For real estate fund managers, taking advantage of the preferential tax treatment for carried interest has always been crucial. However, if structured properly, using a Self-Directed Roth IRA to hold the carried interest from a real estate fund would create the ultimate prize – tax-free gains. This article will explore the rules involved in using a Roth IRA to invest in a carried interest via the general partner of a real estate fund.
- A Self-Directed Roth IRA shelters gains from tax forever
- Carried interest on a real estate deal can provide large gains for a savvy investor
- Be mindful of the prohibited transaction rules so that your investment is respected by the IRS
What is a Self-Directed IRA?
Alternative investments, such as real estate, have been permitted in IRAs since its creation in 1974. A Self-Directed IRA is a retirement plan that is administered by a custodian and allows the IRA owner to invest in any type of asset he or she wants, so long as it is not prohibited by the IRA. A Self-Directed IRA can be structured with a traditional, Roth, SEP, or SIMPLE IRA, and even an HSA, or Coverdell. Regulated trust companies, such as IRA Financial, exist to serve IRA investors that wish to diversify their retirement assets and gain exposure to alternative asset investments.
Tax Advantages of a Roth IRA
The Taxpayer Relief Act of 1997 introduced the Roth IRA which is an after-tax IRA which allows any US person with earned income under a set income threshold to make contributions. Unlike a traditional plan, there is no immediate tax break, however, all qualified distributions from the plan are tax free. Further, the Roth IRA is not subject to the RMD rules, so if one owned a real estate asset or a carried interest, all gains would be sans tax. There would no holding period requirement and no risk of short-term capital gain exposure.
Structuring a Real Estate Investment Fund
A real estate investment fund is generally structured as a limited partnership or limited liability company (LLC). The fund is typically managed by a general partner (GP) or managing member who is responsible for managing the fund and its investments. Whereas the passive investors investing in the real estate fund are generally known as limited partners (LPs) or members.
The GP gets the equity needed from capital contributions from LPs, who provide funding for real estate investments in exchange for returns. In other words, limited partner investors get capital interests in exchange for their investment in the fund. Capital interests provide LPs with a right to profits generated by the fund. Profits distributed to a capital interest are generally proportionate to the amount invested, and incur less fees and expenses.
On the other hand, the general partner along with key employees would receive a profits interests/carried interest exchange for their viewpoints, expertise, and work to make the fund successful. A profits interests provides the GP and key employees a right to profits generated by the fund if the fund is a success. However, a profits interests does not give key employees a right to any of the capital received from limited investors to start the fund.
The General Partner
A GP is typically structured as an LLC which includes funds from the GP, investors, or sponsors used to fund their requirement of capital contribution. When the investment generates profits, the GP fund distributes the profits that the GP is entitled to among the investors that helped capitalize the fund.
The concept behind the GP is that it (and its sponsors) take on the labor and liability associated with an investment deal in exchange for capital to fund their projects. The primary purpose of a GP real estate fund for an investor is to benefit from the expertise of the GP while generating passive income.
Carried Interest & The GP
A “carried interest,” also known as a profits interest, is the interest in partnership/LLC profits that a general partner/sponsor receives from the investing partners/limited partners for managing the investment and taking on the entrepreneurial risk of the venture. Carried interest may be taxed as ordinary income or capital gains depending on the character of the income generated by the partnership/LLC.
However, in many cases, investment funds tend to structure their investment so that the carried interest generates long-term capital gains treatment instead of ordinary income. With the long-term capital gains rate at between 15%-23% versus a maximum ordinary income tax rate of 37%, the carried interest strategy continues to be highly popular for real estate investment fund general partners or sponsors.
Beginning in 2007, Congress has introduced various proposals to change the tax treatment of carried interest. In the Tax Cuts and Jobs Act of 2017, Congress created a three-year holding period requirement in order for carried interest to qualify for the reduced long-term capital gains rate. President Biden’s Build Back Better agenda called on Congress to “close the carried interest loophole so that the hedge fund partners will pay ordinary income rates on their income just like every other worker.” However, the bill did not pass.
The expectation is that the taxation of carried interest will continue to be an item of interest amongst Democrats on the Congressional Ways and Means Committee and Senate Finance Committee.
In the typical real estate fund, the limited partners/cash investors will receive their return of capital and a preferred return on the amount invested before the GP or managing member would be entitled to their carried interest. Generally, the carried interest for a real estate fund can range from 10%-50% of returns exceeded the return of capital and preferred return thresholds.
The IRS Prohibited Transaction Rules
Now that we have reviewed how a real estate investment fund is structured and have covered the tax advantage of the carried interest, we will not explore how one can use a Self-Directed Roth IRA to potentially hold a carried interest in a real estate fund and some of the IRS rules that need to be considered.
The Internal Revenue Code (“IRC”) does not describe what an IRA can invest in, only what it cannot invest in. IRC Sections 408 and 4975 prohibits a “disqualified person” from engaging in certain types of transactions. Essentially, you cannot use your IRA to invest in life insurance, collectibles, or any transaction involving a disqualified person.
Who is a “Disqualified Person?”
The IRS has restricted certain transactions between the IRA and a “disqualified person.” The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed. The definition of a disqualified person (IRC Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.
Hence, one cannot invest an IRA into an entity in which he or she personally own more than 50% of the partnership or LLC interests individually or in the aggregate with other family members.
Using a Roth IRA to Hold a Carried Interest
The primary purpose why a general partner, managing member, or sponsor of a real estate investment fund would seek to use a Roth IRA to acquire a carried interest is to shelter all income/returns from taxation. Because carried interest returns can potentially be quite sizable, gaining the opportunity to shelter all carried interest distributions from tax is a massive tax benefit. Depending on the size and success of a fund, the carried interest could potentially be worth millions of dollars over a period of years.
Before surveying the various ways to do so, it is helpful to review what the IRS has publicly said on this topic.
In 2014, the Government Accountability Office (GAO) issued a report on IRAs involving founder shares and carried interest-type investments. The report stated that the carried interest is another means by which key employees of private equity firms and hedge funds can generate large IRA balances and has the potential to provide the GP as well as key employees investment returns that are disproportionate to his or her invested capital if the fund is a success, In addition, because profits interests represent an investment of effort and expertise rather than capital, their initial purchase price for the profits interest is typically quite low and even zero, making profits interests uniquely suited to the contribution limitations of a Roth IRA.
The IRS has agreed with the position that a profits interest is generally not a taxable event since on liquidation of the entity, the profits interest recipient would be entitled to zero value since all capital would be returned to the limited partner investors. As a result, many GP and investment managers have taken this to mean that a carried interest/profits interests can have an initial value of as low as $0.00, referred to as a liquidation value.
Structuring a Self-Directed Roth IRA Investment into a Carried Interest
The most common way that a Self-Directed Roth IRA is used to acquire a carried interest from the GP of a real estate fund is as follows:
Step 1: The GP entity grants or sells a profits interest into the GP entity to managers, sponsors, or key employees granting them a share into a percentage of any carried interest received by the GP entity. Fair value is paid for the GP entity profits interest, which is often zero.
Step 2: If the fund is successful, the GP entity distributes the profits as carried interest.
Step 3: Since the profits interest interest in the GP entity is owned by a Roth IRA, all distributions are tax-free and are not subject to any tax or any holding period.
Potential IRS Concerns
Anytime there is a perceived unfair tax advantage that is being exploited by certain group of taxpayers, it is understandable that the IRS would have concerns. There are a number of potential arguments the IRS could make to prevent a Roth IRA from acquiring a carried interest from a real estate GP fund:
- Is the IRA owner a 50% or more owner of the GP entity. If so, the IRA would likely not be able to acquire a profits interest from the fund since the entity would be a deemed a disqualified person as per Code Section 4975
- Did the IRA pay fair value for profits interest received from the GP fund. Because profits interest often has a value of zero, the IRS may have trouble pursuing this argument.
- The profits interest was granted to a manager or key employee for the performance of services and, thus, could violate IRC Section 4975. The IRS could have difficulty making this argument if non-employees, such as sponsors were also given the opportunity to acquire a profits interest in the GP entity. However, the GAO report stated that according to DOL officials, ERISA does not necessarily prohibit an employer from contributing a profits interest to the DC plan of its employees.
- The profits interest granted is in essence a contribution to the IRA. Again, the IRS would find this argument potentially fruitless since the value of the profits interest acquired would be zero or close to zero.
IRS Enforcement Hurdles
The GAO report was published in October 2014 and yet the IRS has made little public comments on the issue of an IRA acquiring a carried interest. It detailed the difficulties facing the IRS in examining IRA investments into carried interest investments. Below is a summary of the difficulties they face:
- It is often difficult for IRS to pursue cases of potential abuse based on inappropriately valued assets. The IRS generally requires individuals to assess the fair market value of assets in IRAs rather than use a liquidation value or other valuation method. However, IRS guidance implies that individuals can use the liquidation value of a profits interest for certain tax purposes.
- Valuation can be subjective, and IRS may expend resources and ultimately conclude that the taxpayer’s valuation is reasonable.
- The statute of limitations for IRS to pursue cases is generally only three years, which poses certain obstacles to tracking non-compliant activity that crosses years of IRA investment.
- Despite expanded reporting requirements by SEC on registered real estate investment funds, it is very difficult for the IRS to determine how general partners distribute carried interest among various partnership interests, such as those held by employees investing in IRAs.
Putting It All Together
The 2014 GAO report on IRAs is clear, “as with non-publicly traded shares, key employees at private equity firms and hedge funds may use IRAs to purchase profits interests from the general partner.” The primary ways the IRS could attack an IRA investment is that is triggers the IRS prohibited transaction rules under IRC 4975 or it involves IRA stuffing due to improper valuation. Accordingly, the industry belief is that so long as the IRA owner acquiring the profits interest from the GP fund owns less than 50% of the fund and the value paid for the interest is fair and equal to what other key employees or management are paying, the IRS will have great difficulty attacking the profits interest transaction.
The fact that the IRS has agreed with the position that a profits interest in an LLC can be zero based on the liquidation value, would seemingly make it quite difficult to argue such an investment could be classified as IRA stuffing. Still, the fact that one can potentially generate large tax-free gains from a transaction involving little to no capital outlay should assume that it will bother the IRS and could potentially lead to legislation limiting its benefits.
That being said, so long as the profits interest investment does not violate 4975 and the partnership agreement/LLC operating agreement is structured so that the profits interest value at liquidation is zero, the IRS will have a very difficult time attacking these types of transactions. This is especially true considering the three-year statute of limitation rule and the fact that very limited data is available to the IRS on the character of distributions involving private real estate investment fund transactions.
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