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What is the Carried Interest Loophole?

by: Anthony Parent   2017-09-05

There is actually no such thing as the Carried-Interest Loophole. Try as one might, it is impossible to find a special tax rule that allows Hedge Funds and Hedge Fund managers to take advantage of the US tax code in a way that no other investor can. In this article we will explain the rules, and why any attempts at closing the non-existent loophole would necessitate the removal of long terms capital gains treatment --- something that is completely infeasible.

 

What is this interest you are carrying?

The phrase "Carried Interest Loophole" itself is misleading. If you hear the phrase "Carried Interest Loophole", you could think it allows someone to pay taxes on earned interest at a later date, like a 401k plan. For instance, say a Hedge Fund invested in bonds. It wouldn't have to pay taxes on earned interest year-after-year until some later date.

 

This is called tax deferral -- it the goal of many tax planning strategies. The benefits of tax deferral are based on the present value of money. Quite simply, money is worth more now than it is later. Generally, it is better paying your taxes later, if at all, than now (with the exception of Roth 401k treatment).

 

Yet, this is not what "Carried interest loophole" is at all.

 

What the Carried Interest Loophole is: Let's use an example.

Suppose you want to invest in an investment property that is worth $1 million. You don't want to risk all this money yourself in this property, so you find nine other people also willing to make a $100,000 investment. The ten of you are partners, and you act as the general partner. You believe the property is undervalued and that in 5 years you can make a handsome profit.

 

After year one, you see the value of the property increase...as it does all the way to year five. Then you sell it for $2 million.

 

According to the long term capital gains treatment, your taxes will be about 20% of your gain. In this case, it's your share of the sales: $200,000 minus your share of the investment of $100,000. On top of this gain of $100,000, the other partner agreed that you should be entitled to another $100,000 due to your hard work in making the deals happen. This means that your total gain of $100,000 will be taxed at the long term capital gains rate of 20%.

 

This example is the basic outline of how hedge funds operate. A fund manager invests his own money in a partnership investment, and additionally, typically get a larger share of the gain because of the value he provides.

 

It is this additional value portion that some people want to tax as ordinary income --- the higher 39.6% tax rate. The argument is that fund managers provide labor in the same way employees do, and thus should be taxed at the same high rate of employees. I can't imagine anyone who takes risks in the private sector believing that for a second.

 

The Carried Interest Loophole can't be closed

Did you notice that the general manager above wasn't taxed until there was actually a sale? That is, the partners weren't taxed as the value of the property was going up, but rather when it was actually sold.

 

What proponents of the "Carried interest loophole" seek to also do is to make investors liable on accrued gains. But, this runs afoul of the long term capital gains treatment and also might fail the Glenshaw Glass test for income. Calculating accrued gains on increases in investment property is an arduous task, and probably a pointless one, too. You never know what a property is actually worth until it is sold. 

 

Yet, long terms capital gains treatment taxes not on probable gains, but actual gains.

 

Hedge funds many times pool investors into investments, and the fund managers act as general manager. The general managers will be compensated by the performance of the investment. Because general managers perform a higher proportion value and undertake greater risks, it is only fair their portion from the gain be higher than that of a limited investor.

 

Becuase "Carried interest" is so intertwined with long term capital gains, one could argue that "carried interest" is a long term capital gain. Attempts to rewrite the code are technically impossible unless long term capital gain tax treatment is basically eliminated.

 

Additionally, eliminating long terms capital gain rates is politically unfeasible. Both parties rely on long terms capital gains; many seniors also rely on the sale of investments for income. If a politician wanted to be voted out of office quickly, a removal of the long term capital gains rate would likely do it.


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