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This week we're releasing a recording of Kim Lisa Taylor of The Syndication Attorneys and Thomas Castelli discussing the tax treatment of carried interest and other fees that General Partners (GPs) of real estate syndicates and funds receive. This recording was originally published on The Syndication Attorney's website for replay. This recording includes important information about taxes as they relate to the structure of a deal, K-1s and 1099s, and a Q&A session with Thomas and Kim Lisa.
Carried interest, also known as 'sweat equity' , or a 'promote' or a 'profit' interest is the portion of a deal that the GP or sponsor receives for putting together and managing a deal on behalf of the passive Limited Partners (LP). In other words, carried interest is the GP's share of the 60/40, 70/30, or 80/20 percent split for running the deal. Generally, these are the Class B investors who are receiving a portion of the income, loss, or gain in exchange for their services to manage the deal. The LPs would be the Class A investors, who receive their share of the income, loss, or gain in exchange for the cash they invested.
Carried interest is a share of the profits paid to the investment manager, most likely a GP, in excess of the amount that the manager contributed to the partnership. This is very common in real estate, it is compensation for ensuring the limited partners achieve returns on their investments. This carried interest typically occurs with Class B members, being that this interest is compensation for their management of the deal.
"When you receive your carried interest, or your profit interest, the income that you receive retains its character. If you have a carried interest, any asset needs to be held for at least three years to achieve long term capital gains rates. If you hold it for less than three years, it will be tax at short term capital gains tax rates."
Ordinary Income Tax
This is income that's taxed at the ordinary income tax rates, from 0-37%. This includes wages, business income, interest, royalties, and many other forms of income.
When you're self-employed, the first $137,000 of your income has an additional tax at 15.3% for the self-employment (SE) tax.
In a syndication, the manager or GP may receive acquisition fees, refinance fees, disposition fees, and asset management fees - this is all considered ordinary income and it's taxed at ordinary income rates. In addition, in most structures, this income will also be subject to the SE tax.
Distributions Paid to Class A Investors
The distributions aren't being taxed, but the rental income allocated is being taxed. If there's $100,000 of rental income, and the passive investors were allocated 80% of this, the Class A investors will pay ordinary income tax rates on that $80,000, before applying any other tax treatments such as depreciation, certain expenses, and other situation that will cause a loss.
"You're not necessarily taxed on the distributions, you're taxed on the rental income that's allocated to you... at ordinary income tax rates. There's usually depreciation and different types of expenses that cause a loss. [Upon sale], it's capital gains tax."
Capital Gains Tax
Capital gains tax is the tax on the difference between the sales price of a capital asset and its adjusted basis. Aka purchase price less accumulated depreciation over the entire holding period. It's a tax on the gain from the sale of the asset.
Tax on distributions received from equity upon sale for Class B investors:
If the asset is held for longer than 1 year, that's considered long term capital gains. There are three different rates for long term capital gains tax, depending on your income.
$0-$39,000 Single or $0-$78,000 MFJ = 0% capital gains tax
$39,000 - $434,550 Single or $78,000 - $488,850 MFJ = 15% capital gains tax
$434,500+ Single or $488,850+ MFJ = 20% capital gains tax
If the asset was held for less than one year, that's considered short term capital gains. This is the same tax rate as the ordinary income tax rate for the individual.
Flippers/rehabbers/developers - the properties are considered inventory, depending on your classification as being in the trade or business of flipping properties. At this point, the properties are no longer considered capital assets by the IRS. The profit, or gain, is taxed as ordinary income and can be subject to SE tax.
Cash flow distributions for Class B Members:
The income received retains its character. Rental income will be taxed at ordinary income tax rates. Refinancing proceeds are generally not taxable unless the cash taken out is in excess of the investor's basis in the partnership.
Distribution from Equity Earned on Disposition:
If you have carried interest, the asset needs to be held for three years or long to achieve long term capital gains tax and the applicable rate. If the asset is held less than three years, this income is taxed at ordinary income rates.
From a structural standpoint, the manager would get taxed at two different rates depending on the form and split of the income. If Class B investors sign on the loan for qualified non-recourse debt, this increases their basis in the partnership. This allows Class B members to take losses that are generally prevented by the typically lower amounts of capital invested. Some managers may be considered a real estate professional for tax purposes. Therefore, the losses from rental activities can offset ordinary income. Generally, these losses can only offset passive income.
K-1 vs 1099
Partnerships don't pay taxes on their income. The partnership files a partnership tax return, form 1065. Form 1065 reports K-1s to each partner that includes the income, loss, deductions and credits, and the partners report their share along with their individual tax return form 1040 and pay the tax based on their individual circumstances and tax rates.
A 1099-Misc reports business income that's paid to somebody during the entire year. This is most common with contractors. The manager LLC would receive a 1099 from the investor LLC. Assuming the manager LLC is a partnership, they would give K-1s out to each individual partner. If the manager LLC also owns a Class B interest, they only receive a K-1. The income is broken down by sources on the K-1 in separate boxes.
Class A member will almost always receive K-1s reporting rental income or loss and gains upon sale.
Joint Venture/Member-Managed LLC
If all members are actively involved. Everybody in this situation would be a GP by default, there is no more carried interest, just partnership interest. The long term capital gains rates upon sale is achievable with just one year of holding. This applies only to carried interest. It is very complicated to allocate depreciation disproportionate to the investments.
Using a Corporation to Take Title to a Property
Generally no, unless you're full-time into flipping and development, then it's more common to hold title in an S-Corp. Using the S-Corp allows the investor to mitigate their exposure to the 15.3% SE tax. S-Corps cannot have non-U.S. members. It is possible to sell interest in an S-Corp, but it may not be the ideal structure for this move. There's no ability to do any special allocations.
Investing in an IRA
When investing with a SD IRA, you're subject to UBIT, the Unrelated Business Income Tax. This tax is calculated and results in UDFI, which is Unrelated Debt Financed Income. This is the percentage of the income that's derived from debt financing. Usually this UBIT comes into play upon sale of an asset, and it usually isn't a dealbreaker on the investment.