The Tax Cuts and Jobs Act of 2017 (TCJA) created a sweeping overhaul of the U.S. tax landscape—the biggest set of changes in 30 years. Among the key provisions from that legislation for real estate businesses were:
- Corporate tax rates were lowered to a flat 21 percent of taxable income
- Broader tax base and a territorial tax system
- One-time tax on overseas earnings that are deemed repatriated
- Limitation on business interest deductions
- An increase of the bonus depreciation percentage from 50 percent to 100 percent for qualified property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023
- Immediate expensing of certain capital expenditures
Although TCJA was passed in 2017, significant final and proposed federal regulations and other guidance continue to be released. Then, with the current pandemic, there has been the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which contains numerous revisions to the TCJA. Ongoing change is also inevitable at the state level, as states and local jurisdictions either conform or diverge from the TCJA.
However, proposed policy changes from the Biden administration may yet again change taxes for real estate investment. The recent American Rescue Plan Act was light on tax aspects that may affect commercial real estate, which is already hard hit by the effects of the COVID-19 pandemic.
On March 31, 2021, President Biden and the White House released the $2 Trillion “American Jobs Plan” which is aimed primarily at upgrading infrastructure, electric grids, broadband capacity, and expanding affordable housing. According to a fact sheet released on March 31st, the Made in America Tax Plan was proposed alongside the American Jobs Plan. The key takeaways from the tax plan that would affect private equity investors in real estate are:
- Increase in U.S. corporate rate to 28 percent from 21 percent
- Impose a 15 percent minimum tax for very large corporations based on book income
- Increase in the effective rate on global intangible low-taxed income (GILTI) to 21 percent, calculate GILTI on country by country basis and eliminate 10 percent return on tangible assets
- Seek global agreement to encourage other countries “to adopt strong minimum taxes on corporations” and “deny deductions to foreign corporations on payments that could allow them to strip profits out of the United States if they are based in a country that does not adopt a strong minimum tax”
- Tougher rules for preventing U.S. companies from “inverting” (become foreign-domiciled)
- Eliminate the deduction for foreign-derived intangible income
If these pass, private equity investment firms will be seeking ways to minimize their tax burden. Private equity real estate investors may restructure the entities they own to work around these taxes.
The President looks forward to working with Congress and will be putting forward additional ideas in the coming weeks for reforming the tax code.
This current tax environment impacts transactions in some significant ways, whether it is tax due diligence, pricing and valuation, deal financing and structuring or any post-deal integration. Private equity investors can turn this tax uncertainty into potential opportunity by being proactive and engaging with tax advisors from the outset of the deal.
Based on what President Biden said during his presidential campaign, other tax policy proposals that may be forthcoming in the next round of tax legislation having serious considerations for private equity investors include:
- The potential repeal of 1031 like-kind exchanges will surely have a strong impact on the real estate industry. These transactions have long been in legislators’ sights, but their economic importance has always overshadowed previous attempts to eliminate them. It remains to be seen how the real estate lobbies will push back and to what effect. If the 1031 exchange is eliminated, the question remains: Will there will be an alternative available to benefit U.S. taxpayers?
- President Biden wants to increase the rate for individual long-term capital gains for taxpayers with more than $1 million a year in income. These changes would result in long-term capital gains being taxed at ordinary tax rates for taxpayers with more than $1 million in income and eliminate the carried interest loophole.
- Carried interest (which is taxed as capital gains) held for more than three years is currently taxed at preferential rates. The proposal is to raise it from 20 percent to a top rate on ordinary income for individuals, which is also proposed to be increased from 37 percent to 39.6 percent.
- If this passes, general partners of private equity funds will see a drop in their post-tax incomes.
- General partners of private equity funds are usually compensated through "carried interest," which is usually around 20 percent of profits accrued above a specified hurdle rate. The higher tax rates may result in increased percentage of profits paid as carried interest.
- This could result in private equity funds having to revise their investment models, resulting in lower return on investment for the limited partners investing in such funds, thereby reducing valuation of these portfolios.
- During the Trump Administration, Congress and the IRS gave taxpayers the opportunity to invest in qualified opportunity zones (QOZ) via qualified opportunity funds (QOF). QOF investments are designed to invest in real estate and businesses in QOZs, which are areas designated as economically distressed. The tax incentives for these types of investments included deferring and potentially reducing taxes on capital gains. Once designated as QOF, the fund must invest at least 90 percent of its assets in QOZs to receive preferential tax treatment, and it must make substantial improvements to the property. Investors who elect to reinvest capital gains into Opportunity Funds will receive multiple capital gains tax benefits that will allow an investor to defer, reduce, and ultimately eliminate future capital gains. Private equity investors can defer tax on any prior gains invested in a QOF until the earlier of the date on which the investment in a QOF is sold or exchanged or until Dec. 31, 2026.
President Biden plans to keep the incentives for eligible projects, but include more disclosures and transparency, which will create more scrutiny for investors. Biden’s proposed increase in capital gain tax rates may also have a negative impact on QOZs as current gains are deferred and taxed at a potentially much higher rate in 2026. On the other hand, an increase in capital gain rates would make the tax-free exit from a QOZ investment more attractive, assuming the increased rates are still in place after the required 10-year holding period. Also, if Section 1031 like-kind exchanges were to go away, there may be a surge in QOZ investments to seek at least a limited tax-deferral.
Regarding cash liquidity for private equity investors in the commercial real estate sector: The bottom line is always to maintain or increase liquidity and mitigate or defer tax liability. Some private equity sponsors may choose to use traditional tax planning strategies to achieve these goals; others may use strategies that plan around the recent tax reforms to defer income, accelerate deductions, and fully utilize losses. Reclassifying and accelerating asset depreciation through a cost segregation analysis can yield significant results in terms of cash flow and tax savings. This cost segregation may be performed for various real estate asset classes.
While the Biden administration’s tax proposals are not yet on the congressional bargaining tables, investors should be aware of the potential legislative updates and how they will affect commercial real estate investment for private equity funds and investors. Higher tax rates, reduced profits, and possible liquidity issues may force some sponsors to make adjustments in their real estate portfolios to ensure more positive investor outlooks.
Ashalata Shettigar serves as a senior director in the business tax group within the real estate solutions practice at FTI Consulting, Inc. She is based in the Roseland, N.J. office and can be contacted at [emailprotected]. The views expressed herein are those of the author and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
Their mission is to invest in companies (with a majority or minority stake), create value during a period of approximately four or five years and then sell their share with the greatest capital gain possible. Therefore, they look for businesses that show clear growth potential in sales and profits over the next years.
Carried interest compensates investment executives
Carried interest is a form of compensation paid to investment executives like private equity, hedge fund and venture capital managers. The managers receive a share of the fund's profits — typically 20% of the total — which is divided among them proportionally.
The controversy over carried interest comes from how it's taxed. Current tax law allows fund managers to declare carried interest as capital gains rather than earned income. This means that it gets taxed at the lower rate reserved for investments — with a maximum tax bracket of 20% for income over $445,850.
Private equity and hedge funds are generally structured as pass-through entities, allowing them to pass their entire tax obligation along to their investors or limited partners. Investors report their share of the fund's income (or losses) on their individual tax returns.
A private equity fund's multiple of money invested (MoM) is represented by its total value to paid- in ratio (TVPI). 3 The TVPI consists of a fund's residual value to paid-in ratio (RVPI) and its distributed to paid-in ratio (DPI).
One reason they rarely face audits is that private equity firms have deployed vast webs of partnerships to collect their profits. Partnerships do not owe income taxes. Instead, they pass those obligations on to their partners, who can number in the thousands at a large private equity firm.
In the most general terms, the carried interest loophole allows money managers to treat what is functionally their income as capital gains—garnering all the preferential tax treatment that attaches thereto.
A provision in the laws governing taxation that allows people to reduce their taxes. The term has the connotation of an unintentional omission or obscurity in the law that allows the reduction of tax liability to a point below that intended by the framers of the law. SHALL WE PLAY A "SHALL" VS. "SHOULD" CHALLENGE?
Carried interest serves as the primary source of compensation for the general partner, typically amounting to 20% of a fund's returns. 1 The general partner passes its gains through to the fund's managers.
Because carried interest is taxed at the 20% capital-gains rate rather than ordinary income rates up to 37%, investment managers pay lower rates than many wage earners.
Hedge funds are alternative investments that are available to accredited investors on the private market. Funds are also able to avoid paying taxes by sending profits to reinsurers offshore to Bermuda, where they grow tax-free and are later reinvested back in the fund.
In the United States a tax barrier also exists. Whereas private equity funds, organized as private partnerships, pay no corporate tax on capital gains from sales of businesses, public companies are taxed on such gains at the normal corporate rate.
Hedge funds typically do not pay taxes at the entity level on their income and gains. Instead, each investor in a hedge fund must typically report his allocable share of the fund's income, gains, losses, deductions and credits on his own tax return.
Short-term capital gains (assets held 12 months or less) are taxed at your regular income tax rate, whereas long-term capital gains (assets held for more than 12 months) are currently subject to federal tax at a rate of up to 20%. 1 Remember that each dollar of capital loss can offset a dollar of capital gain.
What Is Dry Powder? Dry powder is a slang term referring to marketable securities that are highly liquid and considered cash-like. Dry powder can also refer to cash reserves kept on hand by a company, venture capital firm or individual to cover future obligations, purchase assets or make acquisitions.
When they do buy companies outright it's known as a buyout. Using a combination of their own resources and debt, the latter of which is generally piled onto the target company's balance sheet, private equity companies acquire struggling companies and add them to their portfolio of holdings.
Dry Powder is a term referring to capital committed to private investment firms that still remains unallocated. Under the specific context of the private equity industry, dry powder is a PE firm's capital commitments from its limited partners (LPs) not yet deployed into active investments.
What is a Good IRR For an Investment? Most venture capital firms aim for an IRR of 20% or higher. However, it's important to consider the length of a project when evaluating an IRR. Longer-term projects could result in more returns, even if the IRR is lower.
The ratio of money distributed to Limited Partners by the Fund, relative to contributions.
The public market equivalent (PME) is a collection of performance measures developed to assess private equity funds and to overcome the limitations of the internal rate of return and multiple on invested capital measurements.
"Two" means 2% of assets under management (AUM), and refers to the annual management fee charged by the hedge fund for managing assets. "Twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark.
For the first time, the Ending the Carried Interest Loophole Act closes the entire carried interest loophole—re- characterization of income from wage-like income to lower-taxed investment income and deferral of tax payments.
In a hedge fund environment, carried interest is usually referred to as a "performance fee" and because it invests in liquid investments, it is often able to pay carried interest annually if the fund has generated a profit. This has implications for both the amount and timing of the taxes on the interest.
Their most lucrative (and perfectly legal) tax avoidance strategies include accelerated depreciation, the offshoring of profits, generous deductions for appreciated employee stock options, and tax credits.
Background on the Medicare tax loophole
The ACA addressed this disparity by applying a 3.8 percent parallel tax, the net investment income tax (NIIT), to unearned income such as capital gains, interest, dividends, and business income that is earned passively by high-income households.
- Work your tax bracket. ...
- Use tax-loss harvesting. ...
- Donate stocks to charity. ...
- Buy and hold qualified small business stocks. ...
- Reinvest in an Opportunity Fund. ...
- Hold onto it until you die. ...
- Use tax-advantaged retirement accounts.
A distribution waterfall is a way to allocate investment returns or capital gains among participants of a group or pooled investment. Commonly associated with private equity funds, the distribution waterfall defines the pecking order in which distributions are allocated to limited and general partners.
Carry is calculated as a percentage—typically between 20% and 30%*—of the return on investment after limited partners have been paid out 1X their investment. Carry is split (though not always equally) between partners.
Also known as carry or a performance fee. In private equity, a share of a fund's profits that the general partner is entitled to receive from the fund. This method of compensation is designed to incentivize the general partner to generate profits for the fund.
In 2021 and 2022, the capital gains tax rate is 0%, 15% or 20% on most assets held for longer than a year. Capital gains taxes on assets held for a year or less correspond to ordinary income tax brackets: 10%, 12%, 22%, 24%, 32%, 35% or 37%.
The Corporate AMT is a tax of 15% on “adjusted financial statement income” (as described in detail below) as opposed to adjusted taxable income — a significant departure from the general approach to U.S. tax policy. The new Corporate AMT will apply to tax years beginning after December 31, 2022.
The “super” tax-exempt investors are public pension funds claiming an exemption from U.S. federal income tax under Code Sec. 115. The super tax-exempts are not subject to “unrelated business taxable income” (UBTI) under Code Sec. 511 because their tax-exempt status does not derive from Code Sec.
Fund managers pay a 20% tax on their share of investment profits, plus a 3.8% investment tax, instead of the higher rates they would pay if the money were taxed as ordinary income, according to the Tax Policy Center.
US Tax Exempt Investors
The typical investors in an offshore hedge fund structured as a corporation will be foreign investors, US tax-exempt entities and offshore funds of funds.
Investors seek out private equity (PE) funds to earn returns that are better than what can be achieved in public equity markets. But there may be a few things you don't understand about the industry. Read on to find out more about private equity (PE), including how it creates value and some of its key strategies.
Background and experience in the industry.
Investors look for experienced entrepreneurs and management teams with a track record of high performance and leadership in the company's industry or in prior ventures. Most investors will research your business experience and your background in the industry.
Why is it difficult to find a potential buyer for the participation the PE owns? wrong: The buyer may not be intereseted in the financing of the company. wrong: The price is defined by the market and a seller could buy the shares forspeculative purposes.
In 2022, the average annual compensation for a Private Equity Associate with less than three years of experience was roughly $99,000. 1 The nationwide average salary range was $54,000 to $180,000.
It will be very difficult to get into private equity without experience in IB or PE and without having gone to a typical target school. However, it is not impossible to break into the industry.
The results echo another recent compensation study, by executive recruiting firm Heidrick & Struggles, which found that 62 percent of associates and senior associates at private equity firms were “not happy” with their salaries and bonuses.
Private equity is the tier 1 among finance careers, so there are few exit opportunities more prestigious than private equity.
While these elements are essential in getting the business up and running, one needs to have their head on their shoulders to calculate a fair percentage. With most startups, the general rule is to offer approximately 20-25% of your business earnings to an investor.
- Why is now the right time to start the company? ...
- What trends do you see in the market? ...
- Why is the team uniquely capable of executing the plan? ...
- Why do users care about your product? ...
- How did you come up with your business idea? ...
- Which competitor is doing the best job and why?
Most investors would view an average annual rate of return of 10% or more as a good ROI for long-term investments in the stock market.
Private equity investments are traditionally long-term investments with typical holding periods ranging between three and five years. Within this defined time period, the fund manager focuses on increasing the value of the portfolio company in order to sell it at a profit and distribute the proceeds to investors.
Why is protection not always granted during a PE deal? These deals can take place without legal approval. PE deals can last for more than twelve months. The deal is the outcome of a negotiation process.
Private equity firms raise money from institutional investors (e.g. pension funds, insurance companies, sovereign wealth funds and family offices) for the purpose of investing in private businesses, growing them and selling them years later, generating better returns for investors than they can reliably get from public ...
Salary Ranges for Vice President, Private Equities
The salaries of Vice President, Private Equities in the US range from $200,000 to $400,000 , with a median salary of $349,000 . The middle 67% of Vice President, Private Equities makes $349,000, with the top 67% making $400,000.
Private Equity Managing Director Salary + Bonus: Compensation here is highly variable, but a reasonable range is $700K to $2 million, with slightly less than half from the base salary. “Senior Partners” will earn more if the firm makes the distinction.
For the vast majority of private equity associates, the base salary is around $135k-$155k. Then, based on fund performance, bonuses tend to range from 100% to 150% of the base salary.