What is Carried Interest?
Carried interest is a share of the profits of an investment paid to the investment manager, non-equity partner, or sweat equity partner that provides services but no or a reduced capital contribution.
For example, a developer or private investment fund manager may invest only 5% of the total contribution but receive 20% of all profits (versus just a 5% share) if certain metrics are met. The 15% increase, or the difference between the investment and the share of profits to be received, is known as carried interest.
Tax Changes for Carried Interest in 2018
Prior to 2018, carried interest needed to originate from an investment lasting at least a year to be treated as long-term capital gain and taxed accordingly. However, the Tax Cut and Jobs Act, beginning this year, provides, carried interest is taxed as long-term capital gain if it originates from an investment having lasted at least three years.
While most real estate investments typically endure for at least three years, it is something to keep in mind in order to avoid profits being treated as short-term capital gain or taxed at the ordinary income rate. This is especially true for non-real estate investments, such as private investment funds, which are much more likely to keep investments for less than three years.