WHAT is carried interest? And why does it get the tax treatment it does?

These arcane questions are usually reserved for the green-eyeshade crowd. And for good reason: they can be so bewildering that they seem to be taken from an I.Q. test written just for accountants. But because they concern a few very high-income individuals, including the presidential candidate Mitt Romney, for whom I am an adviser, they have been getting broader attention lately. So let’s examine the issue.

Throughout almost the entire history of the United States income tax, the tax rate on capital gains has been lower than that on ordinary income. Today, the top rate is 15 percent for capital gains and 35 percent for ordinary income. There are good reasons for this — including, for example, the fact that capital gains are not indexed for inflation. But put that aside. If we are going to tax capital gains at a lower rate, one question necessarily arises: What is a capital gain, and how can we distinguish it from ordinary income?

The answer seems simple. If you have a job, the money you are paid for your work is ordinary income. If you buy an asset at one time and sell it later for a higher price, the profit you made from holding it is a capital gain.

But is it really that easy? Consider five examples, and see if you can identify what is ordinary income and what is a capital gain:

 Abe buys a vacation home for his family for $800,000. Some years later, when his children have grown and left home, he sells it for $1 million. He makes $200,000.