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Donald Trump sure knows how to pour gasoline on the dying embers of an issue---in this case, the carried interest tax loophole, which allows hedge fund managers to be taxed at lower income tax rates than say, doctors, lawyers, or ordinary workers. “The hedge fund guys didn’t build this country. These are guys that shift paper around and they get lucky,’’ Trump said last month on Face The Nation. He later added, “The hedge fund guys are getting away with murder. They’re making a tremendous amount of money. They have to pay taxes.” On 60 Minutes this past Sunday, Trump doubled down stating, “I don’t want to have certain people on Wall Street getting away with paying no tax.”
“A year ago no one was talking about this,” Professor Victor Fleischer, who wrote an influential law review article on carried interest in 2008, told The New York Times. Now, it is all anyone seems to be talking about.
One intriguing aspect to all this is that thanks to Trump, talk of repealing the carried interest loophole has overshadowed Washington discussion of eliminating another questionable tax giveaway: section 1031. Section 1031 has long been an unsupervised real estate tax boondoggle, one from which Trump has most likely benefited.
And what does Trump think about section 1031?
We don’t know exactly. Trump released his long promised tax plan today, and the three and a half page document says his plan “ends the current tax treatment of carried interest for speculative partnerships that do not grow businesses or create jobs and are not risking their own capital, and reduces or eliminates other loopholes for the very rich and special interests.” But it doesn’t specify what those loopholes are.
Moreover, it appears that Trump’s attack on carried interest is narrower than the one in Jeb Bush’s tax plan, which eliminates the carried interest break for a broader group of partnership managers, including those running real estate partnerships and private equity funds. Trump’s plan appears to take aim more narrowly at the hedge funders. Americans For Tax Reform, Grover Norquist’s anti-tax group certainly reads it that, noting in a statement that “Partnerships that do not speculate but rather buy hard assets for the long run will not face a tax increase - for example, private equity firms. “
As for the 1031 break, we have no way of knowing for sure whether that is one of the “loopholes” for “special interests” that Trump has in his sights. But we do know that “Trump University” licensed books have had a lot nice things to say about it. Here’s David Lindahl’s , Trump University Commercial Real Estate 101: How Small Investors Can Get Started and Make it Big (p.14):
“The Declaration of Independence may tell us that all men are created equal, but the government definitely favors us real estate investors!
Not only do we get to depreciate (that is, take a tax deduction on) the value of our investment real estate, but we also get to use an astonishingly powerful tool called a Section 1031 Tax-Deferred Exchange.
It’s like an IRA account on baseball steroids.”
What should “[a]ny investor in real estate [need] to know about §1031, or like-kind, exchanges?” asks J.J. Chiders in Trump University Asset Protection 101. That when you sell real estate that is categorized as investment you can take the proceeds and effectively roll them over into a new piece of investment real estate without paying tax on your gains.
How powerful is this break? Very, according to the Trump University Commercial Real Estate 101 book. If you sell a piece of property you bought for $1,000,000 for $1,500,000 without 1031, you could buy a new property with debt for $2,125,000. With the benefits of 1031, you can buy a replacement property worth $2,500,000. That extra $375,000 is the effect of the borrowing capacity of the $75,000 of foregone current tax.
This gives the investor “more potential for cash flow and appreciation,” Lindahl writes. Moreover, there is no limit on the amount number of times you can exchange properties and defer tax. Actually, the very best part of 1031 exchanges is that when you die, the deferred tax might disappear altogether thanks to something known as step-up in basis, which allows heirs to mark up the tax basis of property to its market value at the time they inherit it.
Significantly, Jeb Bush’s plan would eliminate step-up in return for eliminating the estate tax. Trump’s less detailed plan proposes getting rid of the estate tax, without saying word one about step-up. If the estate tax is repealed and step-up and 1031 survive (as they may in Trump’s plan—he hasn’t specified) real estate families will do very well indeed.
Has Trump engaged in 1031 exchanges? From current financial disclosures filings, it is impossible to know. But Trump made most of his wealth in the investment real estate market and it would be illogical to think he hasn’t. Maybe if he stays in the race long enough, we will get to see his tax returns and find out.
So, are there qualitative differences between the carried interest loophole that Trump abhors and the 1031 exchanges that he likely engaged in?
With carried interests, investment managers receives a fee from investors when they make the underlying property more valuable (they only get paid if to the extent that the fund exceeds a high-water mark). The simplistic explanation of what makes this such a sweet deal is this fee for performance is treated as an equity interest in the fund (even though the fund manager hasn’t put his own capital up for the carried interest) and is therefore taxed only when the manager sells the interest and then only at a lower capital gains rates. So, tax is deferred and then paid at a lower rate than a performance bonus paid to a corporate executive would be.
With 1031 exchanges, the profits are rolled over from one property to another without tax. Only if the investor wants to pull the equity out of investment real estate (which is a very broad term) is tax triggered. The rate of the tax is more complicated than the carried interest example because of the additional depreciation deductions we provide for investors in real estate. This is actually an important point – the real estate benefits are actually greater in current dollars than the carried interest loophole Trump is so concerned about. At minimum, the tax is deferred.
It is because of those real tax benefits that President Obama and top lawmakers have proposed eliminating or at least significantly restricting the 1031 exchange rules. These proposals, like the proposed elimination of the carried interest rules, are running into industry pushback. Backers of the breaks warn that markets will crash, people will lose jobs and the economy will sink if they’re tampered with. So, is there a real difference between the two tax deferral strategies? Not really.
In spite of his zeal to make sure that rich people pay their fair share of taxes, Trump may prefer to keep section 1031. This would at least be consistent with his op-ed from 1999 when he was commenting on the Regan administration 1986 revision to the tax code. The tax code was revised to eliminate the various real estate tax shelters prevalent at the time. At the time, Trump was quite unhappy. He thought that the elimination of the real estate tax shelter “sent real estate markets through the windshield.” It hurt the common man and put developers out of business, which had the collateral effect of putting contractors, builders and workers out of business that relied on the developers. Market liquidity dried up for these flippers of real estate. It would seem that he advocates for the retention of these breaks to make sure the economy flourishes.
Back to Trump’s attack on carried interest for hedge fund managers: he says that they didn’t “build” anything. But 1031 isn’t a tax break for construction---it’s a benefit when you are trading one investment property for another, just as hedge fund managers trade assets.
If Trump is happy getting rid of the carried interest loophole for hedge funders, then he should be just as happy getting rid of carried interest for real estate fund managers and the even bigger 1031 loophole for real estate investors.
David J. Herzig is a distinguished professor of law at Valparaiso University. He often writes on taxation focusing on alternative investment vehicles.
