9%). This calculation yields an estimated annual reduction of state and local property taxes of $242 million or $2.42 billion over ten years.

Using these estimates, a rough estimate can also be generated for commercial real estate properties. Assume only 60% of the nearly $190 billion of property tax revenues for state and local governments not allocable to owner-occupied or rental housing is due to commercial real estate. Further, assume applicable property tax rates are approximately the same for commercial and multifamily rental properties, but the average hold period is only five years instead of seven (but the share of recently built commercial real estate is about the same as the share of recently built commercial property). Using the same calculation as above, this approach yields a reduction of state and local property taxes due to commercial real estate equal to $966 million per year.

Thus, the total amount of property taxes lost to state and local governments due to the increase in carried interest taxation for the real estate sector is approximately $1.2 billion per year. Given that the federal revenue estimate for the carried interest proposal is $24.6 billion, this $12 billion ten-year estimate demonstrates that the proposal generates a significant transfer of tax revenues from state and local governments to the federal government.

We can also estimate the share of the national impact by state using ACS data for the counts of recently-built rental property (and assuming the geographic distribution of commercial property is approximately the same) and the effective median tax rates per state. We weight the state allocation by the number of recently-built structures and relative tax burden. The results are presented in Table 4.

Table 4: State Estimates of Lost Property Tax Revenues

Lost Economic Benefits due to Lost Future Development
The estimate of lost property tax revenue is the impact of the proposed change in carried interest taxation for current properties. The proposal will also eliminate projects in the future by decreasing the after-tax return, thus causing the projects to be abandoned.

NAHB Economics and Housing Policy forecasts non-condominium multifamily starts of 67,000 for 2010, and 123,000 for 2011. By modifying this forecast, it is possible to estimate the reduction in multifamily starts that would occur for these years, and the corresponding reduction in economic benefits from this lost construction activity. We use the reduction in the after-tax return for the general partner and apply an elasticity of -1 for the impacts on housing supply (again being conservative given the relatively elastic response of capital investment to after-tax return), thus suggesting a 23.5% reduction in non-owner occupied multifamily starts for each year.

Using jobs, income and tax multipliers estimated in prior NAHB research, we can estimate the lost economic activity.[7]  These impacts are reported in Table 5.

Table 5: Lost Economic Benefits of Incresing Tax on Carried Interest

As an example, in 2011 the change in the taxation of carried interest would eliminate more than 33,000 jobs.

This paper presents estimates of some of the economic consequences of changing the taxation of capital gain to ordinary income when the gain is due to a carried interest. These impacts include $1.2 billion of lost state and local property taxes per year (due to the real estate sector) and more than 18,000 jobs in 2010 and 33,000 jobs in 2011 due to reduced multifamily development. These estimates add further weight to the argument that increasing the tax on carried interest in the real estate sector will result in lost jobs and reduced property tax revenues for state and local governments.

For more information about this item, please contact: Robert Dietz at 800-368-5242 x8285 (

[1]H.R. 4213, Tax Extenders Act of 2009, which was approved by the House of Representatives on December 9, 2009 by a vote of 241 – 181. Section 601 of the bill establishes a new Internal Revenue Code Section 710 that would redefine the taxation of capital gain due to a carried interest.
[2]Note that technically this definition describes both promoted and carried interests. A “promote” is often used to refer to any share of profit allocation greater than the initial equity stake, and a “carry” is a type of promote for which there is little or no equity stake. However, in the current debate, the term “carried interest” now captures all of these scenarios.
[3]Joint Committee on Taxation. JCX-59-09. December 7, 2009. The revenue pattern associated with the estimate is revealing as to the timing of the impacts, on both current and future deals. The estimated revenue peaks in 2011, declines until 2015, and then increases again through the end of the budget window. This is suggestive of a proposal that is expected to affect current projects, and then generates significant change in either the arrangement or existence of future multifamily projects.
[4]Holtz-Eakin, Douglas. 2007. Commercial Real Estate and Changing the Tax Treatment of Carried Interest. White paper for the Real Estate Roundtable.
[5]As a cross-check on this imputation, when accounting for single-family rental properties as well, the imputed value of total rental housing units is 34.6 million. The 2000 Census reports a value of 35.6 million rental units. This is therefore a conservative imputation that biases to undercounting.
[6]The after-tax change in investment return to the general partner is equal to (t_2-t_1)/(1-t_1 ), where t_1is equal to the present law tax rate on the carry (15%) and t_2 is equal to the proposed tax rate on the carried interest (35%). Note that this assumes, conservatively, no employment tax rate effect.
[7] The Direct Impact of Home Building and Remodeling on the U.S. Economy. Paul Emrath and Helen Liu. 2008.

For more information about this item, please contact Robert Dietz at 800-368-5242 x8285 or via email at

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