The Hedge Funder and the Log Cabin

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George Hunter | Riser | Getty Images

Yesterday I explained that difference between what gets taxed as capital gainsand what gets ordinary income is not the bright line many imagine.

Let me illustrate the point with an example. Imagine that John Paulson decides that he’s had it with all the investing business. He’s going to move up to the mountains and build a log cabin. Live closer to nature.

Paulson buys a piece of property undeveloped up in Vermont for $100,000. He roughs it at first, living in a quickly assembled lean-to. But he starts building a log cabin, using nothing but what he finds on the land and his own strength. Fallen trees are used for the logging.

Once he’s built the basic place, he keeps improving it. Bit by bit, he adds to the cabin. Finally, he’s got a grand place, high up in the mountain. He sits on his front porch each morning, meditating and drinking tea made from wild berries that grow on his property.

A few years pass. Paulson is at peace. All those demons that grew inside him during his years running money have been exorcised. Now he’s ready to get back into investing.

He calls a friend and asks to look into selling his property so he can stake himself for a new fund.

“Bad news, buddy,” his friend Paolo says. “That piece of land you bought is still worth only 100 grand these days. Land prices are stagnant.”

Paulson explains that it’s not just land these days. It’s got a grand log cabin on it. Paolo does some quick research and discovers the house will bring the price up to $120,000. Paulson sells the house.

How does tax law see all of this?

Paulson’s initial investment in the land was a capital investment. If the land itself grew in value, that would be a capital gain. But the land didn’t rise in value.

The entire gain was due to Paulson’s labor improving the property. He “invested” no further financial assets.

This worries Paulson. He’s afraid that because the rise in value was due to labor rather than capital, it will be taxed at a higher rate.

His lawyer tells him not to worry. It will be taxed as a capital gain.

So what can we learn about carried interest from this?

The tax code treats the returns on Paulson’s labor as a partial owner of his hedge fund the same way it treats the returns on Paulson's labor as an owner of his land.

But would it make a difference if Paolo had been the one who paid for the property? Stay tuned for the next post.

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