Carried interest, also known as a promote, is an ownership interest in a partnership or Limited Liability Company (LLC). Specifically, carried interest is a profits interest with no initial capital value assigned. A carried interest owner participates in future appreciation of a fund with no risk, no immediate recognition of income, and no upfront investment of capital. Carried interest investments apply in the real estate fund sector, the hedge fund sector, the private equity fund sector, and many private ownership arrangements. For the purposes of this article, we will focus on carried interest relating to real estate partnerships.
Typically carried interest is issued as part of the initial fund-raising process. For instance, a real estate professional is raising funds to purchase a $10 million commercial building held in an LLC. The investors would have a capital interest in the LLC which is taxed as a partnership. They would be allocated income or loss from day-to-day rental operations of the LLC. In addition to finding monetary investments, the LLC holding the real estate can issue carried interest investments. This means that the holder of the carried interest would not have to contribute any money into the partnership for the building investment, but when the building is sold, they would receive a percentage of the liquidating funds. They would only have a profits interest in the LLC, not a capital interest, so they would not be allocated income or loss from rental operations.
An individual, or entity, can split their interest into two pieces. They can be issued interest for a capital investment and issued a second interest as a profit’s interest or carried interest. It is important to separate the two investments upfront as the tax treatment can be different for each investment whereas both are considered capital assets, however, carried interest has a three-year holding period to be considered a long-term investment for preferential capital gains tax rates.
Carried interest is a fundamental part of real estate partnerships. Generally, managing partners make an initial capital contribution to a real estate partnership during the fund-raising process. In addition, at this point, it is common for managing partners to also receive a carried interest, or share of the profits when an asset is sold, for their time, management expertise, and the risks they take relating to debt, litigation, cost overruns, etc. throughout the investment period.
For example, partnership X holds a building purchased for $10 million in 2015. The partnership’s operating agreement states that the managing partner owns a 5 percent carried interest. In 2020, the partnership sells the building for $20 million, creating a long-term capital gain of $10 million. In this example, the managing partner would receive $500,000 for their carried interest investment in addition to their allocation of the liquidating distributions from holding a capital interest in the partnership.
Carried interest essentially allows for the converting of ordinary income into long-term capital gains. Currently, the highest ordinary income tax rate is 37 percent compared to the highest capital gains tax rate of 20 percent. Using the example above, the managing partner who received $500,000 carried interest would pay $100,000 (20 percent) of tax on the capital gain compared to $185,000 (37 percent) if it was taxed as ordinary income. As you can see, this differential in tax rates can be significant and has been a hot topic for decades in the political arena.
One of the many impacts from The Tax Cuts and Jobs Act of 2017 (TCJA) was the addition of Section 1061(a) which changes the required holding period of carried interest to qualify for long-term capital gains tax rates. A long-term capital gain is typically a gain from sale of a capital asset that has been held for greater than one year. The TCJA changed the holding period for carried interest to three years, meaning if you held the carried interest for less than three years, it was considered a short-term capital gain which is taxed at the same rates as ordinary income.
While most real estate partnership interests are held longer than three years, the new carried interest holding period rules could have an impact if the partnership sells the property within three years. This is referred to as the “Look through Rule.” For example, a person could have a carried interest in a real estate fund for 10 years, exceeding the three-year holding period for capital gains tax treatment, however, the fund sold a building that it only held for two years. This would cause the carried interest received from the sale of that building to be taxed as a short-term capital gain. It would also be possible for this individual to have both long-term and short-term capital gains from carried interest in one fund. Using the same example, in addition to the two-year-old building being sold, another building that the fund owned for 20-years was sold in the same year. In this case, the carried interest on the second building sold would qualify as a long-term capital gain since both the carried interest and the building were held for greater than three years.
As detailed above, the difference between ordinary tax rates and long-term capital gains tax rates can be significant, there are still benefits of being taxed as a short-term capital gain. Some of the benefits are:
- Not subject to self-employment tax.
- Short-term capital gains can be offset by capital losses.
- The capital gain can still be deferred to 2026 through the Qualified Opportunity Zone program.
There are many scenarios to consider in order to provide partners in the real estate industry the best tax treatment when retaining their partnership interest through carried interest. Contact our tax and real-estate experts today to learn more.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute an accountant-client relationship.
