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Tax Smart Real Estate Investors Podcast
MLRE: Carried Interest: What’s Really Behind the “Loophole” and Why It's Misunderstood
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In this solo episode, Nate Sosa breaks down one o…
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Welcome to the Major League Real Estate Podcast. A podcast for large scale real estate portfolios. My name is Nathan Sosa and I'm your host. Together with my co host Tom Castelli, we talk about tax and legal strategies and we bring on operators of large portfolios for in depth discussions on how they grow their business and this tax strategies behind what they do. We hope you enjoy. Hey everyone. Today, as you can see, it's a solo episode. No, Tom. Tom is enjoying the wonderful life in Vegas right now. So I just actually wanted to kind of do a technical deep dive today. So for those of you who are interested, right, it's going to be a part history lesson, part tax and I think the topic we're going to go about today is carried interest. Now, oddly enough you might not realize this, but carried interest goes way, way back. So I'm a pause there because I just wanted to precursor and we'll be back to the show in just one second. Real estate syndication tax is confusing to you? Well, that's why hopefully you listen to the podcast today. Also you should go to our website, www.therealestatecpa.com and you'll be able to get access to the ultimate guide to Real Estate Syndicators and sponsors which breaks down everything from preferred returns, depreciation strategies. Whether you're a GP or an lp, avoid costing mistakes and maximize your returns. Download the complete guide free and get the tax clear you need to succeed. All right guys, so the goal of today is to just kind of do a deep dive on carried interest, why it works, how it works and honestly kind of talk about the nuances with profits, interest, sweat equity, that type of stuff, right? I know a lot of people say, hey, I want to work so that I can have the opportunity for economic upside, right? And so actually we can talk about that structure, how it all works and just kind of go through the history, how it works in the current real estate market and what a lot of people see. So let's dive in. I actually have a. So this is for those who are on YouTube. I've got a presentation for us to go with, to go for over today. So I've got a little slide deck. Hopefully you guys find it entertaining. All right guys, we're talking about profits and carried interest, what syndicators need to know, the history mechanics, what the tax advantages are with that. So let's get rolling. So again we'll talk about the history basically from the 16th century, right? Shippers, right? The original big time entrepreneurs, people who would literally sail across into the unknown unknowing whether or not they would make it back, make it home. It was truly an act of bravery if you really think about it. One of my favorite stories out there that exists is there was once upon a time a 13 year old who captained a ship. Right? And this is a 13 year old of other grown adults. Now those grown adults are probably more like 15 to 20, but still just like the crazy stuff that went back in those times. I highly recommend you take a dive into that. But basically just kind of how it works when it comes to gp, LP splits, waterfalls, and then when the promote really kicks in, the tax advantage of it. Oh, and we'll of course talk about the political risk because who loves to talk about Congress legislation more than me? Probably nobody, but we'll go through all that today as well. Okay, so where did carried interest come from? Right, where did carried interest come from originally? So way back when, back in the old 1500s, medieval merchants and ship captains received interest. A carry, right? What does this mean, a carry? Basically a share of the profits on the cargo that they didn't own. Right? Because it's the thing, they owned the ship, right. Maybe they owned, lease, loan ship, whatever that wound up being. However the economic structure was back in those days, they earned a carry on the cargo, right? So basically they didn't get paid unless they delivered the cargo. Right? That's the really interesting thing. Right? So hey, they're taking enormous risk on, right? There are privateers, pirates, sea monsters, right? All kinds of things that were out there that they had no idea if they were able to make it or not. Right? So to be compensated for doing this, they received the carry as compensation for it, Right? You don't see that in Pirates of the Caribbean, unfortunately. I wish they talked about it. It might have been. Movies were interesting in my opinion. Who cares about Jack Sparrow? It's a joke. But basically that is where it originated. Right? And then we moved into the oil and gas exploration partnerships, right. In the 19th century, they received profit shares taxed as capital gains very early on, right. Early 1900s, like right into the development of oil industry. And then of course in the 1940s through 70s, private equity decides to that they are going to work on this carry structure. Right? They're going to modernize or make something similar to these incredible ship captains from so long ago. So it's really intriguing the history of it. Like I highly recommend you like doing your own little deep dive of it just to see how it all works and how it's gone through over time. It's really intriguing in my opinion. All right, now that we've talked about the history behind it, let's now talk about how does a carry split actually flow? How does this work? Right. So typically in syndication structures, I'm not, this is like most of you probably know this, I've read this, have seen this, but basically there are two types of people. There's a general partner, the sponsor slash operator and the limited partners. Right now there's way more limited partners than there are general partners. And that's because they provide the capital, right? They provide 80 to 95% of it, right. The rest is generally financed and they also then create preferred returns. Right. Here's the other key part. They're passive. They're actually not involved in the day to day business. A lot of limited partners, including myself, could be any of us, right, Go evaluating these types of deals and seeing what makes sense and then flip over to the ship captain, the general partner, right? They are the ones who are finding the deals. They're managing a property or finding your op or managing the manager. They put in far less capital, either 0 or up to 5, 20% somewhere in that range, just depends. But they generally earn some kind of salary or fee for what they are working on in the fund, right? So they go find the deal, they pitch the deal, they raise for the deal and then they execute on said deal, right? That is what the general partner is doing. They are quote unquote, today's normal day ship captain. So that's pretty cool. And so how does this work from a waterfall structure perspective, right? Pre return LPs generally do it. Now there are times a GP also puts money in as an LP as well. Like hey, they trust their own deal. Actually I think it's not a bad point when you see that happen just because that means, hey, they're putting up their own investments at stake too. Preferred returns, LPs receive 8% prep first, step two. And the LPs start to get their principal back, right? They start getting all this principal back to them and so they get that, they get that and then comes to the profit split, right? Normally that winds up being a 70, 30 type split where the, the LPs get their split and now the general partner starts receiving their profit quote unquote distributions, right? This is cash, by the way. Right? That's something we got to really emphasize on. While profit split is important, cash is also important too when you got to think about that and consider that. Right? And well actually maybe I'll mention The fact why GPS have issues wanting to take a lot of losses because they sure they carry a ton of risk. There's a ton of risk that, that general operators carry in development deals, buying and finding, right there a lot of times having to put up personal risk or something of that nature in this. So it's super, super important for these people that they get something out of this. And that's where the carry comes into play. The promote slash carry, right? You'll hear all different type of turns. I remember when I was learning all this stuff, right? Like you can't just know this stuff off top like at the beginning. But when I was learning all this stuff, finding out, oh hey, a carry are basically the same thing, right? There's not a whole lot of differences between the two. It's more of a legal terminology, tax wise all the same. So let's kind of run through a potential deal, right? Let's run through a deal how this might all work. So let's assume purchase price of $10 million, right? Shave off some zeros, add some zeros, divide it in half, whatever you want to do for your own deal. Now we have debt generally 70% loan to value, right? Is generally what you wind up seeing. And like I said, all this stuff's across the board. So it means total equity that exists is about 3 million. So we'll say the GP equity is about $500,000. LP equity is 83% preferred return markets generally around 8%. But we see the profit split goes 70, 30 in terms of GPL P split, right? So that's just, this is an example of multifamily deal, right? This is just what happens. We see all this and so GP puts in 500k, LP puts in two and a half million, right? That's typically what we see here. Okay. Then they have the LP preferred return of 600k. Again this is for anyone that wants to see the YouTube, right? Like you can pop over there and see actually see some of these numbers, how it's all working out, right? And so cool. So now the LP gets 600, 630,000. The GP gets the 30% carry of 270k, right? These are just the numbers. Not going to spend too much time here. And so hold on, what happens now? What's super advantageous that you'll find when it comes to these types of operations is the carried interest is taxed at a max 20%, right? So all that upside now granted the carry is generally got to follow the character of whatever the deal actually is. So Just FYI on that, right. It's got to follow the character of whatever the deal actually winds up being. And so when you sell real estate generally outside of recapture, these gains fall into what I consider to be 1231 capital gains. Right? What does that mean? Well, when you sell a stock, there is certain assets that are considered capital in nature. There is a very, very favorable part of the tax code and like I don't think people realize how favorable it is, is that whenever you sell an asset in a business, right. Whether it be real estate or not real estate, it is considered 1231 income or I guess 1231 character. And what does that mean? That basically means that it since a trade or business type of asset it has taxed at the max 20% rate, right? You can add knit in there, you might see 23% floating around there at times. That's because that's just incorporating net investment income tax into that calculation. So just FYI there. But so whenever you have a carry and the underlying character of the gain is long term capital gains, that's taxed to that max 20% because real estate is 1231 capital gains, right? So no self employment tax. And if you look on the flip side, the management fees, right. Can be taxed at the max 37%, right? Subject self employment tax is compensation, right? You're doing for the day to day work. So hold on, so why taxes differently? Why on earth would we do this? Why should this be done? I don't understand it. Well, the whole reason why it's being performed like this actually is because that one of these is viewed as compensation and the other is viewed as long term appreciation or risk. Right? That's why it's being done that way, right. Whether that's right or wrong, Let Congress figure that one out. You can have the conversation with them, talk to your congressman or woman. Some people want all these to be taxed the same, the same way. Some of them, some people understand that there's differences to this stuff right? Now in 2017 Tax Cuts and Jobs act added a three year hold period for anything post 2017, right? This is where 1061 comes into play, right? Code section 1061, where you have a carry, the carry must have a three year holding period requirement. And so what that means to qualify for carried interest type treatment have crystallization occur. Which is basically means you hold everything, everything thus gets to its point in time where now you'll qualify for long term capital gains. That's what that happens. What I will say with that, however is that there is an exception for any 1231 type asset underlying that is significant because that means that real estate, even though it says would fall under this applicable partnership interest, is actually not the case. Right? So just FYI on that, so going to that effect, that is the massive exception. Now if you sell the partnership interest, that's different, right? That's where could kick into play potentially. I've heard some discourse, different discourse on that, but that's how that works there, right? So FYI, right, that on a $2 million carry per se, right, that is basically a 17 point tax rate spread. That is basically $340,000 in potential tax savings here in the example I gave earlier. And so what's happening with the loophole? What's going on with it? Look, you hear this every single year. So we've had this, it's been consistent for a long period of time, so consistent that it's got to exist and got to live. The only way to get rid of it is through Congress, right. Or if people will decide to treat this incorrectly or improperly. And so is this loophole going to get closed? Right. Is it? What's going to happen with it? Honestly, the answer is I don't think so. Right. Every single year there's always proposals coming from Congress that you see consistently saying we're going to get rid of the carried interest loophole. It's going to get rid of. Right. Hedge fund managers can't do this. They're not allowed to do this. I shouldn't be allowed to do this type of thing. It's constantly what you hear and see over, over and over and over again. And so again in 2007-2008-2012-2017, right. This is the actual, the biggest change we've seen that wound up coming where you extended the hold period of the partnership interest from one to three years to actually qualify. So if you sell the interest of itself, that means you're not going to qualify. Now if you're actually selling the real estate, what's underneath, which is what 90% of syndications do, there are the oddballs. We sell the partnership interest. I don't normally see that happen, but that does exist. Now what about the build back better and IRA proposals to close the loophole? Right. Actually is so close. It was the closest, I think it's been a long period of time. Right. They had an idea to remove carried interest and have it be taxes or 1061 is going to apply it to be taxed as ordinary income. Right. So that means for Anyone? Now there's always stipulations in time frame starting from this date, right? Normally it doesn't go retroactive. I can't remember 100% if they're gonna make it retro or not. But normally they don't do retroactive provisions normally. Cause it's just really hard to score, right. And what I say by scoring it's just like how they go through the legislative budget and figure out this tax stuff, right. If anybody's interested in that. And so it was in there until the very last moment when Senator not Mansion, I think Cinema of Arizona said that was like two of our top priorities to get removed right now. Why? Who knows? Precisely why? Who knows? Maybe a large hedge fund manager came in or maybe it did not line up with her philosophically and she thought that it makes sense for these types of items to be taxed that way. Who knows? At the end of the day it was very last minute. And what blew up a lot of the stuff in the Build Back Better act right now, the Inflation Reduction act, but had that in there, but it got removed and yanked out again. They were again talked about throwing it in there as a pay for. But honestly the thing is like the proposals they were running with was like 10 billion as much as that. As much as $10 billion is a lot of money. It's a drop in the bucket for the government to where it's not worth upsetting or messing with their constituents from this, right? Could they have done it? I think it would have made a lot of sense to do it and get rid of it. But they didn't. So it doesn't really matter anymore and doesn't like doesn't get an effect now. So are they going to keep bringing this up over and over and over again and one day are they going to get the right members of Congress on board to agree to it and the right president to spend sign it? Maybe even President Trump said that he thinks this loophole should be closed despite him having actually used it over and over and over again. But that being said, I think it's going to require the right numbers of members of Congress to do it. I don't know if we have those right now to get rid of this quote unquote 20% carry loophole, right? So just FYI from a perspective, right guys, to be safe, three year holds, right? Most deals anyways run five years. So you're well past that treatment and past that and past having to be concerned with that. So no need to cut it close. You know, a Lot of times where you have overlays with qualified opportunity zones or things like that, right? So like your GP sponsor, hey, and you want something like this. This is what I unfortunately see is that someone runs to and like there's no fault on the attorneys that someone has an attorney who uses broad, generalized boilerplate language because this is what they've done before. And so it made sense on those deals, but it changes per perspective, right? Whenever somebody says they get sweat equity, that changes the character and the operating agreement must be swapped and changed. And the reason that is is because we can't actually like a profits interest or carry interest partner can't actually receive certain types of distributions or at some points before the LPs can, right? And that's because capital accounts would be effectively zero so that we can't be allocated losses. That's a lot of times what we see from general partners are saying, oh, I've been receiving $500,000 of depreciation for so long. What do you mean? I can't. I'm not supposed to be able to take that like, well, unfortunately, I am sorry, but I'm saving you from potential audit risk in the irs. We're staying compliant here, right? So just FYI, now the question is too, is like, what if the Congress gets rid of this? Does that still make the carry important? Right? That's what we always got to factor in the cost of taxes, right? It's just part of doing business. Part of doing business in America, part of doing business as just business owners and entrepreneurs, Right. I have to factor that in when I do my own wedding venue calculations of our business. Like, hey, how much am I have to pay in taxes this year? What can I do to minimize that? Right? So just FYI, like, we're all trying to think around those types of things too, right? For an lp. Hey, I think it's worth checking to promote how aggressive it is. What kind of amount it looks like, does this actually align with the market? Right. And go look at some other deal. I think it's good to get market research and figure these types of things out personally. So carried interest isn't necessarily a quote unquote loophole. It's definitely a big structural feature of a partnership economics. But the tax treatment is politically vulnerable. So just FYI, right? Hey, you guys have questions. If you want help, if you want us to just take a read on your operating agreement, we would be more than happy to, if you like, help looking at it. And let's let me put it this way, like, I have had three awkward agreements brought to me this week where someone wanted to do a profit interest, some form of a carry and actually wasn't right now. Like the reason why is because they had structured it like another deal and they thought they could just add this provision in there, right? And it made sense on why they wanted to do these things, but turns out that's actually not the correct way to do it. So I had to talk with their attorney and then make sure that they get engaged. And so look, look, it's just way easier when all this is done on the front end. Build that bench. I say this probably all the time. Build the bench of CPAs, financers, lawyers, attorneys, right? I know a lot of people. You think you can place out AI and look, maybe there's a chance that you can. I think you're always going to need someone to talk to and work through these types of items just to figure out and make sure it makes sense. So highly recommend you guys having a discovery call with us. Here's something I want to announce too, guys. We are hiring for tax advisors working in the private equity space and also just real estate tax and we're hiring for sales representatives. So if you're listening to this and you're someone who's really interested in this type of work and you're interested in having conversation with lots of real estate investors every single day, right. If that's right up your alley, I definitely recommend in having a conversation with us, go to our LinkedIn page and you can have conversations there. Guys, thanks so much. This has been another episode of the Major League Real Estate Podcast. Thanks for listening to the Major League Real Estate Podcast. There are three ways you can connect with us. If you're interested in getting email updates on upcoming shows, go to www.therealEstateCPA.com and subscribe there. If you'd like to explore a tax and accounting relationship with our CPA firm, you can go to www.therealestatecpa.com mlre and fill out a web form to get started. And if you'd like to connect with Matt or I on social media, you can find us on LinkedIn or Twitter. Just search Nathan Sosa, CPA, Matt Hamilton, CPA and shoot us a request. We'd love to connect. See you guys next time.