Carried Interest: It’s Not a Loophole, It’s the Tax Code
They’re at it again. Like clockwork, some Congressional Democrats and President Obama are pushing to raise taxes on “carried interest.” Just as they have several times in the last few years.
This proposal repeatedly failed in the past, and for good reason: it hurts economic growth and job creation. Increasing taxes on carried interest impacts not only hedge fund managers, as its proponents imply, but also negatively affects real estate partnerships that need capital to finance development projects throughout the country.
Carried interest refers to the shares of profits earned by managers of successful investment funds. Proponents of this tax increase seek to tax these gains as personal income, rather than at the existing 15% capital gains rate.
The administration describes the treatment of carried interest as a “loophole,” but it is nothing of the sort. Changing the tax treatment of these partnerships turns on its head over 50 years of tax law characterizing carried interest as a capital gain. For decades, our tax code has recognized those who invest capital and have expertise to grow businesses. Section 702(b) of the code allows partnerships that realize dividend and long-term gains from their arrangements to be taxed at the capital gains rate, rather than income.
There is a clear reason for this, as carried interest differs substantially from a traditional salary. Under most agreements, the manager of the investment partnership receives no carried interest if the endeavor fails. The manager is also on the hook for returning the principal from the partners, regardless of his performance. Most workers in our economy do not have to return a significant portion of their salary if they do not accomplish what their colleagues and supervisors expect of them.
This tax hike disproportionately hurts real estate, which accounts for almost half of the approximately 2.5 million partnerships affected by this proposal. At a time when the real estate market is struggling, this would be a significant blow to the economy.
Real estate depends on carried interest as a crucial component of its investment strategy. Development of hospitals, hotels, shopping centers and underserved neighborhoods carries risks, and partners combine to insure against these risks by granting the general partner the carried interest. This protects against potential holdups, such as construction overruns or changes in public policy.
Carried interest also attracts financers who might seek shorter-term ventures absent any incentive to participate in large-scale development, which usually entails a multi-year commitment. These investors may include smaller real estate firms, who would favor a partnership arrangement in a long-term undertaking. If the federal government takes a larger share of these investments, there will be less capital and incentive to start projects in disadvantaged neighborhoods. As building slows, construction and real estate jobs decrease, as do property values and property tax revenues.
As talks of “raising revenue” and “closing loopholes” dominate deliberations in Congress about the budget and the economy, our elected officials need to look beyond talking points about the “one percent,” the “super-rich,” and not be fooled by class-warfare rhetoric.
Here in New England, Senators Olympia Snowe and John Kerry carry influence as key members of the Senate Finance Committee. If this proposal makes it to the Senate floor, Senators Scott Brown and Susan Collins will play a critical role. Hopefully, they understand the negative consequences of a carried interest tax increase and will not support any proposal that includes one.