Implementing a Real Estate Incentive Strategy

The two basic ingredients needed to form a real estate venture are money and talent. Cash distribution waterfalls, including preferred returns and other promotions or incentive arrangements, are ways to attract money and talent to the venture. An organization may utilizean incentive strategy to giveits key employeesthe ability to participate in its real estate ventures. While the money is compensated throughout the term of the project with preferred returns and returns on its investment, the talent usually sees money after the venture has met certain performance hurdles.

The Incentive Strategy

Often times, a key employee wants to participate in the formation of an organization’s real estate venture but doesn’t have the available funds to invest. One way to structure the venture and attract the talent while keeping them vested in the performance of the project is to grant them a share of ownership in the real estate partnership at formation. The employee is an equity partner from the outset of the project, but puts in zero funding. The initial granting of the partnership interest provides the employee a set percentage of participation in equity; however, the employee will not have rights to distributions until certain performance hurdles have been met and the money partners have received returns for their invested funds and a preferred return on such invested funds.

The partnership and partner can use the liquidation value of the interest to determine fair market value of the partnership interest for purposes of quantifying the employee’s income from receiving the grant. Given the fact that the key employee would be not be entitled to distributions upon the grant of the interest, there would be no income inclusion under IRC Section 83 because the fair market value of the interest is zero. If the partnership interest granted to the employee is subject to a substantial risk of forfeiture, the employee can elect under IRC Section 83(b) to include in income the value of the interest on the grant date rather than the value when the risks of forfeiture expire. The election would include the fair market value of the partnership interest at the time of the grant (zero) less the amount paid for the property (in this case, none). This way, there is no tax impact to the employee upon receipt of the partnership interest.

Is This a Carried Interest?

The new carried interest rules apply to profits interests received in connection with the performance of services. Generally, new IRC Section 1061 requires a three year holding period for profits interests in order to benefit from long-term capital gain rates. A profits interest is the right to receive future profits in a partnership. It does not generally include any right to receive money or other property upon liquidation of the partnership on the date of grant. The definition of a carried interest does not include any “capital interest” in a partnership giving the taxpayer a right to share in capital commensurate with the capital contributed or the value taxed pursuant to IRC Section 83. Given that the partnership interest granted to the employee is subject to tax pursuant to Section 83 (even though the includible income is zero), the interest may not be considered a profits interest for purposes of the carried interest rules. The definition of a profits interest and its interplay with Section 83 will be clarified once the Internal Revenue Service issues guidance.

This incentive strategy is a win for employees as they can participate without having to come up with funding and a win for the organization that wants to share their success with those they value.