Tax Advisory for
Real Estate Syndicators
and Fund Managers

Syndications and funds are taxed as partnerships. Income, losses, and distributions flow through to investors based on the allocation rules in the operating agreement. Those rules are not just legal language. The IRS reads them as economic substance.

This is the core of Subchapter K — the section of the tax code that governs partnership taxation. The governing standard is substantial economic effect: allocations of income and loss have to correspond to who actually bears the economic burden of that loss or receives the economic benefit of that income. Translation: who gets the K-1 loss needs to be the person who would actually eat the loss if the deal went sideways.

Most operating agreements are drafted by attorneys who are competent deal lawyers but not partnership tax specialists. The agreement may be enforceable. It may still expose your investors to reallocation by the IRS if the allocations don't hold up under that standard.

704(c) allocations add another layer. When investors contribute appreciated property, or when the partnership's inside basis diverges from outside basis, 704(c) requires specific allocation mechanics to prevent investors from shifting built-in gain or loss to their partners. If your agreement doesn't address them correctly, the IRS addresses them for you.

For fund managers, carried interest is compensation structured as a profits interest in the partnership. The benefit is that profits interests receive capital gains treatment when the fund realizes gains, rather than the ordinary income treatment that would apply to a management fee. Capital gains rates are lower, and the tax is deferred until realization. That's a real structural advantage.

What managers often miss is how narrow the rules for qualifying profits interest treatment actually are. The interest needs to be structured correctly at issuance. The fund needs the right allocation provisions. And the arrangement needs to be documented in a way the IRS can verify: the economics have to match the structure, not just the paperwork.

Section 1061 added another constraint starting in 2018. It extends the holding period required for long-term capital gains treatment on carried interest from one year to three years for certain assets. Most real estate funds hold assets long enough to clear that threshold — but it requires knowing which assets are subject to the rule and how the holding period interacts with fund-level versus deal-level dispositions. If you haven't mapped that out, you're making assumptions about your carry tax that may not hold.

By the time most syndicators and fund managers call about exit planning, they're under contract. That's too late for most strategies to work.

A 1031 exchange is the reflexive answer for most sponsors. It can be the right tool. It can also be the lazy answer to a decision that deserved more analysis. Whether a 1031 makes sense depends on your investors' basis positions, their individual tax situations, and whether deferral actually benefits them relative to recognizing the gain in the current rate environment. That analysis has to happen well before you're in escrow.