Carried Interests Explained: Key Considerations for Real Estate Funds
Originally published on November 14, 2024
Whether you’re a developer, syndicator or general partner (GP) in a real estate fund, carried interest likely plays a key role in your compensation. This form of performance-based compensation aligns your interests with those of your limited partners (LPs), allowing you to share in the profits your fund generates.
Carried interest is not just a negotiation point with investors. It is also critical for tax planning. When structured properly, carried interest income may benefit from favorable capital gains tax treatment.
Below, we explore how carried interest functions in a real estate fund and what tax implications GPs should consider.
How Carried Interest Works for Real Estate Fund Managers
Real estate funds typically bring together two parties:
- Investors (LPs): Provide capital but may lack the time or expertise for complex real estate projects.
- General Partners (GPs): Bring skills, market knowledge and management capability but usually need outside capital.
GPs earn compensation in two ways: fees (e.g., acquisition, property management) and carried interest, also known as a promote.
Carried interest allows the GP to share in profits after LPs receive a preferred return, commonly referred to as the hurdle rate. Once that hurdle is cleared, profits are split based on pre-agreed terms. This may include a waterfall structure with multiple layers of return depending on performance.
This promotes alignment of interests between LPs and GPs and incentivizes strong fund performance.
Carried Interest in Action: An Example from a Real Estate Fund
Consider a GP who raised $10 million from LPs to purchase an apartment building in 2019. The agreement includes a 10% non-compounding annual hurdle rate and a 30% carried interest for the GP.
In 2024, the building sells for $18 million. Here’s how the profit distribution might look:
- Capital returned to LPs: $10 million
- Preferred return (10% x 5 years): $5 million
- Remaining profit: $3 million
- 70% to LPs: $2.1 million
- 30% to GP as carried interest: $900,000
This illustrates how GPs can earn significant income via carried interest, especially in successful projects.
Tax Implications of Carried Interest for General Partners
Unlike fees, which are taxed as ordinary income, carried interest is generally treated as an allocation of partnership income. If certain conditions are met, it can qualify for long-term capital gains treatment. This is taxed at a top rate of 20% versus 37% for ordinary income.
The 2017 Tax Cuts and Jobs Act extended the required holding period for carried interest to three years to qualify for capital gains treatment. However, there is an important carve-out for section 1231 property, such as depreciable real estate. This means gains from those assets can still receive favorable tax treatment.
GPs should note that land (non-depreciable) and sales of partnership interests are excluded from this carve-out.
Proposed IRS Changes and What They Mean for Real Estate Funds
While the IRS has floated additional carried interest regulations, mainly targeting arrangements lacking entrepreneurial risk, none have passed to date. Any major change would require new legislation.
As it stands, carried interest remains a powerful tool for structuring performance incentives and tax-advantaged compensation within real estate funds.
Partner with James Moore for Strategic Real Estate Fund Advisory
Carried interest gives real estate GPs a compelling way to benefit from their fund’s success. Structuring your real estate fund and understanding the tax implications requires careful planning.
At James Moore, our real estate accounting professionals help GPs manage fund accounting, optimize tax strategies and structure carried interest arrangements that align with long-term value creation.
Contact a James Moore professional today to learn how we can support your goals.
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