Finance
Carried Interest and Its Part in the CRE Industry
Understand carried interest and uncover the details of the carried interest loophole. This guide explains what carried interest is, how it works within investment funds, and explores the debate surrounding its tax treatment and implications for investors and policymakers.
Carried interest finances development in a way that spreads the risk and balances rewards. It is an important method for real estate finance.
“Carried interest is a common method for financing development,” said Matthew Berger, vice president of tax for the National Multifamily Housing Council. “It’s a way of aligning a developer’s interest with those of the general partners.”
The Real Estate Roundtable defines “carry” in private equity as “…the interest in partnership profits a general partner receives from the investing partners for successfully managing the investment and bearing the entrepreneurial risk of the venture. Carried interest may be taxed as ordinary income or capital gain, depending on the revenue the partnership generates.”
Berger says that the general partner or developer often has the idea but not the capital to get a project off the ground. To move it forward, they raise money from limited partners or investors.
“The general partner is awarded a carried interest to promote and make the deal work,” Berger said. “The simplest example is a ‘2 and 20’ where (the developer) gets a two percent management fee and then a specified rate of return on project completion.”
Why is carried interest controversial?
The development financing option provides tax advantages for the general and limited partners. This tax treatment generates controversy, which is sometimes called the “carried interest loophole.”
“Of the returns and those 20 percent (share) of those returns are taxed at a capital gains rate,” Berger explains. “Whereas the two percent of the management fee is taxed as ordinary income.”
The controversy comes with the applicable partnership interest held by the general partner. This allows the fees for developing the project to be partially shifted to a reward for the general partner’s performance of substantial services.
The partnership agreement makes the complex arrangement work. In real estate, a “parent” partnership often manages the risk, creating a “lower-tier partnership.”
Suppose a partnership owns an asset, such as a real estate development. In that case, it is eligible to see the return classified as either a long- or short-term capital gain, according to an article on critical considerations, written by Justin Dodge, CPA, at Plante Moran.
Berger said that the purpose of carried interest is to compensate for the risk people have taken.
“That’s the reason it’s taxed at a lower rate than ordinary wage income,” he said.
While the system has its tax advantages, NAIOP says that critics complain that preferential treatment encourages risk-taking and wealth accumulation among already wealthy individuals.
Proponents say carried interest is necessary to incentivize investment and risk-taking in real estate.
What is an example of carried interest in commercial real estate financing?
One of the largest examples of carried interest financing is the massive Hudson Yards project in New York City. The ultimately 25 billion dollar development on 28 acres is the largest and most expensive real estate project in the United States.
The project was a significant collaboration between New York City and the project partnership.
General Partner, Related, planned and entitled the development with funding from limited partner, Oxford Properties Group. The risk was spread by creating lower-tier partners who took ownership of specific phases and buildings. This is carried interest provisions in tax law.
Related was paid a fee for managing the project to completion and received a share of the profits after the milestones within the agreement.
How carried interest differs from more conventional financing
“(A developer) could go and borrow from a bank,” said Berger. “This is sort of a way of recognizing the risks the managing partner takes.”
He added that the risk to a developer with debt financing is that delays or cost overruns could raise project costs beyond the amount approved by the lender.
This is why carried interest is a prevalent method of financing development projects.
“You’re typically going to use all of your credit to get a project to pencil,” Berger said. “The question sort of becomes, who’s going to get paid first if it doesn’t work out.”
With conventional financing, the debt holder will be paid first, and the developer will be paid last.
According to Berger, with carried interest, the general partner always gets the management fee but is still the person to be paid last if a project goes south.
“Other investors are going to be paid first,” he said. “They are the ones taking the risk.”
With conventional financing, the bank is paid before anyone else.
What are the risks and rewards?
Berger said the risk is a project failing. The general partner then only receives the return on its investment after all other limited partners are paid. After all the time and expense, the general partner walks away with only the management fee.
Using limited partners’ money spreads the risk. If the project is successful, the general partner gets a share of the rewards with the return taxed at the lower capital gains rate.
The tax advantages are why so many use carried interest financing for their projects.
