What Is Real Estate Carried Interest & How Is It Taxed?

In real estate investment, carried interest is a share of the profits awarded to the general partner (GP), also known as the sponsor or developer, by the limited partners (LPs) who provide the project’s capital. The purpose of carried interest is to incentivize the GP to maximize the project’s profitability, aligning their financial success with that of their investors. This performance-based fee is often referred to as a “promote” within the industry.

Carried interest is not a guaranteed salary or a management fee paid for day-to-day operations, as those are separate forms of compensation. Instead, it is contingent on the investment achieving a certain level of success. It is only paid out after the investors have received their initial capital back and a predetermined preferred return, rewarding the sponsor for generating returns that exceed the baseline for investors.

The Mechanics of Carried Interest in Real Estate

The foundation of most private real estate investments is a partnership between a General Partner (GP) and Limited Partners (LPs). The GP is the real estate expert responsible for sourcing, managing, and selling the property, while the LPs are passive investors who provide the financial capital. The partnership agreement outlines a distribution waterfall, which dictates the order that cash flow and profits are distributed. This cascading structure defines when the GP is entitled to receive their carried interest.

The waterfall begins with the Return of Capital. In this initial phase, all distributable cash is directed to the LPs until they have recovered 100% of their capital contribution. For instance, if LPs invested $10 million into a project, all proceeds would flow to them until that $10 million is fully repaid. The GP receives no profit distribution during this stage, ensuring the investors’ principal is returned before the sponsor shares in any upside.

Once the LPs’ capital has been returned, the waterfall flows to the preferred return. This is a predetermined rate of return that must be paid to the LPs on their invested capital, often called the “hurdle rate.” A common preferred return is between 6% and 9% annually. For example, if investors were promised an 8% preferred return on a $10 million investment, they would receive their capital back plus $800,000 for each year invested before profits are distributed further.

Following the preferred return is the GP Catch-Up, a provision allowing the GP to receive a high share of profits until they have “caught up” to a specific percentage of distributions. For example, the GP might receive 100% of the next distributions until their share equals 20% of all profits distributed after the initial return of capital. This mechanism accelerates the GP’s compensation once the primary investor hurdles are cleared.

The final tier is the profit split, where the carried interest is fully realized. After all prior tiers have been satisfied, any remaining profits are split between the LPs and the GP according to a predetermined ratio, such as 80/20. The GP’s 20% share is their carried interest.

Tax Treatment of Carried Interest

The taxation of carried interest is based on the difference between ordinary income and long-term capital gains tax rates. Ordinary income, including wages and business profits, is taxed at progressive rates up to 37%. In contrast, long-term capital gains from the sale of an asset held for more than one year are taxed at lower rates, typically 0%, 15%, or 20%.

Historically, carried interest has been treated as a long-term capital gain, provided the underlying assets were held for more than one year. This treatment is based on the view that the GP’s interest is an equity stake in the partnership’s investment. The character of the income “flows through” from the partnership to the partner. Therefore, if the partnership generates a long-term capital gain from selling a property, the GP’s share of that gain is also taxed as a long-term capital gain.

This favorable tax treatment has faced scrutiny, with some arguing that carried interest is compensation for services and should be taxed at higher ordinary income rates. This debate led to legislative changes in the Tax Cuts and Jobs Act of 2017, which established new, more stringent requirements that must be met to qualify for the lower rates.

Navigating the Three-Year Holding Period

The central rule governing the taxation of carried interest is the three-year holding period requirement established by Internal Revenue Code Section 1061. This rule dictates that for a sponsor’s carried interest to qualify for the long-term capital gains tax rate, the underlying assets generating the gain must be held for more than three years. If this holding period is not met, the sponsor’s gain is recharacterized as a short-term capital gain and taxed at the much higher ordinary income rates.

This provision applies to an “Applicable Partnership Interest” (API). An API is any interest in a partnership held by a taxpayer for performing substantial services in a business that involves raising capital and investing in assets like real estate. For a real estate professional, this means their interest as a GP falls under this definition.

The practical implication for a sponsor is a change in investment timing. A sale at the two-year mark, for example, might be profitable for LPs who would receive long-term capital gains treatment, but the GP’s carried interest would be taxed as ordinary income. This creates an incentive for sponsors to adopt longer-term hold strategies, which can misalign with LPs who may wish to exit sooner.

The consequence of failing to meet the three-year threshold is purely financial for the sponsor. A gain that would have been taxed at 20% could instead be taxed at a rate as high as 37%, significantly eroding the net value of the sponsor’s promote.

Exceptions and Special Cases

While the three-year holding period is the general rule, there are exceptions that can allow a sponsor to receive long-term capital gains treatment.

A primary exception is the Capital Interest Exception. This rule clarifies that the three-year holding period applies only to the profits interest received for services, not to returns earned on a sponsor’s own invested capital. If a GP contributes their own money to the deal, the returns on that capital qualify for long-term capital gains treatment if the standard one-year holding period is met.

Another exception relevant to real estate involves Section 1231 gains. This section of the tax code applies to gains from the sale of depreciable property used in a business and held for more than one year, which includes most commercial real estate. Gains from these assets are not subject to the three-year holding period rule for carried interest purposes. This means a sponsor’s carried interest from the sale of a building held for more than one year but less than three can still qualify for long-term capital gains treatment.

This exception is a benefit for real estate sponsors, as a large portion of a property’s sale gain is often from the building. However, the exception does not apply to the gain attributable to the land, which is not depreciable. A sale of property held between one and three years may result in a bifurcated tax treatment for the sponsor, with the building gain taxed at long-term rates and the land gain taxed at short-term rates.

A final exception is that the three-year rule does not apply to interests held by a C corporation. If the partner receiving the carried interest is a C corporation, the holding period provisions do not apply, though this structure has its own tax considerations.