What Might Happen To Carried Interest Under A New Administration

The lower tax rate for carried interest, which largely benefits equity fund managers but also partnerships that own commercial real estate, might be at risk of disappearing under a Biden administration — might being the operative word.

"Carried interest" is accounting jargon for the share of a private fund's or partnership's profits that is paid to managers as part of their compensation. Federal law treats carried interest the same as a return on investment, meaning it is taxed at a capital gains rate, and not at regular income rate, which would be higher. 

Long-term capital gains are subject to a current maximum tax of 23.8%, while regular income is taxed at a rate of up to 37%, though the exact amount depends on the income of the taxpayer and other factors.

Proponents say carried interest is an incentive to invest, which benefits the economy. But critics say it is an egregious tax loophole, and it has detractors on both sides of the political aisle — former Vice President Joe Biden has said he would eliminate the practice if elected president, as did President Donald Trump when he was on the campaign trail in 2015.

But so far carried interest has proved a durable part of the tax code. It took its present shape with the last major tax reform in 1986, though it was modified somewhat in 2017. All efforts in Congress in recent decades to eliminate it have come to naught, with lobbyists for private equity funds proving particularly adept at preserving it. It isn't clear whether a new administration would have any more success.

"I expect a Biden administration would try to end the carried interest loophole," Urban-Brookings Tax Policy Center Senior Fellow Steve Rosenthal said. "But who knows if Biden would succeed. Private equity is powerful."

Rosenthal said Trump promised to eliminate the loophole and made a "feeble" attempt in the 2017 tax bill. 

"But the 2017 provision was riddled with new loopholes, and worthless in my view," Rosenthal said.

In a commercial real estate context, income from partnerships that own real estate can be, and often is, treated as carried interest. The Real Estate Roundtable estimates there are millions of real estate-oriented partnerships that would be adversely affected by any change to carried interest.

In response to the introduction of the Carried Interest Fairness Act (H.R. 1735) last year to eliminate the preferential tax treatment on carried interest, the RER penned a letter in support of carried interest that it encouraged its members to send to their representatives.

Real estate partnerships represent nearly 50% of the 3.7 million partnerships in the United States, the letter says, citing IRS data. Those real estate partnerships owned $5.9 trillion in assets, earned over $90B in net income and recognized roughly $50B in long-term capital gain in 2015.

The RER warned that the carried interest legislation would apply retroactively to real estate partnerships formed years or even decades earlier, disrupting the predictability of the tax system and discouraging long-term investment. In any case, higher taxes would be a disincentive to real estate investment and development, it said.

"In short, H.R. 1735 would make it more expensive to build or improve real estate and infrastructure, including workforce housing, assisted living communities, and industrial properties, to name just a few," the letter said. "Some development simply won’t happen, especially in long neglected neighborhoods or on land with potential environmental contamination."

Critics argue that carried interest amounts to a tax loophole for the already-wealthy because fund managers aren't risking their capital to obtain the return, and so it should be treated as ordinary income. 

"Our contention is that using this rate for money that does not belong to the fund managers at the start of the venture is not only unfair, it is wrong," writes John Hooker, a member of the group Patriot Millionaires, which advocates higher taxes for high net worth individuals.

"Expertise and talent, no matter how great — and no one would claim otherwise — is a service. And every other American in this country is taxed for their services, or labor, as ordinary income. That is what carried interest is, or should be — ordinary."

If Biden is elected president, the system may come back under the spotlight.

"In the past, Biden has endorsed taxing carried interest as ordinary income," Urban Institute Fellow and Director of Economic Policy Initiatives Donald Marron said. "I expect he would pursue that in some way if he is elected. The question is how."

Marron notes that Biden hasn't emphasized the taxation of carried interest in the campaign. He has, however, proposed taxing all capital gains at the top ordinary tax rate for people earning $1M or more.

"In effect, that would tax carried interest at ordinary rates for anyone in the income range," Marron said. "Biden has also said that he does not want to raise taxes on people earning less than $400K. Some people below that level receive carried interests. So I don't expect him to propose taxing all carried interest at ordinary rates. Instead, he will focus on doing so for people with sufficiently high incomes."

Trump's 2020 campaign has put forth no specific proposals to change the way carried interest is taxed, though he had done so in his 2016 campaign and has mentioned his interest in changing the policy a few times in his tenure as president.

He claimed he could have insisted on the elimination of the provision in the negotiations ahead of the passage of the tax cut bill in 2017, but did not do so as a negotiating tactic to get a lower overall tax rate.

When H.R. 1735 was introduced in the House in 2019, Trump repeated that he would like to eliminate the special treatment of carried interest. But three days later, Treasury Secretary Steven Mnuchin said the administration had no plans to do so.

"If Trump is re-elected, I do not expect that he will push it," Marron said. "But there’s always room for surprises."

The future of carried interest depends on more than whether Biden or Trump occupies the White House beginning next year, New York-based tax attorney Marina Vishnepolskaya said. The composition of Congress is also critical.

"There haven't been any Republican sponsors of such proposed legislation, but Democratic lawmakers proposed a number of bills in the Senate and House following the 2017 tax reform," she said. "If Democrats gained control of the Senate and White House, they likely would want to use a carried interest provision as a revenue-raising measure to offset federal spending."