What Is Carried Interest in Real Estate?

Carried interest in real estate represents a form of performance-based compensation for the manager or sponsor of an investment. It is a share of the profits paid to the sponsor after investors have received their initial investment back and have achieved a minimum, predefined return. This compensation model is designed as an incentive, aligning the financial interests of the sponsor with those of the investors. The payment is not a guaranteed fee; it is entirely contingent on the property’s ability to generate profits above a specific threshold, rewarding the sponsor for delivering returns that exceed expectations.

The Core Components of a Carried Interest Structure

A real estate partnership is composed of two types of participants: the General Partner (GP) and Limited Partners (LPs). The GP is the sponsor or manager responsible for all operational aspects, from acquiring the property to executing the business plan. LPs are passive investors who contribute the majority of the equity capital, typically 90-95%, but have limited liability and no involvement in day-to-day management.

Central to the carried interest structure is the preferred return, often called the “hurdle rate.” This is a predetermined rate of return that LPs must receive on their invested capital before the GP is eligible for performance-based compensation. A common preferred return in real estate is in the range of 7% to 9% annually. This return acts as a protective threshold for investors, ensuring they are the first to benefit from the project’s profits.

Before any profits are distributed, the first priority is the return of capital (RoC). This step ensures that Limited Partners get their initial investment money back from distributable cash. Only after LPs have been made whole does the distribution of profits, starting with the preferred return, begin.

Within the real estate industry, the terms “promote” or “promoted interest” are frequently used as synonyms for carried interest. The term refers to the GP’s disproportionate share of profits earned after the LPs have received their return of capital and preferred return.

Calculating Carried Interest The Distribution Waterfall

The mechanism for calculating and distributing cash flow is known as the distribution waterfall. This is a tiered structure that dictates the order and proportion in which money flows from the investment to the LPs and the GP. The waterfall is named for its cascading nature, as cash fills one tier completely before “spilling over” to the next.

To illustrate the process, consider a simplified example where LPs contribute $900,000 and the GP contributes $100,000 to a $1 million project. The agreement stipulates an 8% preferred return to LPs and a final carried interest split of 80% to the LPs and 20% to the GP. If the property is sold, generating $1.5 million in total distributable cash, the waterfall would begin.

The first tier is the return of capital. Here, the first $1 million is distributed, with $900,000 going to the LPs and $100,000 to the GP, returning their original investments.

With capital returned, the waterfall flows to the preferred return. The LPs are owed an 8% return on their $900,000 investment. Assuming for simplicity this amounts to $72,000, the next $72,000 of distributable cash is paid entirely to the LPs, leaving $428,000 in remaining profit to be allocated.

Some waterfalls include a “GP catch-up” provision as the subsequent tier. This clause allows the GP to receive a high percentage, often 100%, of the distributions after the LPs have received their preferred return. The GP continues to receive this high split until they have “caught up” to a specified percentage of the total profits distributed to all partners.

The final tier is the carried interest split. After the return of capital, preferred return, and any catch-up provisions are satisfied, all remaining cash is divided. In our example, the remaining $428,000 would be split 80/20. The LPs would receive $342,400, and the GP would receive $85,600, which represents the GP’s carried interest.

It is also useful to understand the distinction between American and European waterfall structures. An American waterfall is calculated on a deal-by-deal basis, meaning the GP can start receiving carried interest from one successful property sale even if other properties in the fund have not yet returned investor capital. A European waterfall is calculated at the whole-fund level, so the GP cannot receive any carried interest until the LPs have received their entire invested capital and preferred return across all investments in the fund.

Tax Treatment of Carried Interest

The taxation of carried interest has long been a subject of discussion, as it has historically received more favorable treatment than typical service-based income. For many years, a GP’s carried interest was taxed at long-term capital gains rates, which are lower than ordinary income tax rates. This treatment was based on the idea that the GP’s profit share was a return on an equity interest in the partnership.

A change came with the passage of the Tax Cuts and Jobs Act of 2017, which introduced Internal Revenue Code Section 1061. This law specifically targets the taxation of carried interest to address criticism that managers were benefiting from lower tax rates on compensation for their management services. Section 1061 imposes a stricter condition for qualifying for capital gains treatment.

The core of this law is the establishment of a new three-year holding period. For a GP’s carried interest to be taxed at the long-term capital gains rate, the partnership must have held the underlying real estate asset for more than three years. This is a substantial increase from the standard one-year holding period required for most other investments.

If a property is sold in three years or less, the GP’s carried interest is recharacterized as a short-term capital gain. Short-term capital gains are taxed at the same rates as ordinary income, which can be as high as 37%. This is compared to the top long-term capital gains rate of 20% (plus a potential 3.8% net investment income tax), creating a strong financial incentive to hold assets longer.

This tax rule applies specifically to the GP’s carried interest or promote. It does not affect the taxation of returns the GP earns on any personal capital they invested in the deal. If a GP contributes their own money, the gains on that capital contribution are subject to the standard one-year holding period for long-term capital gains, not the three-year rule.

Documenting the Carried Interest Agreement

The entire carried interest structure is legally defined in the partnership’s governing documents. The primary document is the Operating Agreement or the Limited Partnership Agreement. This legally binding contract contains the detailed “Distributions” or “Waterfall” section that dictates exactly how all cash flow from the investment will be handled.

This section of the agreement explicitly states the preferred return rate, whether it is cumulative, and the precise percentages for every tier of the waterfall. It also defines the carried interest split that the GP will receive after all higher-priority distributions are made. This language is often one of the most heavily negotiated parts of the agreement.

For real estate syndications that raise capital from multiple investors, a Private Placement Memorandum (PPM) is also used. The PPM is a disclosure document that provides prospective investors with a comprehensive overview of the investment, including a summary of the distribution waterfall. The Operating Agreement, however, is the controlling legal document that provides the full, binding details.

Potential investors should pay close attention to these sections in any deal documents. Reviewing the distribution waterfall provisions will clarify exactly how and when the GP gets paid, what performance hurdles must be cleared first, and how profits are ultimately shared. A clear understanding of these terms is fundamental to making an informed investment decision.