How Waterfall Errors and Tax Mismatches Create Real Estate Fund Disputes
Originally published on March 2, 2026
“If two smart people read it and disagree, then the agreement is defective.” – Daniel Roccanti
In this episode of Real Estate Industry Update, Daniel Roccanti and Kyle Paxton break down the most common fund structuring pitfalls that lead to investor disputes, from waterfall calculation errors and preferred return confusion to tax allocation mismatches and unclear operating agreement language. Whether you’re a fund sponsor or a real estate investor, this conversation covers the structural details that make or break investor trust.
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Full Transcript
[00:02] Daniel: Welcome to the Real Estate Industry Update. I’m your host Daniel, back with Kyle to talk about a pretty important subject matter today, and that is basically real estate fund structuring and the common mistakes that happen with it. This is important because you could have two different sponsors with the same deal, but one goes smoothly and the other one is just a huge mess with delays and disputes between all the investors. Instead of being a successful deal, it just turned into this huge mess and you wish you never got into it in the first place. So today we’re going to talk about how to avoid these mistakes so that you can actually have a pretty quiet real estate fund, which is actually what we want.
[00:45] Daniel: Today we’re going to talk about the most common waterfall errors, special allocation mistakes or phantom income, and operating agreement clauses that trigger disputes. So Kyle, let’s start with waterfalls here. Waterfalls is just a rule book of how cash gets split between investors and the sponsors over time. It should be predictable, and the operating agreement is just the enforceable contract. So when the two don’t match, you have an issue. When you have an issue, there’s usually an economic dispute waiting to happen. So Kyle, let’s go into what is a waterfall.
[01:09] Kyle: Yeah, let’s dive in. So real quick, I just want to take a step back and talk about how this comes back to investor trust, right? All we’re talking about today is building investor trust in the fund. And Daniel said quiet real estate fund. I don’t know if that exists, but make it quieter. And just making sure expectations are aligned all the way through the process. Ultimately, these investments are about trust. A lot of times with these funds, you have a lot of limited partners who are contributing potentially significant amounts of capital. They may not be educated in real estate investments prior to entering this deal.
[01:52] Kyle: And so how these go really determines if you get repeat capital contributions down the line for future deals, the reputation of your fund, if you can even fundraise for future deals, and it starts with cash. To me, this is the low-hanging fruit in the real estate fund, right? Real estate inherently is a cash game. We’re looking at cash flows pretty much straight up start to finish, and cash flows are driving the success of the investment. So I don’t normally see cash flows being a huge problem in operating agreements, but you just want real clarity around how these things are calculated and defined. So we’re going to talk about just a couple quick pitfalls here.
[02:43] Kyle: A couple things that I really want to point out here are to start around preferred returns. Deferred preferred returns are a major component in most real estate funds, and they can be defined in several different ways. So I want to talk about compounding versus non-compounding preferred returns. And again, this is just making sure that our operating agreement is crystal clear on how these things are calculated.
[03:05] Kyle: So when you have a compounding preferred return, if preferred returns go unpaid over time, the amount that is payable through that preferred return is continuing to grow and compound on top of that unpaid portion. So it’s what you typically see with interest on debt. And then on the other side you have non-compounding preferred returns where that base payable, the base for which we’re calculating that preferred return, isn’t changing over time even if those payments aren’t being made. So making sure you have clear definitions there really can help drive clarity. And those two differences, I mean that’s a significant swing between compounding and non-compounding. It’s a very important factor to look into when you’re crafting your operating agreement in the deal itself.
[04:01] Daniel: Yeah. I mean, when Kyle mentioned this in the waterfall, preferred returns are pretty standard in your waterfall. And so this is something that you want to make sure Kyle mentioned, transparency is important in every aspect and transparency in how your preferred is actually done. Because an 8% preferred return can actually mean five different things. So if it’s not defined, you could actually end up with basically, “Hey, I think I should have gotten this, and it’s this.” And it all comes back to what Kyle was saying: compounding. What’s your base? Like, is it my capital? Is it my unreturned capital? Is it average capital? And ways the timing. So when cash is available, does it happen at a refi or a capital event?
[04:47] Daniel: So let’s put this into a simple example here. An investor puts in $100,000, gets preferred at 8%. There’s no payout until it sells in three years. All right, simple. What’s the difference between compounding and non-compounding? So if we do a non-compounding, it’s $100,000 times 8% by three years. That’s $8,000 a year, $24,000 total. So when this is sold, I get my $100,000 back plus my $24,000 in preferred return.
[05:11] Daniel: Change that and let’s do compounding. So now instead of doing it at simple, my first year I have $100,000. I was supposed to get eight, I never got it. So now it is going to $108,000. And it’s going to keep going. If I was to do the math, by the end it’s almost $26,000. So it went from I was supposed to get $24,000 to I should get $26,000. That’s a big difference, especially when you start playing with larger numbers or you have more than one investor, which most people do. And so $2,000 is a big deal if the investor is expecting $26,000 back plus their obviously their capital, or they’re expecting $24,000 back. And it’s all going to go back to that waterfall allocation, your operating agreement, what is at stake. That’s going to be where the transparency needs to lie.
[06:18] Kyle: Absolutely. Great example, Daniel. And then I want to parlay that a little bit into the timing and the timing of when cash flows out of here, right? So if I’m a partner in this deal, Daniel, and I’m using our $100,000 example, I’m contributing $100,000. The number one thing I want to know is when am I getting that back to start, right? Obviously I want a return on top of that. It’s the whole point of the investment, but number one, when do I get that back?
[06:37] Kyle: And so really defining what that return of capital sequencing looks like and making sure that that is clear in our waterfall setup is hugely important for the investor trust and setting good expectations. And then when does the return of capital happen? Does it happen every year? Is it just when we exit the property? What happens if we refinance? How does that play into these definitions? So there’s all these different scenarios you have to run through and really lay out clearly so that you have good expectations on those cash flows.
[07:06] Kyle: Because again, a lot of times I’m finding in the funds we work with, the folks that contribute cash are accountants like me. Maybe I don’t understand real estate. I hear everywhere that real estate is a good investment. It’s a great time to own real estate, and I’m throwing money at it, but I don’t quite understand how all that flows. And so timing is a big one too where we see mismatches in expectations around cash. When maybe still the dollars align with expectations, but when you’re receiving them, especially in connection with potential tax liabilities, can cause pain through this process.
[07:46] Daniel: Yeah. And refinancing is where I see a lot of confusion, because most investors at a refinance, they’re going to expect a check. Money came in, I want a check. But what does the actual operating agreement say? Does it count as return of capital? Does it actually trigger a promote? Like, are you leaving this up to interpretation? So it really comes back to that operating agreement.
[08:11] Daniel: And today I guess I’m going to do all the examples. So let’s do a simple illustration again. Basically, an investor invests a million dollars. So he has capital contributions of a million dollars. There’s a refi event and there’s going to be a $300,000 payout to this investor. So he invested a million, he’s going to get $300,000 back, right? Does the operating agreement treat that as a return of capital, which basically means now his capital went from a million minus $300,000, so $700,000, which is important because that’s going to reduce his preferred return in the future. Instead of being based on a million, it’s going to be on $700,000.
[08:53] Daniel: Or does it just treat it as distributable cash? Which then it could be a lot of things. It can satisfy the preferred faster. It could actually hit promote tiers sooner and pay out a promote. So it really comes back to that operating agreement, making sure that it truly is transparent of when an event happens, how does it actually flow down into the return into your investors.
[09:22] Kyle: Yeah. And what Daniel touched on too, with any sort of those trigger events, you want to make sure your hurdles are clearly defined. So a lot of the waterfall deals have hurdles set in where compensation changes when you hit certain metrics. You look at IRR, and then how is IRR defined for purposes of crafting that hurdle? Is it, if I’m a real estate fund with five different deals within the fund, is it one asset’s performance? Is it the performance of the five assets before I hit these hurdles? Again, I just keep coming back to, broken record already a couple minutes into this video here, but it just comes back to making sure there’s no wiggle room for surprises and that everything is defined very clearly.
[10:06] Kyle: And then if a catchup is required due to cash flow or how timing of cash is defined within the operating agreement, what do those catchup provisions look like and do they have the proper teeth to them to make sure that they’re executed in a clean manner? Again, aligned with expectations, right?
[10:37] Daniel: And the IRR, the internal rate of return, I think this gets a lot of times inconsistent. And so you want to make sure that everyone’s assumptions on this, because it’s a math term. This is math, right? But it gets thrown around like it’s a marketing term a lot of times in any syndication. So we want to really make sure that we’re defining the methodology of how an IRR is truly being calculated because many different people can calculate it different ways.
[10:54] Daniel: And the catchup, this is great, something that Kyle mentioned. It’s kind of a lever, right? If you don’t define exactly when it turns on and off, you’ll either overpay the sponsor or never pay them at all. And no one likes doing deals for free. So you’ve got a lot of problems there potentially.
[11:15] Kyle: All right. Let’s dive into tax allocations and how they align with the cash. Daniel, do you have anything else you want to chime in on waterfall before we pivot there?
[11:37] Daniel: The only thing I was going to mention before we get into that is we probably should mention clawbacks. So clawbacks, this isn’t about distrust. It’s just about the math. A lot of times the GP is giving or the LPs are getting everything up front and there’s eventually going to be a clawback provision. It just needs to be transparent and how and when you truly are going to true this up. If you don’t have one or it doesn’t exist or it isn’t giving you enough information of when this triggers, this can really mess up when it should be happening because it’s going to get your expectations between the LPs, the investors, and your GP off.
[12:10] Daniel: So like a common waterfall is just, I’m returning my investors’ capital as quickly as possible. Then I’m paying my investors their preferred return. Then there’s a GP catchup. And then after the catchup, then the profits are split basically based on ownership and stuff like that. We can get into more complicated stuff with promotes, but that’s basically a simplified version of that. And so that catchup is a lot of times where I will see a lot of disconnect between the LPs and the GPs.
[12:52] Kyle: Totally agree. All right. Thank you. Good clarification. All right. Let’s talk tax now. So when we’re looking at tax, this is more often where I see issues with operating agreements and really what’s been communicated to investors. What’s in the operating agreement? Because we fixate a lot on cash sometimes and then we don’t necessarily look at, all right, what does the after-tax return look like? How, what tax levers are in play, what traps might we have depending on where the property is, all that good stuff.
[13:21] Kyle: And so we say this in just about every video, but having your CPAs or tax advisors on the front end to set up here is huge. So really what I want to establish, the core concept here, is that tax allocations in these deals have to follow the economics. Generally, real estate investment funds are structured as partnerships for tax purposes. Those can come in a lot of different forms legally, but for tax purposes, partnerships. And the beauty of partnerships is you have a lot of flexibility in how you structure. At times, maybe too much flexibility.
[13:41] Kyle: But the ultimate, while there’s a lot of flexibility in how you structure partnerships from a tax perspective, it really has to come back to and tie back to the economics. So ultimately our tax allocations should be following the cash flow. If we have a solid cash flow, we have a good basis to figure out how the heck do we allocate taxable loss or income to the investors in the deal or the deal sponsors.
[14:31] Kyle: And so again, we’re tying together here. We’re tying the waterfall, which is who gets the cash and when, with the allocations, who gets that taxable income and when. And where this gets problematic is when you have taxable income and you have no cash to pay the tax. Because with the partnerships, the tax liability is going to flow through to the investors personally, or if it’s a corporate partner, the corporate return up at the higher tier there. And so you want to make sure that what’s communicated to investors and in the operating agreement in terms of how taxable income or loss is being allocated aligns with the cash.
[15:02] Daniel: And I would say it’s important to understand that the economics of the deals and the tax of the deals are a lot of times going to get mismatched. And this is where it gets off. Waterfall decides who gets the cash. Allocations decide who gets actual taxable income. And they don’t always match. But the beauty of the deal is they start the same and they end the same. The middle gets crazy. So it all has to eventually, it’s all temporary differences. At the end it all actually matches.
[15:45] Daniel: But for tax purposes, to not get too technical, we have the 704(b) substantial economic effects that we have to talk about. But the waterfall can change temporarily who gets what and then it all evens out at the end. So this mismatch can throw people for a loop. This is where the transparency needs to be, because you’re selling all these agreements with these allocation of losses and then the capital accounts and the mechanics don’t support it, and then you get a K-1 and you’re surprised. And so it’s really important that you understand that the economics of the deals and the tax of the deals could have a mismatch.
[16:39] Kyle: Yeah. And a couple things I want to point out with this, because like Daniel, we both alluded to, I see issues with this all the time. So ultimately as the tax preparer, I have to go back to what the heck does your operating agreement say? I’ve had several deals I’ve worked on where I’ve onboarded new clients that another accountant prepared, or it’s a brand new fund where the sponsor says, “Hey, in our pitch deck, this is how the taxable loss is being allocated to the investors,” and I say, “Yes, sorry, that is not what this says, and I have to go by this.” So that is where we have a problem now, right? Because we have a mismatch between investor expectation, what’s been communicated to them by the fund sponsor, the sponsor themselves, and then the accounting team. And that’s not a fun situation to be in.
[17:01] Daniel: Yeah, if your operating agreement can’t explain why someone got taxable income without cash, then you’re setting yourself up for a problem. All right. This is one of the biggest headaches dealing with the fund here, understanding why cash and taxable income is going to be different. And so you need to make sure that you understand your targeted allocations.
[17:20] Kyle: Yeah. And my personal opinion on this is I think the fund sponsors have a duty to their investors to really educate them on this process, because again a lot of people come into these deals with either limited or no real estate investment background. And so what you often see, Daniel talked about this, is that on the front end of these deals, depreciation drives a large taxable loss. Right? So we’re in the era of 100% bonus depreciation. Cost segregations are everywhere. You have a multifamily property in your fund, you do a cost segregation, you get a large chunk of five, seven, 15-year property that qualifies for that bonus depreciation, and you get to take a huge deduction in year one of that fund.
[18:05] Kyle: That’s great. Everybody’s happy, depending on your operating agreement. Everybody gets a taxable loss. Real estate professionals, if they meet the thresholds, can offset their other sources of income. We like taxable losses that are driven by depreciation. As Daniel mentioned, it’s a timing mechanism, right? So you have a big loss now. In the future, you’re going to have income when you exit the property, barring a 1031 exchange or some other strategies to potentially defer the gain. You’re going to recapture that depreciation. And so in that recapture, you are going to have significant taxable income. Where you got a big deduction year one, and year seven you kind of have a big offsetting gain.
[18:52] Kyle: And so educating our investors on what that looks like and making sure they have the cash flow available to stomach that tax liability, I think is a huge part of this trust in this process. And then the other thing I want to point out with this, just getting back to making sure we’re clear in expectations and how depreciation works: if, knock on everything around me that’s wood, this deal goes south and a property has to be foreclosed, you potentially trigger an event here where these investors who have taken losses previously driven by depreciation have an income event in that year of foreclosure to recapture depreciation when they got zero cash out of this deal.
[19:34] Kyle: And I’ve been down that road before with clients, and that is the worst. So not only are you not getting your money back, but you have taxable income on the back end you weren’t expecting. Those are unhappy customers. So there’s a lot here around making sure all of that is, and I’m focusing on the education here, but making sure how these income or losses are allocated is very important.
[20:01] Daniel: Yeah. And I mean, real estate is famous for giving investors big tax losses early. But then that comes with tax gains later because it’s all temporary, right? And that’s not bad, but you need to make sure you’re setting the expectations so your investors are not blindsided. All right. We’re getting a cost segregation. You’re going to get all these taxable losses, but your cash isn’t going to match that. And then later on, you’re going to have to make up for it, and you might have more income than your actual cash. It’s a timing mechanism. It all evens out at the end.
[20:33] Daniel: But it can get kind of complicated if the investor’s expectation is different than what reality is. And so communication with your investors can be an issue. So you need to make sure you’re saying, “No taxes for years,” and they’re assuming K-1 losses always match cash. This is where it can get really complicated.
[20:52] Daniel: And then there’s even more complicated scenarios. I probably won’t go down this very long, but 704(c) is if someone contributes property into the partnership. Now you have a difference between books and tax if the fair market value and the original cost basis don’t match. And so this can create some mismatches because I invest or I contribute a million-dollar property into the fund. It’s like the same to me as I contributed a million dollars in cash, but when we get to the tax side, it’s not like that at all. And so you can see that there’s a huge mismatch here. And so you want to make sure that you’re really writing that out in your operating agreement so that your investors understand, and then it’s done right on your tax return so you’re not having this huge mismatch of what your investors are expecting and then what they actually get when they get their K-1s.
[21:53] Kyle: Yeah. And to piggyback off that, the other component in that same realm is when partners enter and leave. It’s not unusual in this deal where, as part of a capital raise or if partners need to exit for whatever reason, that occurs. And having clear definitions around how income or loss is allocated in those years of membership transfer, dilution of membership, your interest, all of that being clear helps me as the preparer, but helps clear up the expectations everywhere.
[22:25] Kyle: The last two things I want to touch on in this space: Daniel and I have harped on it, we’ve got plenty other videos on it if you want to dive into it, but K-1 timing and transparency around the tax prep process is very key for that investor trust. And then avoiding having a quiet fund, as Daniel says. And then also the other piece is really looking at the promote or other ways in which the general partners or the partners providing services to the funds are being compensated. Clearly defining what these payments look like in the operating agreement. The spirit of the payments, what these payments are for, what they’re trying to achieve helps factor into the hurdles we’ve talked about and the success of the fund and the fund modeling. Clear definitions around what that compensation is helps avoid ambiguity.
[23:15] Daniel: Yeah. And promote is just basically a disproportional share of the profits once the fund meets a certain mechanism. So if it’s 8% preferred return, that’s what we’re getting back, and it might get triggered at like 12% or 13%, which just means that the GP is going to get more share of the profits and things like that. So you really need to make sure it’s truly transparent in your operating agreement of when a promote is triggered.
[23:41] Daniel: And then the phantom income, it’s the number one investor trust breaker. So just make sure that you’re being transparent with them and communicating, “This is how your K-1 is going to look. It is going to have phantom income.” If you’re doing any kind of accelerating deductions or anything like that, there will be phantom income at some point. So you want to make sure that your communication with your investors is upfront about that so it meets their expectations when they finally get their K-1s.
[24:20] Kyle: And the other piece to this that’s a little bit relevant but I want to make sure we touch on is, depending on where the property or properties you hold are located, states potentially have withholding requirements on exit of deals. Getting back to cash here, venturing out a little of the tax realm, where on behalf of the non-residential partners in the fund, if those partners aren’t actually located in state, the fund itself may be required to withhold sale proceeds from the sale, remit it to the state directly, and then the partners get credit for that at the individual level.
[24:53] Kyle: And so I’ve seen mismatches where the fund distributed all the cash, and now the fund itself has a tax liability that it can’t pay. Which you may not be expecting because typically these are pass-through entities, the fund doesn’t pay income tax. There’s a catch there where they may. It’s on my mind with tax, a little more of a cash concept, and making sure that that’s clear. But having a good understanding of those tax triggers is important.
[25:30] Daniel: Yeah. And so let’s move on to the operating agreement and kind of what triggers disputes, because most fights are actually not about someone being unethical. It’s actually about the agreement being unclear. It’s a misunderstanding. And so when you’re looking at this, you want to make sure your operating agreement doesn’t have any contradictions. Does one section like the waterfall section agree with your liquidation sections? So across all these different ones, what happens when a capital event happens with a refi, different from a sale?
[26:04] Daniel: You want to make sure your body, your text body is matching your exhibits, right? I can’t tell you how many times I’ve seen an exhibit and it completely is different than what the text says. And so if two smart people read it and disagree, then the agreement is defective. It needs to go back. That’s the biggest thing. No one’s trying to get one up on someone else. It’s just there’s a miscommunication of how it’s being read.
[26:28] Kyle: It’s super fun when Daniel and I disagree on our operating agreement readings. Keeps us employed, I guess. But yeah, it creates ambiguity and confusion for professionals, for the investors, for everybody involved.
[26:48] Daniel: Yeah. And next one I see a big time problem is the capital calls. If anyone’s ever invested in real estate, especially funds, nobody likes a capital call. I put X amount of money in, that’s all I want. Now I want money back, right? But your language needs to be practical because we live in a real world where unfortunately things happen, and so you need to have clear expectations of when is a capital call. It can’t be too weak. It can’t be too nuclear. But in unfortunate situations you’re going to have to have a capital call. So when are the deadlines? I also, we don’t want it to be too harsh, but we want a clear notice process of when this is going to come out and when, transparent around when is a capital call and what is it used for.
[27:36] Kyle: Absolutely. And then we get into more of, this is a little bit legal territory, but talking about governance, right? And who and how the fund is governed, who are the key people, how are decisions resolved, obviously all that’s important. If there’s any related party activity, making sure that is disclosed and transparent is key. And then getting back into more of the tax realm, both the partnership audit regime, who controls the tax decisions, are big drivers of clarity in this.
[28:08] Kyle: And so that role carries a lot of weight. A lot happens with the designated partnership representative. That is the person who represents, stands in front of the IRS on behalf of the partnership, makes the tax decisions, is working with the accounting team to make sure everything is done timely. We talked in other videos about kind of being that quarterback, right? This is your quarterback for tax purposes. And so having that clearly defined is obviously important.
[28:56] Kyle: And the last piece I really want to talk about in there is the partnership audit regime. So how partnerships are audited and amended have changed. And in the current environment, by default, the partnership is making the adjustments. If we decide in two years we have to amend the partnership, the partnership is making the adjustments at that point. And then depending on how that adjustment operates, the partnership may stomach the adjustments itself or have the option to push out the adjustments to their partners, and the partners pick up those adjustments in the years down the line instead of having to go back and amend that original year return.
[29:20] Kyle: But how that’s defined is very important because you may have a hundred partners in this deal, and if we create a scenario where we have to go back and amend a hundred partners’ tax returns based on an adjustment at the partnership level, that’s a nightmare scenario and typically what we don’t want. So those provisions are key and important to scrutinize in the current environment.
[29:43] Daniel: Yeah, I mean with what Kyle is saying, you just need to make sure that your operating agreement is clear about when things go wrong, almost. Expect the big events. What happens when people come in and out? We have to remove an officer. Something happens. We have to replace somebody. There’s a related party, there’s some kind of key person that something happens with them. Or on the tax side, Kyle mentioned the partnership audit regime. No one likes having to amend returns, but it happens. Or what if you get audited? Who’s controlling that? What’s going to happen in that situation? How are we going to push out the audit changes? There’s actually multiple ways you can do it. You can do it in the partnership. Sometimes you can push it out in K-1s. And so there’s a lot there. You want to make sure it’s very clear that if you get yourself in some of these situations that hopefully you never have to deal with, but it happens, that you have clear written text of what is the process to go through that.
[30:49] Daniel: And so I mean we kind of end it here, Kyle. The best structures are just explained in plain English and then you can reproduce that in a spreadsheet with no hidden assumptions. If everyone can read my text, know exactly what needs to be done, and then I can take it in a spreadsheet and show it to you, and it matches what my K-1s are going to be, then that’s good.
[31:12] Daniel: And then you want to make sure that all the incentives are aligned. People understand that you’re going to have incentives. You just want to make sure they’re not misaligned. How am I getting this? If a sponsor is getting extra money, there should be some kind of increase in performance. Investors want transparency. That’s what they really, really want. And then making sure that your operating agreement is understandable to every single person that invests or is going to read it, whether it’s CPAs, attorneys, investors, should all be able to read it and interpret it in a very similar manner.
[31:53] Kyle: In most real estate partnerships, Daniel, I love when I can get that block of text that’s maybe one page on the sheet, but it’s clear in that one page. I can paste it on top of my spreadsheet and I have my tax allocations all the way through. It’s a beautiful thing, my friend.
[32:13] Daniel: Well, I hope today was great. We went over a bunch of things, common mistakes in operating agreements. Went a little longer than we normally do, but I think this is very important, and I hope you guys have a great rest of your weeks.
[32:39] To learn more about James Moore and Company’s real estate accounting and business solutions, go to jmco.com. And don’t forget to subscribe to our Real Estate Industry Update series to receive updates when new videos are released. If you’d like to be a guest or if there’s a topic you’d like to see covered on a future episode, contact us through our website or email us at info@jmco.com. You can also follow us on social media for more news as the landscape of real estate continues to evolve.
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