As a real estate investor, your tax saving strategies may depend on how you are holding those properties. Do you own the property as an individual? Are you holding it in a C corporation or S corporation? Or do you have a partnership where the partners are making different financial contributions to purchase a property? Today we’ll focus on the latter—a tax strategy that is especially suited to partnerships called the “carried interest” strategy.

The carried interest strategy (also known as the “profits interest” or “promote” strategy) is often associated with hedge funds and private equity funds but can also be used by business partners going in on an income-producing property together. While this strategy may seem complex at first glance, it actually works the way most real estate tax strategies work—by “recharacterizing” income so that you qualify for a lower tax rate. In this case, the goal is to shift away from ordinary income tax (which can be as high as 37%) and toward capital gains tax (which ranges from 0% to 20%). This can result in major savings for you and your business partners! 

Money vs. Sweat Equity

In many real estate partnerships, you often have two (or more) people making very different contributions to the business. Typically, you have at least one “money person” whose main contribution is capital. They may not have the time or the skillset to operate the business itself, but they are willing and able to invest the money needed to purchase the income-producing property. Then you have a “working” person who may not have much money to invest, but they can offer “sweat equity”—the time and skills needed to actually run the business. This makes for an uneven investment and a setup where the different “investors” likely have different needs. For example, the financial investor likely wants to get paid out first, but the working person may not get paid out until the property is sold, depending on the agreement. 

When you have this setup with a “big” partner and a “little” partner, this can be the right formula for the carried interest strategy.

Splitting the Investment Could Be in Your “Interest”

How does the carried interest strategy work? First, the business needs to formally separate these two types of investments: capital interest and carried interest. Each partner could have both types of interests, or certain partners might only have one. The key is that the two interests are treated differently from a tax standpoint. 

Capital interest refers to a financial investment. So in some cases, the “big” partner might be the only one with a capital interest—they footed the bill to purchase the property. Typically, this type of partner gets their investment back as the property earns income. Say the property is rented out. As the tenants pay rent, those with a capital interest are allocated that income. The same is true if the property experiences losses (say, months without tenants). Those losses are allocated to the capital investors. 

Carried interest applies to partners who either do not contribute financially to the investment or who contribute very little. These are the “sweat equity” partners mentioned above. Instead of receiving the income and losses the property generates day-to-day, partners with a carried interest only receive a payout if the property is sold at a profit. Their share of that profit is their compensation for their time, expertise, and “sweat equity.” 

Now one benefit of holding carried interest is that this income can qualify for long-term capital gains treatment. The catch is that you must have held the property for at least three years—a change brought about by the 2017 Tax Cuts and Jobs Act. The long-term capital gains treatment is not automatic, so you will need to consult the IRS’ guidance or work with a professional tax planner to ensure you take the right steps. 

But First… Set Up a Waterfall Agreement
If you do have a partnership where the profits are not split up based on financial investment, you will want to write up a formal “waterfall agreement.” This type of agreement lays out how the profits will be shared at different stages. Even amateur investors have waterfall agreements, though they may not call it that. A formal agreement, spelled out in black-and-white print, is essential to provide clarity on who gets what when it comes time to sell the property. 

If you have not already ironed out these details with your business partner, start by asking these questions:

● Are we sharing profits according to our interest in the company (e.g. 90% vs 10%) or according to another setup? For example, should the “working” person receive a larger than 10% share because they are putting in the work to manage the business?
● Will the split stay the same for the duration of the partnership, or will it change as you reach different milestones? For example, once the money person receives their initial investment back, you might shift the split so that the “sweat equity” person receives more, since they are putting in the hours to generate that income (say, a 80-20 split). 
● What happens when one or both of us want to sell the property? Will we revert to our original split (90-10), stick with the current split (80-20), or split the proceeds 50-50?

Without a written plan, confusion and conflict can arise. By sitting down to set up a simple waterfall agreement, you will save yourself many headaches down the road and be better prepared to factor those different stages of the business into your tax plan. 

Summary

If you own a real estate investment as an individual or through another entity like a C corporation or S corporation, this tax strategy won’t apply to you. However, if you have a business partnership—or are considering a joint venture of some kind—one of the benefits may be the use of the carried interest strategy. This is especially true if you will be the “little partner” in the setup, contributing less of the money but investing more of your hours to ensure that property generates income. When it comes time to sell, the carried interest strategy will allow you to convert your property’s growth into long-term capital gains instead of ordinary income, reducing your tax bill. 

For help making this and other tax reduction strategies work for you, reach out to a Certified Tax Planner today.