How Carried Interest in Real Estate Works

Carried interest represents a share of profits from a real estate investment paid to the sponsor for their work. It is a performance-based fee, earned only if the investment returns the initial capital to investors and clears a minimum return threshold. This compensation model is common in real estate deals where a manager raises capital from passive investors. The structure aligns the financial success of the deal sponsor with that of the investors, as the sponsor’s compensation is tied directly to profitability. This performance fee is distinct from other fees, like acquisition or asset management fees, which cover operational overhead.

The Core Concept of Carried Interest

In a real estate investment structure, there are two main parties: the General Partner (GP) and the Limited Partners (LPs). The GP, often called the sponsor, is the real estate expert who finds the deal, arranges financing, and manages the property. They are responsible for the day-to-day operations and strategic decisions that drive the investment’s success.

The LPs are passive investors who provide the majority of the equity capital, relying on the GP’s expertise to generate a return. In exchange for their operational efforts and taking on risks, the GP is entitled to a share of the profits, which is the carried interest. This interest is a contingent reward for creating value.

The Distribution Waterfall Explained

The “distribution waterfall” is the contractual method for allocating and distributing cash flow from a real estate investment to the partners. It is a sequential process with multiple tiers, ensuring that money flows in a specific order of priority from rental income or sale proceeds.

Return of Capital

The first tier is the Return of Capital. In this stage, 100% of all distributable cash is directed to the Limited Partners until they have received back their entire initial capital contribution. For example, if LPs invest $1 million, all initial net cash flow goes to them until they have received $1 million back.

Preferred Return

Once the LPs’ capital has been fully returned, the waterfall moves to the Preferred Return tier. This is the first level of profit distribution, where LPs receive 100% of the profits until a predetermined annual rate of return on their investment is achieved. This “hurdle rate” is typically 6% to 9%.

Catch-Up Provision

Following the preferred return, some agreements include a “Catch-Up” provision. This tier is designed to benefit the GP, allowing them to receive a high percentage of profits until they have “caught up” to a specific share of the total profits distributed, aligning with an 80/20 overall split.

Carried Interest Split

After the preferred return and any catch-up provisions are satisfied, the waterfall enters the final tier, the Carried Interest or “promote” split. All remaining profits are divided between the LPs and the GP according to the pre-negotiated ratio. A common arrangement is an 80/20 split, where 80% of the remaining profit goes to the LPs and 20% to the GP.

Tax Treatment of Carried Interest

A significant aspect of carried interest is its tax treatment. For the General Partner, the income received as carried interest can often be taxed at the more favorable long-term capital gains tax rates instead of the higher ordinary income tax rates. The top federal rate for long-term capital gains is 20%, which is substantially lower than the top 37% rate for ordinary income. An additional 3.8% Net Investment Income Tax can also apply.

To qualify for this lower tax rate, Internal Revenue Code Section 1061 mandates a holding period of more than three years for carried interest to be eligible for long-term capital gains treatment. If an asset is sold in three years or less, the GP’s carried interest is generally taxed as a short-term capital gain at higher ordinary income rates.

A significant exception exists for many real estate deals. Gains from the sale of real property used in a trade or business and held for more than one year can still qualify for long-term capital gains treatment, bypassing the stricter three-year rule. This exception makes the one-year holding period a more common benchmark in real estate.

The tax treatment also means that carried interest income is not subject to self-employment taxes. The rationale behind this tax structure is to encourage long-term investment and risk-taking in capital-intensive ventures.

Structuring in Legal Agreements

The specific terms of the carried interest and the distribution waterfall are defined in the partnership’s governing documents. For investments structured as a Limited Liability Company (LLC), these details are in the LLC Operating Agreement. If the structure is a Limited Partnership (LP), the terms are laid out in the Limited Partnership Agreement.

These agreements will detail several items, including:

• A precise definition of “Distributable Cash,” clarifying what revenue is included and which expenses are deducted.
• The explicit percentages for the preferred return and the carried interest split.
• The mechanics of each tier in the distribution waterfall, outlining the exact sequence and calculations for payments.
• A “clawback” provision, which requires the GP to return previously received distributions if the investment’s overall performance fails to meet certain long-term targets.