Carried Interests Explained: Key Considerations for Real Estate Funds

Regardless of whether you’re a developer, syndicator or general partner in a real estate fund, carried interests likely play a significant role in your compensation. This performance-based compensation aligns the incentives of the fund manager with those of their investors, enabling fund managers to share in the returns they deliver for their investors.

As a fund manager, you should expect that carried interest will be a point of negotiation with potential investors. Beyond this understanding, it’s also important to take note of how carried interests are taxed, since in many instances there are significant tax benefits.

In this overview, we’ll explain both of those concepts, helping you understand not only how to structure your real estate fund, but also how to plan for the tax implications of receiving significant carried interest income.

How Carried Interests Works for Real Estate Funds

Large real estate investments tend to include two main parties:

1. The investor(s), who has capital but lacks the willingness or understanding to invest in complex real estate projects by themselves. Investors are often referred to as limited partners (LPs).
2. The principal, who lacks capital but has the skills and expertise to manage multi-year real estate projects. They are typically referred to as general partners (GPs).

The goal of a real estate fund is to unite these two groups, pairing capital with the skills required to grow that capital over time. GPs are typically compensated in two ways: through fees (such as acquisition fees, loan guarantee fees, property management fees and so on) and through carried interests.

Carried interest, also referred to as carry or promote, allows fund managers to participate in the profits generated by their fund after a certain hurdle has been met. Typically, this works as follows.

After the LPs in the fund receive their initial investment plus some agreed return known as the hurdle rate (for instance, 10% annually), all future profits are split between the GP and the LP according to a pre-agreed allocation. This allocation is negotiable; it may be driven by the reputation of the GP, their appetite for risk and the fees they plan to collect. It can even have multiple layers of returns based on the success of the project (sometimes known as a waterfall).

The income the GP receives from their share of the profits is referred to as carried interest. It’s an approach to compensating the fund manager that aligns the incentives of all parties, giving the GP clear economic motivation to deliver strong returns for their investor.

Carried Interest in Action: A Worked Example

GPs typically only realize carried interest gains upon the sale of an asset. In most cases, this is the only time the investment generates enough cash to meet the hurdle rates agreed upon by the GP and LPs. Let’s look at an example.

In 2019, a GP acquired an apartment building for $10 million, raising $10 million from LPs. Included in the investment terms are a 10% annual hurdle rate (non-compounding) and a 30% carried interest for the GP. (In real life, the GP would raise less and take on some level of debt. But let’s ignore that for the simplicity of this example).

In 2024, the fund sold the apartment building for $18 million. The profits are split as follows:

• Initial capital returned to LPs: $10,000,000
• Preferred return to LPs (10% Hurdle x 5 Years): $5,000,000
• Excess profits above hurdle:
  • 70% to LPs: $2,100,000
  • 30% carried interest to GP: $900,000

This example shows how carried interest compensates the GPs of real estate funds that perform strongly for their investors. Upon the sale of the apartment building, the GP walks away with a sizable check. And there’s further good news for the GP: This carried interest is taxed more favorably than ordinary income.

How Are Carried Interests Taxed?

Unlike the management fees a GP may charge (which are taxed as ordinary income), carried interests are taxed as an allocation of income in the year it was received. In this case, the carried interest was earned in the year of a sale, so the majority of the income will be taxed as capital gains. Since long-term capital gains are taxed at a maximum of 20% (whereas ordinary income is taxed at rates as high as 37%), carried interest can be very advantageous from a tax strategy perspective.

In recent years, there have been several challenges to the way carried interest is taxed. Only one of these has become law: the 2017 Tax Cuts and Jobs Act. This act changed the holding period required for carried interest to receive long-term capital gains tax treatment from one year to three years.

However, there are carve-outs within the bill that offer the real estate industry significant protections. Gains on the sale of section 1231 property, which is depreciable property (such as real estate), are exempt from this characterization and would be classified as long-term capital gains. Land, which is not depreciable, is not included in this carve-out. Neither is the sale of partnership interests, such as the GPs stock in the real estate fund.

Recent years have also seen the IRS propose new regulations governing carried interest. While none of these passed, they shed light on how the agency thinks about it. Proposed regulations drilled in on ensuring that there was some form of entrepreneurial risk inherent in carried interest. The goal was to prevent fund managers from having some form of guaranteed income be characterized as carried interest and taxed at a lower rate.

While the taxation of carried interest remains a point of debate, changes to these regulations would require legislative action. As things stand today, the real estate industry is well protected. Structuring funds to include carried interest remains an effective strategy for real estate fund managers.

Manage Your Real Estate Fund’s Accounting with James Moore

Carried interest is a fantastic tool for real estate GPs, offering them the ability to participate in the upside of the deals they spend years actively managing while having their income taxed at long-term capital gains rates. But it’s not without risk. If an investment fails to reach the hurdle rate, the GP won’t receive any carried interest. And complex tax issues increase the importance of working with a trusted advisor.

Whether you need help managing the accounting of your real estate fund or have a complex tax situation involving carried interest, James Moore’s real estate accounting professionals are here to help. Our team brings significant experience advising funds and individuals in the industry, taking a long-term, strategic approach that helps our clients create and sustain lasting value.

Contact us today to learn more.

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