Taxing Carried Interest As Ordinary Income: The Idea That Never Dies, But Never Becomes Law Either

Tucked away in the Biden administration's proposed budget for the federal government for fiscal year 2023 — among more headline-grabbing ideas, such as a minimum 20% tax on high net worth individuals — is the revived idea of taxing carried interest as ordinary income. 

Though seemingly an arcane part of the tax code, the impact of taxing carried interest as ordinary income is straightforward: It would significantly raise taxes for investment funds' general partners. That includes many partnerships whose main focus is real estate investment.

"Carried interest" is an accounting term for the share of a private fund's or partnership's profits that is paid to managers as part of their compensation, though they typically get fees as well. For almost 30 years, the federal tax code has treated carried interest the same as a return on investment — in other words, at a capital gains rate, and not as regular income. 

Currently, capital gains are taxed at a maximum rate of 23.8%. Regular income is taxed at a top rate of 37%, though the exact rate depends on various factors, such as a taxpayer's income and other considerations.

As a goal of tax reform, adjusting carried interest has made the rounds on Capitol Hill for years. Now that the proposal is once again in play, the standard pro and con arguments are being dusted off again as well.

“The president’s carried interest budget proposal would, for the first time, limit capital gain tax treatment to the return on cash and cash-equivalent investments," Real Estate Roundtable President and CEO Jeffrey DeBoer said.

"This would ignore the reality that real estate owners and developers bear significant financial risks beyond their capital contribution," DeBoer said. 

Advocates for the change characterize carried interest as an unnecessary, and unfair, tax loophole for the rich.

“Private equity executives have used the carried-interest loophole to avoid paying their taxes since the IRS allowed them to in 1993," Americans for Financial Reform Communications Associate William Pierre-Louis Jr. said.

"The loophole allows them to call their salaries ‘capital gains,’ and take advantage of the tax code’s preferential tax rate for wealth accumulation," Pierre-Louis said. Americans for Financial Reform is a nonprofit advocacy group specializing in financial policy.

The inclusion of taxing carried interest at ordinary rates in the FY 2023 budget proposal is an acknowledgment by the administration that private equity and hedge fund managers misclassify their salaries as investment income, the organization's Take On Wall Street Advocacy Manager Mandla Deskins said.

"Next, his colleagues in Congress must take up the challenge and finally close this egregious tax giveaway,” Deskins said.

Calling carried interest a tax giveaway misses the dynamic of wealth creation undertaken by general managers, advocates for the status quo say.

"The capital gains tax incentive has always recognized and rewarded other factors beyond just invested cash, including the assumption of construction, litigation and market risk, as well as the sweat equity associated with owning investment real estate," DeBoer said.

Targeting tax evaders and illegal transactions is appropriate, DeBoer noted, but he added that penalizing entrepreneurship and discouraging noncash risk-taking by recharacterizing all carried interest as ordinary income would be a mistake.

If history is any guide, taxing carried interest as capital gains has the edge over reform efforts, due to vigorous lobbying by the industry players most affected, namely private equity funds, hedge funds and venture capital funds. 

Even as long ago as the Obama administration, carried interest was in the crosshairs of reformers. President Barack Obama, for one, said that "keeping this tax loophole, which leads to folks who are doing very well paying lower rates than their secretaries, is not helping the American economy.”

His administration proposed the change, but Congress didn't act on the proposal.

The push to tax carried interest at a higher rate has largely been supported by Democrats, but that hasn't entirely been the case in recent years. When running for president, Republican Donald Trump said he was in favor of closing the carried interest "loophole."

As president, Trump signed the Tax Reform Act of 2017, which modified carried interest slightly. Rather than taxing carried interest as normal income, the bill merely specified that to qualify for the capital-gains rate, investments must be held for three years, up from one year as with standard capital gains.

“I don’t know what happened,” Larry Kudlow, the economist who crafted Trump’s campaign tax plan, told The New York Times after the bill passed. “I don’t know how that thing survived,” he said, adding that the lobbying must have been "intense."

During the 2020 presidential campaign, then-candidate Joe Biden didn't emphasize doing away with carried interest, but he was sympathetic to the idea, Urban Institute fellow and Director of Economic Policy Initiatives Donald Marron told Bisnow.

After the election, the prospect of treating carried interest as ordinary income became a serious concern among real estate professionals, according to a Bisnow survey conducted in late 2020. Some 29% of respondents said changes to carried interest, probate taxes and other tax breaks could have the biggest impact on commercial real estate.

In mid-2021, the Senate Budget Committee passed a resolution providing recommendations to other committees regarding the $3.5T budget plan for fiscal 2022, including — once again — a plan to do away with the preferential tax treatment of carried interest. That same year, a standalone bill to do the same, the Carried Interest Fairness Act of 2021, had been introduced in Congress.

Advocates for the status quo pushed back, and with deep pockets. The private equity industry has contributed about $600M to congressional campaigns over the past decade, according to a New York Times analysis in 2021.

Moreover, during the 2020 election, the Biden campaign received over $3M from private equity interests and various other types of investment funds, CNBC reports, citing data from the nonpartisan Center for Responsive Politics, making him the top recipient of campaign money from that industry in the last cycle.

During last year's tussle over carried interest, the U.S. Chamber of Commerce went so far as to publish a report detailing economic harms that would follow reform, including a hit to local and state tax collections, as well as a "chilling effect" on investment activity.

"Private equity funding provided a lifeline to thousands of American businesses and real estate partnerships that are crucial for new home construction and affordable housing," U.S. Chamber Center for Capital Markets Executive Vice President Tom Quaadman said in a statement.

"Almost doubling certain taxes on private equity and venture capital investments will restrict access to capital, harming job creation and innovation," Quaadman said.

Eventually, the status quo won out. In September 2021, the House Ways and Means Committee voted to preserve the low tax rate for carried interest. Now the same committee will take up the suggestions made in the president's proposed budget.