Hedge Funds

Hedge funds may lose this tax loophole, but they don't care

Key Points
  • Hedge fund managers aren't worried about losing the tax advantage on carried interest, largely because they aren't taxed that way to begin with.
  • The lower capital gains rate applies to profit on long-term investments, but hedge fund managers usually hold stakes for less than one year.
Steven Mnuchin
Mary Catherine Wellons | CNBC

Treasury Secretary Steven Mnuchin has made one thing clear when it comes to the way hedge fund managers get paid: a big tax loophole will disappear.

He reiterated as much last month but hinted that it's less certain what will happen to private equity, venture capital and real estate fund managers regarding the same loophole.

The issue has to do with something called carried interest, which is the manager's share of a fund's profit, typically around 20 percent a year. The lower capital gains tax rate applies to profit from investments held for more than one year.

But hedge fund managers aren't worried about losing this advantage. In fact, they currently receive very little benefit from the way their carried interest is taxed.

"It's of no benefit to them," said Robert Willens, an independent tax consultant, about the tax treatment of their carried interest. "They couldn't care less if the taxation of gains was changed."

Because of the way the tax rules are written, hedge funds pay taxes for most of their so-called carry at the higher rate used for ordinary income.

That's because they hold many of their positions for less than a year. In order to be taxed at the lower capital gains rate, as most private equity firms are, hedge funds would have to hold their positions for more than 12 months.

The difference in the tax rate for carried interest being treated as capital gains versus ordinary income is striking. Under the current rules, capital gains are taxed at a maximum of 23.8 percent, while ordinary income has a rate of 43.4 percent.

Mnuchin is scheduled to speak Tuesday at CNBC's Delivering Alpha conference in New York.

Another loophole is closing for hedge funds regardless of tax reform. The IRS has allowed hedge funds to grow their deferred income from offshore funds, tax-free, for decades. That rule expires next year, meaning hedge funds will have to fork over billions of dollars.

That loophole has them more concerned than anything related to carried interest.