Help - Carried Interest as it Applies to Real Estate

Technical topics regarding tax preparation.
#1
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Client approached me regarding the 2018 tax changes surrounding carried interest. Upon looking further, carried interest seemingly applies primarily to private equity and hedge fund managers.

I've seen information related to carried interest (promote interest) in real estate development deals - how does that work? How does carried interest apply to real estate syndications/funds where the assets owned are 1231 assets?

I guess I'm confused on why carried interest would be beneficial in a real estate syndicate/fund where a 1231 asset is owned as the gains are already tax advantageous. Not sure how that works with development deals though.

If anyone has thoughts/comments or any reading material that you can point me to I'll be very appreciative!
 

#2
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I've seen information related to carried interest (promote interest) in real estate development deals - how does that work?


Allocations are straight-up, initially, based on relative capital contributions. Say the pure investors put in $65 and the development members put in $35. Allocations would go 65 pure/35 development. But then, once everyone has been repaid their capital contributions (unrecovered capital), plus perhaps a preferred return on capital to the pure investors, the percentages flip such that the development members would get, economically (i.e. in cash), 65% and the pure investors would get 35%. So, the advantage is more cash to the development members once the flip takes place – 65%, even though they only contributed 35% to the deal. If you just structured the deal so that everything was straight-up from beginning to end, but then the development members received their 30% promote in the form of a calculated guaranteed payment at the end, it would be ordinary income.
 

#3
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Thanks Jeff - When the flip occurs and the GP receives 65% even though they only have a 35% capital interest, is the excess 30% profits interest considered carried interest? If so, is the carried interest taxed at LTCG at the end of the project?

Any insight as to how this works with apartment buildings? LP gets their capital plus a certain IRR, the GP then splits in profits spit off by the apartment building - same thing?

(sorry lots of questions!)
 

#4
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is the excess 30% profits interest considered carried interest?


Yes.

If so, is the carried interest taxed at LTCG at the end of the project?


First things first. You have to consider whether or not the “flip” is a taxable event in and of itself (i.e. a taxable capital shift). Most of my clients don’t like this idea, so we ignore it. Here’s an example: Let’s say we have the 35 pure/65 development initial split. While capital may have been returned, and while a preferred return on capital may have fully occurred, we’d still have capital account balances because of differences between income allocations and actual cash distributed. And then, we’d shift that capital from 35/65 to 65/35. (Note that this presumes that the promote is a capital interest; sometimes it’s very hard to tell from the Operating Agreement). Part of the issue here is whether or not a shift should occur or if the ending pre-flip capital accounts don’t get shifted, and instead, remain intact…with the post-flip allocations simply starting from ground zero.

In other words, say cap accounts are $6,500 pure and $3,500 dev. We hit our milestone. Do we flip to $3,500 pure and $6,500 dev? If we do, some would argue for a taxable capital shift. In which case, we’d need to consider values, which may be well in excess of $10k. Or, do we leave things as is, such that final payouts will account for allocations that are baked in to the pre-flip capital accounts?

Now back to your question about LTCG @ end of project. One thing to note here is that the flip might take place well before the project is “sold.” So, we might have allocations going 35% pure and 65% dev for a while before selling the projection. But when the project is sold, it wouldn’t be LTCG if we’re talking about an apartment complex. It would be Sec 1231.

I think we all understand the intent behind the promoted interest. It’s just that the devils are in the details, including the Operating Agreement, and intentions aren’t always reflected in the written word.
 

#5
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Thanks again Jeff.

So what are the tax advantages to structuring a promote interest if a syndicate owns an apartment building that's almost fully leased up rather than a development project?
 


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