Obama's Phony War on Hedge Funds - Attack on Real Estate

Originally Published on forbes.com on September 7th,2011

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I have been rounding up a few real experts to comment on the proposal that is supposed to address the perceived problem of venture capitalists and hedge fund managers getting capital gains treatment on much of their income.  Today I’m qouting Charley Egerton, whom I have previously introduced.  He just finished a term as Chair of the ABA Tax Section.  I didn’t get a lot out of him so I’m going to start with my own explanation of the proposed legislation.  You may want to go back to one of my previous posts where I explain that “carried interest” is not some sort of special deal for hedge fund managers.  It is an industry term for the tax concept “profits interest” which is fundamental to partnership taxation.  The fix that is proposed adds three thousand words to the Internal Revenue Code – Proposed Code Section 710.

The new code section does not somehow define “hedge funds” orventure capital partnerships.  Rather it defines a type of partnership interest.  The reason it takes 3,000 words is that the section has to try to cover all the gimmicks that clever people will come up with to beat it.  It can’t just say  that none of your income allocations with respect to the interest are capital gain, regardless of what the nature of the income is at the partnership level, but it also has to address things like property distributions.  It struck me as reasonably thorough in that regard.  The real guts of the thing is the definition of “investment services partnership interest”:

The term ‘investment services partnership interest’ means any interest in a partnership which is held (directly or indirectly) by any person if it was reasonably expected (at the time that such person acquired such interest) that such person (or any person related to such person) would provide (directly or indirectly) a substantial quantity of any of the following services with respect to assets held (directly or indirectly) by the partnership:

‘(A) Advising as to the advisability of investing in, purchasing, or selling anyspecified asset. 

‘(B) Managing, acquiring, or disposing of any specified asset. 

‘(C) Arranging financing with respect to acquiring specified assets. 

‘(D) Any activity in support of any service described in subparagraphs (A) through (C). 

For purposes of this paragraph, the term ‘specified asset’ means securities (as defined in section 475(c)(2) without regard to the last sentence thereof), real estate held for rental or investment, interests in partnerships, commodities (as defined in section 475(e)(2)), or options or derivative contracts with respect to any of the foregoing.

 The scenario that I have come up with to illustrate the strangeness of this is one that is not entirely unrealistic.  Moe, Larry and Curley form a partnership to develop shopping centers with the idea that the centers will be held for a considerable period.  They will raise equity and borrow money to accomplish this.  They won’t put in much of their own money.  They are able to raise equity pretty easily based on their previous track record.  The way it is going to work is that Moe will scout out locations, negotiate purchases and arrrange financing.  Larry will oversee developing, permitting and construction.  Curly will handle operations – hiring the securty guards to chase the mall rats and similar things.  After 15 years of this the partnership liquidates and they each get $2,000,000 as a share of the proceeds.  I think what the Proposed Code Section says is that Larry gets capital gains treatement and that Moe and Curly do not.  Moe and Curly were selecting, acquring  and managing specified assets.  Larry was not.  This is an arguable interpertation.  There will be many such arguable interpretations.  It may be that if there are enough operations the malls will not be considered “real estate held for rental”.  One more thing that will have to be defined.

So what does Charley Egerton have to say about the legislation:

The bulk of the revenue will not come from hedge fund managers.  It will come from mom and pop real estate operators.

I asked someone I knew in a real estate related industry if there was much concern in his industry about the possibility of the attack on the hedge funds harming them.  He indicated that the common thought was that it only affected the “big guys”.  Someone else told me that there is sentiment among some people in real estate to throw the hedge fund managers under the bus by advocating a more focused solution.  Of course that would not raise as much revenue.

I had one other question for Charley.  In a couple of the pieces I have written so far I have expressed frustration with people writing about hedge funds and carried interests without acknowledging (or possibly even knowing) that they are dealing with a fundamental principle of partnership taxation not some sort of special deal for hedge fund managers.  My comment is that if you want to talk about “carried interests” and you don’t know anything about partnership taxation and you don’t want to learn, you should just shut up.  One of my partners has told me that putting it that way is kind of harsh.  I asked Charley for his comment on my observation.  His answer was and I quote:

Perfect.