HR 4213 and the Carried Interest Debate


In the earlier post regarding Sarah Palin’s train-wreck of a speech at ICSC REcon 2010, I mentioned that she should have talked about the legislation making its way through Congress that could potentially subject carried interest to the normal tax rate (currently 35%, could increase to 39.6% next year). It is currently taxed at the capital gains rate of 15%. The ramifications of this aggressive bill could be quite severe, or mild depending on your particular view. The end result could be good or bad for the American economy. In the rest of this post I will summarize the arguments for both sides, without much opinion (this is going to be hard).
First let’s define carried interest. Carried interest is a share of the profits from a partnership that the manager of the partnership receives. The most common example of carried interest is the 20% (sometimes more, sometimes less) of the profits that a private equity or hedge fund manager receives as compensation. Assuming that the manager’s primary job is to operate the private equity firm or hedge fund, he essentially makes his income from this shared interest. This is then taxed at 15%. This is where the pro-legislation argument comes about. It clearly is not fair that someone’s income is taxed at 15%. The current upper bound of the 15% Federal Income Tax Bracket is $34,000. It’s probably safe to say that this private equity manager made more than $34,000 in carried interest, otherwise he or she should probably find a new career. How does this fix the problem? Well it certainly makes sure that no one is using a loophole to avoid hefty taxes.

While this may be more fair, the way private equity firms could potentially get around this is to not use other people’s capital. By investing more of their own capital, they are going to shield themselves from carried interest taxes. This, however, leads to less equity in the market. Businesses need equity to employ people, and provide their goods and services to the general public. So adverse effect #1 is there is the potential that this could cause the creation of jobs to slow and keep our unemployment rates high.

But there are those that would argue that less equity is a good thing because the combination of a large amount of equity, low interest rates, and the ease of using leverage could very well have led to high demand for real estate causing prices to surge skyward like a space shuttle taking off from Kennedy Space Center. This of course led to way too much debt at peak pricing, and when the prices came back down, people got screwed.

So why should Sarah Palin have mentioned HR 4213 in her speech?According to the IRS a little less than half of partnerships are real estate partnerships (as of 2005). It could be argued that taxing carried interest as normal income could disproportionately affect real estate partnerships (assuming that private equity “fat cats” are the targets of this bill). According to ICSC’s memo about why they oppose the increase, the real estate market could lose $15-20B per year, because the increase in taxes would make the investment not worth it. On top of this, current laws create hurdles for the manager to realize gains on the investment.

This blurs the lines between income and investment return. I’m going to assume that the managing partner has a rather large vested capital interest in the venture. I’m also going to assume the managing partner is probably the last to receive his investment back. In exchange for added risk, isn’t the investor due a higher ROI? So is the extra 20% on top of his capital gain more capital gain or income? Is it possible to quantify the added risk? I think a hedge fund manager taking his 20% every year sounds more like income, whereas a real estate partnership manager receiving 20% of the appreciation of the investment after holding it for a number of years sounds more like capital gain.

To this supporters of HR 4213 would say, “So what?” If real estate is a good investment, it will be a good investment no matter what the tax rate is. It could be argued that although the returns are less, the portfolio theory behind the allocation to real estate should stay the same, otherwise the portfolio won’t be optimized. Essentially, this means that it won’t deter people from investing in real estate, so long as their core investing strategies stay the same.

So which side do you stand on? Both make extremely valid points, and I’m sure there are many more points on both sides. Given the anti-Wall Street sentiment in Washington these days, I see this passing. It will definitely be interesting to watch how this affects the recovery, if at all.

4 comments for “HR 4213 and the Carried Interest Debate

  1. June 2, 2010 at 6:12 pm

    The only thing I’d add is that the hedge fund manager in your example who is taking his 20% every year is not getting taxed at 15%. “Carried Interest” does not magically change the type of income coming in. If you’re getting carried interest, but the source of the income is short-term capital gains, or dividend income, or coupon income from bonds, it still gets taxed at the higher rate. The only time you get the 15% is when the income coming in the door is a long-term capital gain.

    So, to your earlier point, it really is impacting your long-term investors in real estate, some private equity (but not the “fat cats” that DC is thinking of, which buy a company, lever up, and pay out huge dividends in year one!), etc.

  2. John
    June 9, 2010 at 9:18 am

    Why do I get the feeling the author is a registered Democrat?

  3. June 9, 2010 at 10:32 am

    Actually I’m not. I consider myself an independent, but am registered as a Republican in the great state of New Hampshire solely for the sake of primaries (first in the nation!). Fiscally conservative, and socially accepting would be my ideal politician, but these days those are few and far between (Bloomberg for President?). I fully subscribe to the “Live Free or Die” motto that graces the license plate on my car. I guess if you had to label me, I would be more libertarian than anything. I think it’s wrong to want an amendment protecting the “sanctity of marriage,” while at the same time I’m an opponent of single payer health care. That said, I’m not Ron Paul. A certain amount of regulation is necessary to protect the interests of all parties involved (majority rules, minority rights).
    To that end, I guess the reason why I may come across as a Democrat in some of these posts (besides the Sarah Palin bashing) is because I’m trying to provide a fair and balanced view, and thus I need to compensate for my utter disdain of this bill. I sincerely believe that this will hurt our already crippled private sector. The jobs report this month was not promising. Once money starts changing hands again, then the job market will come back. But we need to make it easier for this to happen, not harder.
    Does it make me mad that lower class folks pay a higher tax rate than the hedge fund managers? Sure, but life isn’t fair. The rich have and will always exploit loopholes to avoid paying taxes. This reply gave you way too much information when a simple “no” probably would have been sufficient. If you would like to discuss more, feel free to email me, or just reply to my post. Thanks for your comment.

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