Budding real estate investors may not realize that their tax bill could be dramatically impacted by their decision on how to hold their properties. Whether they’ve created a C corporation, a pass-through entity, or simply own the property as an individual, each set up comes with its own limitations and its own tax reduction opportunities. This is where you as a tax planner can provide essential advice to lower your client’s tax bill. Today’s blog will focus on a unique tax saving strategy available to partnerships.
If your client is part of a partnership entity that owns property, consider whether they might be able to use the “carried interest” strategy. You may have heard of this strategy before in connection with hedge funds and private equity funds, but it can also be applied to partnerships where one partner is making a much larger financial investment than the other. The carried interest strategy is actually just a form of income recharacterization that could allow your client to shift their property interest from an ordinary income tax rate to a long-term capital gains tax rate.
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Which Partnerships Can Use This Strategy?
Oftentimes partnerships have two (or more) people occupying very different roles: one who puts up money and one who does the work of the business itself. The “money” person puts up the majority of the funds needed to buy the real estate, and the “working” person puts in the sweat equity, as we would call it. This results in uneven investments: the financial investor has the funds needed but may not have the knowledge or time to participate in the business, while the sweat equity investor does not have the funds but they are contributing development, management, or operations abilities. Typically, these partners also have different wants and needs. For instance, when it comes to sharing the profits, the money person often wants to get paid out first, but the working person may be committed to the long-term vision of the business.
When you have the presence of a “big” partner and a “little” partner (as far as financial investment goes), this can be the right opportunity for the carried interest strategy, also known as the “profits interest” strategy or the “promote” strategy.
This strategy relies on an individual’s or business’ ability to split their interest in an investment into two parts: a capital interest and a carried interest. For the strategy to work, these investments need to be separated upfront because each will be treated differently from a tax perspective. Both the “big” and the “little” partner could have a capital investment if they contribute financially to purchasing the investment property. As the property earns income (say from renters), partners with a capital investment are allocated the income or loss from those day-to-day operations. Carried interest typically applies to partners who do not have the ability to contribute financially to the investment—or who are contributing much less. Instead of partaking in daily income and losses, they are compensated when the building is sold. This share of the profit is given in exchange for the partner’s time, expertise, and “sweat equity.”
So in short, the capital interest partner is paid out as the property produces income, and the carried interest partner is paid only if the property is sold at a profit. Though carried interest qualifies for long-term capital gains treatment, you must have held the property for at least three years. This was a fairly recent change introduced by the 2017 Tax Cuts and Jobs Act. Keep in mind that the long-term capital gains treatment is not automatic. You will want to refer to the IRS’ guidance through its revenue procedures to ensure you can secure that special tax benefit.
Why Do Your Clients Need a Waterfall Agreement?
Before entering into a partnership, most people talk through how they will split up the profits, especially when there is an uneven investment between a “money” person and a “working” person. What the partners may not do is write out a formal agreement that details what the split will be going into the partnership and whether that split will change once the money person receives their initial investment back or when the partners decide to sell the property. A document that lays out how the profits will be shared at different stages is called a “waterfall agreement.”
This is another point where you can provide essential guidance as a tax planner. You can add value simply by initiating the necessary conversations and asking about details that may have been missed. Some of the questions you might ask include:
● Are you and your partner sharing profits according to your interest in the company (e.g. 90% vs 10%)? Or will the “working” person receive a larger share than their capital contribution suggests because they are managing the business?
● Will the profit share change over time? Once all capital investors have received their investment capital back (plus the rate of return), who should receive what percentage of the income produced by the property? Since the “sweat equity” person is putting in the work to produce that income, should their percentage of the profits increase at that point, say, to a 80-20% split?
● What happens when the partners want to sell the property? Will they revert to their original split (90-10) based on the capital put into the property? Will they apply the current split to the profits (80-20)? Or will they split the proceeds 50-50?
The end goal is to have a written agreement that spells out the answer to all of these questions. By guiding your client through this process, they will be able to make the most of their real estate investment, and you will have the information you need to factor that into their tax plan.
Summary
The carried interest strategy is unique to partnerships and joint ventures. If your client has already opted into a C corporation or is committed to owning the property as an individual, this strategy will not apply. However, if the real estate is held through a partnership (or your client is considering a partnership), this income recharacterization strategy can significantly lower the tax bill for that “little” partner by allowing them to treat their profits as long-term capital gains.
To increase your knowledge of tax strategies specific to real estate investments, sign up to become a Certified Tax Planner today.
