Closing the Carried Interest Tax Loophole Will Reform Real Estate and Hedge Funds

Eliminate the carried interest loophole.  That’s the best way to curb hedge fund abuses.

The recent focus of financial media on the stock manipulation by day traders at GameStop using social websites to pump stock prices is being characterized as a populist revolt against hedge funds.

Nothing could be more naïve.

Day traders are just like bad gamblers. The odds are against them in the long-term.

But if these same traders, and anyone else interested in financial reform, really wanted to know how to cut the power of hedge funds, the answer is simple: Revoke the carried interest tax loophole.

Carried interest allows hedge funds to evade their tax obligations. This loophole also fuels other predatory investing strategies that originate with private equity and real estate developers.

All of these types of investment firms have been accused of victimizing the public, evading their tax obligations, and benefitting from preferential tax treatment buttressed by millions spent on lobbying.

With the Democrats in power, it is time to close the carried interest loophole. It won’t be easy since the financial lobby is the most powerful in Washington, and this loophole is worth billions in profits. But, having a public discussion about the preferential tax treatment given to a small group of elitists is an excellent beginning.

It’s All About Preferential Treatment to Get Tax Loopholes

This tax loophole is the most protected in the collected tomes of tax regulations. It is the pillar of profitability and preferential tax treatment for three investment categories: private equity, hedge funds, and real estate development.

This tax loophole allows these industries to evade paying their fair share of taxes in exchange for a very preferential tax rate. As a result, average taxpayers pay more in taxes than the owners and investors in billion-dollar hedge funds, private equity funds, and real estate developers.

Carried Interest Defined

Carried interest is a nerdy accounting term that allows private equity and hedge fund managers “to mischaracterize their earnings as capital gains rather than income,” according to Patriotic Millionaires University.  This group says private equity and hedge funds claim “they are in a ‘partnership’ with their investors, and their earnings should be classified as capital gains instead of income (because they’re investing their time and expertise into the firm).” However, this is any small business’s exact definition of how they work. The big difference is that they pay a higher tax rate.

Hedge and private equity firms love this loophole since it allows their owners to reduce tax bills by about half. This happens because they are taxed at the much lower capital gains tax rate, just 20%, rather than the top income tax rate of 37%.

So, what’s the real impact of allowing this loophole to continue?

The best  summation comes from the Patriotic Millionaires, who said: “The carried interest loophole is an absurd mischaracterization of income that allows about 5,000 of the richest people in America to divide (conservatively) $1.8 billion a year between themselves, for an average tax break of $300,000 a year.”

Meanwhile, reformers who want to close this loophole contend these PE profits should be treated as regular income and not be subject to special tax treatment. This is the same treatment as most other businesses, large and small.  The big difference is that they have not paid hundreds of millions in lobbying fees to codify their preferential treatment.

If Democrats want to restrain three of the most predatory financial industries—private equity, hedge funds, and real estate development—they must close the carried interest loophole.

Who Opposes Closing the Carried Interest Tax Loophole?

Money talks and controls the politicians who want to prevent closing this critical tax loophole. This includes the Republicans and some corporate Democrats who readily take Wall Street lobbying money, such as Chuck Schumer. In the 2012 presidential campaign, candidate Barack Obama criticized Republican candidate Mitt Romney for his profits from the carried interest loophole. He made a powerful argument that should be repeated today.

According to the New York Times, “Exactly how much Mr. Romney benefited from the carried-interest loophole could not be determined since he refused to release his tax returns before 2010. But as a former Bain Capital partner, he received substantial carried interest—31 percent of his 2010 and 2011 income, The Boston Globe reported.”

Predators in Private Equity

Private equity, the most venal investment category, relies heavily on carried interest. It is known for buying companies and then cannibalizing them to sell off its separate divisions, leaving millions unemployed.

This is why Sen. Elizabeth Warren (D-Mass.) introduced legislation 2019 to reform private equity. The bill had a solid core of progressive and very liberal Democrats who supported it. No Republicans supported the bill and worked hard to prevent it from advancing in Congress. Now, there is a possibility that Elizabeth Warren could be appointed Treasury Secretary in the Biden administration if Biden wants to attract more progressive voters.

Warren’s bill, the Stop Wall Street Looting Act, had three key provisions focused on closing the carried interest loophole.

• It would convert capital gains attributable to carried interest to a higher ordinary income rate;
• It would impose more stringent limitations on interest deductions for leveraged investment funds;
• And, it would effectively impose a 100% surtax on fees paid from target companies to investment advisors.

David Sirota, writing in Moyers on Democracy, has done a great job of reporting on how private equity and the all-powerful Wall Street financial services lobby have unfettered access to Congress. To make its point, Wall Street is well-known as the employer of last resort for corrupt or compromised politicians who lose elections or voluntarily retire from Congress. Wall Street and the right-wing think tanks can always find a job for an ex-politician or general in the private sector without missing a paycheck or suffering a cut in benefits.  These people collect two or three pensions and a complete health benefits package.

To exercise its powerful political muscle, the private equity industry has entered the $9 trillion 401(k) industry.

(Matt Stoller on this site has a great interview with a private equity expert who points out how the PE industry abuses its tax loophole and its supposed benefits.)

This happened because longstanding worker-protection regulations have prevented 401(k) plans from investing in high-risk, high-fee private equity firms. The recent Department of Labor regulatory letter now permits corporations that sponsor 401(k)s to offer private equity funds inside 401(k) plans to unsophisticated investors.

How much money can private equity funds expect to snag from this unsophisticated market?  “If just 5% of the money in these retirement funds were available to private equity, it would be a windfall of $435 billion — real money even to private equity millionaires and billionaires,” wrote Eileen Appelbaum of the Center for Economic and Policy Research.

From the beginning, Trump’s White House has been operating as a de facto subsidiary of the private equity industry: His reelection campaign is being bankrolled by private equity donors. Trump’s Commerce Secretary Wilbur Ross is a significant force in private equity.  Trump SEC chairman was a Wall Street lawyer at a firm that represents private equity clients. Trump’s first National Economic Council was the president of a private equity giant. Trump’s top outside adviser is Steven Schwarzman, the CEO of the world’s largest private equity firm, Blackstone. Blackstone is a major donor to the Republican Party and his firm was named as the leading broker for purchasing stocks and EFTs for the Federal Reserve’s bailout program.

The Lucrative Hedge Fund Industry

The hedge fund industry has manipulated financial regulation for decades.  In its latest iteration, it has even applied for COVID-19 federal bailout money, claiming it has suffered economic losses. Making this claim with a straight face is ludicrous, especially considering how profitable the industry has become.

In 2014, for instance, the nation’s top 25 hedge fund managers earned a combined $11.62 billion, according to Institutional Investor, or an average of $467 million each. The latest data from the Internal Revenue Service for the top 400 earners, including the nation’s top hedge fund and private equity managers, found that in 2012, they paid the second-lowest average federal tax rate since the data was collected, a mere 16.7%. This happened mainly because over half of their income is taxed at the lower capital gains rate, the New York Times said.

Declare War on Carried Interest

In the upcoming presidential election, voters should ask Biden to move carried interest to a campaign promise. Biden is a corporate Democrat and will receive millions from the Wall Street lobby to oppose any changes to this loophole.  But he is now courting progressives to move left and attract the younger progressives. Biden’s best prospect is to attract more progressive voters, including people who want a progressive tax strategy where the wealthy pay more taxes than the less affluent. This is why Biden should appoint Elizabeth Warren as Treasury Secretary.  Wall Street would hate it. Main Street would love it.

Biden should be pushed to close the carried interest loophole. He has no progressive credentials, so this will not be a natural political act for him to adopt.

But if Democrats want to close three predatory financial industries—private equity, hedge funds, and real estate development—they must change this focused preferential tax treatment.