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.