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Why the rich are happy to give up the carried interest loophole: They get to keep a bigger loophole

Another super-wealthy investor came out the other day in favor of killing the notorious carried interest tax loophole.

The latest public-spirited one-percenter is Alan Patricof, a pioneering venture investor. “Close My Tax Loophole,” he pleaded last week in a New York Times op-ed. The loophole, as he explained, allows investment fund managers to treat much of the income they collect from profitable investments by their funds as capital gains.

That’s a big tax break. The top tax rate on ordinary income is 39.6%; the top rate on capital gains is just over half that— 23.8%.

“The capital gains tax benefit was originally created for people who invested with their own capital at risk,” Patricof wrote. Investment fund managers don’t do that. “It is past time,” he concluded, “for fund managers like myself to accept the reality: We should not be receiving a tax break meant for investors when our work does not involve the risk of our own investment of capital.”

Patricof has impeccable Democratic Party connections and is a major supporter of Hillary Clinton. But as he observed, disdain for the carried interest loophole crosses political boundaries. Its repeal is advocated not only by President Obama and candidate Clinton, but by Donald Trump too.

That’s a confluence of opinion that should make you go, “Hmmm.” And indeed, a closer look at the carried interest tax break reveals an ulterior motive for all the plutocrats who are so eager to throw this particular loophole under the bus: They think it will take the heat off the loophole they really value — the capital gains tax break.

It’s hardly unusual to see a business or individual offer a concession of seemingly great value as a sacrificial lamb, hoping to preserve a benefit of even greater value. The drug company Mylan has been offering a crash course in this stratagem over the last week or two in relation to its EpiPen allergy device: It cut the consumer price on the device in the hope of staving off congressional scrutiny so it could continue to stick insurance companies and government programs for the full price. 

The same thing is happening here. “Carried interest is small potatoes compared with the value of the capital gains preference on traditional investment income,” Edward Kleinbard, the peerless tax expert at USC, told me Monday by email. He observes that the loophole justifiably “sticks in the craw of any thinking American” and benefits only a small subset of the top 1%. “So it makes sense to offer it up to quell popular dissatisfaction with how the tax system is operating.”

Here are the numbers: The carried interest loophole produces an aggregate tax break of $2 billion to $20 billion a year, depending on how you reckon. That’s not peanuts, especially at the high end of the estimated range, but the advantage accrues mostly to real estate and private equity fund managers. 

The preference rate for capital gains and dividends, however, costs the treasury an estimated $120 billion a year — anywhere from six to 60 times as much. That’s a commensurate gain for those earning a significant chunk of their income from capital gains, and they’re overwhelmingly members of the 1%.

It’s an even more rarefied zone than that: According to the Tax Policy Center, some 76% of the capital gain tax benefit went to those earning $1 million or more in 2013 — they’re the top 0.1%. Those with annual incomes of $1 million or more got more than half their income from capital gains. And for those earning $5 million to $10 million, it's more than two-thirds. For comparison’s sake, working-class people earning $75,000 to $100,000 receive on average 75% of their income from wages.

There’s more to the capital gains break than merely the preferential rate. As Kleinbard observes, it’s our only truly voluntary tax: Those with accumulated capital gains liabilities can choose when to pay them simply by deferring the sale of the capital asset, because that’s when they’re collected. Up to that point, well-counseled taxpayers can enjoy the value of those assets without selling them, by borrowing against them or, in the case of publicly traded assets, selling options against them. 

Then there’s the ultimate capital gains tax dodge: the step-up in value upon death. The tax on a capital asset bequeathed to a new owner upon death never gets paid at all; the asset is revalued at its market at the time of the previous owner’s death, as if the original capital gain never existed. In other words, if you bought a share of stock for $100 decades ago and it's worth $1,000 when you die, it's valued at the higher figure for your heirs. That means the accumulated capital gains tax liability is utterly extinguished. That break is estimated to cost the Treasury — and produce a tax gain for the new owners — of about $50 billion a year.

This explains why the capital gains tax preference is the one that wealthy taxpayers will go to the mat for. It’s the second-largest break offered by the income tax, outmatched only by the employer health insurance deduction, and it’s worth far more to wealthy taxpayers than the mortgage interest deduction. 

That’s because even the richest Americans have relatively modest mortgage deductions. The average mortgage interest deduction for taxpayers reporting $10 million or more in income was $25,386 in 2013, the most recent year available. For those with income of $2 million to $5 million, the average was about $24,191; for those in the $75,000-to-$100,000 income range, it was about $8,000. These figures aren't surprising, since the mortgage deduction is capped and the first year's interest on a million-dollar home loan even at 4% is less than $40,000.

But the capital gains preference isn’t capped. The differential between the 23.8% top cap gains rate and the 39.6% top marginal rate is pure gold. In 2013, according to the IRS, the average reported net capital gain for those earning $10 million or more was about $12.6 million; for them, the tax rate differential would be worth almost $2 million. That's the income club, remember, that claimed an average of only $25,386 in average mortgage deductions in 2013.

So keep this in mind the next time wealthy taxpayers ask to be patted on the head for advocating an end to the carried interest loophole: The real tax break is the one they’re not talking about. 

Keep up to date with Michael Hiltzik. Follow @hiltzikm on Twitter, see his Facebook page, or email michael.hiltzik@latimes.com.

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