New Tax Law Changes Incentives for Fund Managers

By Elizabeth A. Whitman

Imagine you are a professional musician who is building a performance career. You hire an artist manager to promote you, obtain performance gigs, and to negotiate contracts for your gigs for a period of five years. Your manager’s primary compensation is a percentage (let’s say 20%) of the compensation you receive from your gigs, plus reimbursement of certain of the manager’s costs.  This arrangement is designed to incentivize your artist manager to work hard to get you as many bookings as possible as soon as possible.

The artist manager in this arrangement may be compared to a sponsor of a real estate or manager of a private equity or hedge fund (I will use the term “fund sponsor” in this post to refer to all of these). Although many fund sponsors invest cash into the funds they sponsor, fund sponsors also receive what is known as a “carried interest” in addition to reimbursement for their costs and certain other fees.

When the fund is formed, the fund sponsor receives an interest in the future gains or income from the fund, for which the sponsor pays nothing. However, the carried interest entitles the fund sponsor to receive a percentage of the proceeds upon the sale of the fund’s assets and/or a percentage of operating revenue received by the fund during the hold period for the assets.

Details vary, but typically, the fund sponsor will not receive payment on the carried interest until at least the investors receive a return of capital, most frequently with an additional return on their investments. Payments resulting from a carried interest typically will be a percentage of the fund revenue/proceeds, and it is not uncommon for that percentage to increase so that the fund sponsor receives a higher percentage as the fund’s performance improves.

Although there is debate and there are misconceptions about the nature of carried interests (which are beyond the scope of this post), carried interests do benefit fund investors by providing incentivize compensation for the fund sponsor that does not require a cash outlay from the fund unless and until the fund is profitable, and usually not until the fund investors have received a return of all of their capital.

Simply put, the carried interest, like the music manager’s compensation, aligns the fund sponsor’s incentives with those of the fund investors. The fund sponsor has every reason to manage the fund so that the investors receive a return of their capital plus their minimum return so that the fund sponsor can receive payments on its carried interest.  Plus, the fund sponsor is incentivized to maximize the fund’s performance, because that may result in the fund sponsor receiving a higher percentage of the revenue/proceeds as performance increases.

However, let’s go back to the professional musician. Imagine that in years two and three of your five-year contract, your manager receives only ten percent (10%) of your compensation, but that in years one, four, and five of your contract, the manager receives twenty percent (20%) of your compensation.

It’s clear in this new arrangement that the artist manager’s and the professional musician’s interests are no longer aligned, because your manager is incentivized to obtain bookings for you in years one, four, and five rather than in years two and three. After year one, the artist manager would have a conflict of interest, as the artist manager would be tempted to encourage venues to book your performances in year four, rather than year three, for instance, which of course, would slow the growth of your career and income and therefore, not be in your best interest.

Although this new artist manager scenario makes little sense, this is the situation Congress created in the 2017 tax law with regards to carried interests.

Under federal tax law, payments resulting from a carried interest upon sale of fund assets traditionally have been treated as capital gains. They idea is that when acquired, the carried interest is worthless and therefore, has a tax basis of zero. As a result, any payments resulting from a carried interest due to sale of a fund asset represent a gain, the same as a gain on a fund investor’s investment.

Before 2018, if the fund asset sale occurred less than one year after the fund sponsor received the carried interest, then it would be a short-term capital gain, taxed at ordinary income rates. But, if the fund asset sale occurred more than one year after acquisition of the carried interest, then it would be taxed at the lower, long-term capital gains rate.  Since the fund investors’ returns (after return of their equity) receive similar treatment, until the 2017 tax law was passed, the fund sponsor’s and fund investors’ interests were aligned with respect to asset sales.

However, the 2017 tax law changed this. Now, although fund investors still will be taxed at long-term capital gains rates upon sale of fund assets held for one year or more, a fund sponsor must wait for three years before it can claim long-term capital gains treatment for these same assets.  As a result, like the artist manager in the second scenario, the fund sponsor’s interests no longer are aligned with those of the fund investors.

Depending on the investment goals of a fund, this change could create a conflict of interest for the fund sponsor. For existing funds, this conflict of interest did not exist when the fund was created and therefore, has not previously been disclosed to fund investors.  More critically, carried interest structures and fund exit structures for existing funds may not be consistent with the new tax law.

Under the 2017 tax law, it still makes sense for fund sponsors generally to hold fund assets for a year so that the fund investors can claim long-term capital gains treatment. However, in a time of increasing interest rates, it could be advantageous for a real estate fund to dispose of some assets fewer than three years after acquisition. This will particularly be the case if, for instance, those assets are encumbered by a below-market, assumable mortgage.  Indeed, many funds may have been formed with that specific exit strategy in mind.  Although the interest rate spread and investor return might end up being greater after a three-year hold, there is the old saying about a “bird in the hand being better than three in the bush.”

Yet, the 2017 tax law changes likely will impact the forecasted sponsor return on its carried interest. Even though the fund sponsor’s return under the fund documents remains unchanged, the after-tax return to the fund sponsor has changed.  This may create a significant incentive for the fund sponsor to wait out the three-year old period. To extrapolate on the saying, the fund sponsor may have “six birds in the bush” to the fund investors’ “three birds,” because if the fund sponsor can extend the hold period on the asset to three years or more, the fund sponsor will have larger after-tax return on its carried interest.

In addition to creating an unanticipated conflict of interest for fund sponsors of existing funds, the 2017 tax law could impact the way new funds are structured, so that longer hold periods are planned and change the assets that are attractive to fund sponsors. It is important to remember that fund sponsors put together the funds at the outset, and although they want to produce a fund that provides an attractive return to the fund investors, fund sponsors also expect to make money for their efforts.

Since fund sponsors will know that their after-tax returns on their carried interest will be reduced after a three-year hold period on fund assets, it makes sense for the fund sponsor to structure new funds to contemplate at least a three-year hold period. Needless to say, the types of assets appropriate for a three-year (or greater) hold might not be the same as those with one-year hold period.  For instance, funds geared towards buying value-add real estate, renovating it, and reselling it or funds established to buy distressed debt instruments likely to result in foreclosure or maturity in less than three years might not be as attractive of a business model for fund sponsors not wanting to pay high tax rates on the resulting gains from their carried interests.

One of my favorite reminders to clients is “be careful what you incentivize.” Here what probably was a compromise designed to make it look like Congress was being tough on wealthy fund sponsors may well end up creating incentives which hurt fund investors by creating conflicts of interest for fund sponsors, delaying return of investor capital, and reducing the availability of funds for investors desiring a shorter-term investment.

© 2018 by Elizabeth A. Whitman

For more information, please contact Elizabeth A. Whitman at (301) 664-7713 or

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC or any of its attorneys.

You Now Can Trade Up Your Violin, but Not the Bow or Case – New Things to Consider in Section 1031 Exchanges After the 2017 Tax Law

By Elizabeth A. Whitman

In my February 2017 blog post “Sizing Up in Violins and Investment Real Estate,” I discussed how buying increasingly larger (and more expensive) violins compares to real estate investments. I discussed how starting with a 1/32 size, I had purchased a series of violins and then “traded up” to the next size through a 7/8 size violin. Each time, the primary purchase was a violin, but we also had to purchase a similarly-sized bow, case, and accessories in order to play the larger violin.

A real estate investor might start small, with a single duplex and eventually, through a series of purchases, sales, and reinvestments, the real estate investor may own multiple large apartment complexes, office buildings, or even high-rise mixed-use buildings. In those instances, although the primary purchase was real estate, each purchase would come with a certain amount of personal property in the form of appliances, furnishings, supplies, and other equipment necessary to operate the real estate.

Comparing a real estate transaction to a violin purchase, purchasing the violin would be akin to purchasing the real property, and purchasing the bow and case would be more like the personal property that is purchased with the real estate investment.

My previous blog discussed how there are two ways that an investor might owe taxes upon sale of investment real estate – increase in value (i.e. the property is sold for more than what is invested in it) or a “recapture” of depreciation expenses that the investor took while he/she owned the investment real estate.

Since 1921, one thing that has helped real estate investors accomplish growth while deferring taxes is to use a Section 1031 exchange to defer taxes each time they sell an investment property and reinvest the proceeds in another “like-kind” investment property. Over the years, Section 1031 has evolved, but generally, those changes have provided clarity or expanded the opportunities to defer taxes upon a sale and reinvestment.

The Tax Cuts and Jobs Act signed into law in December (2017 Tax Act) introduces new rules on 1031 like-kind exchanges by limiting the types of assets eligible for Section 1031 exchange. As a result of these changes, effective January 1, 2018, only real estate exchanges will be eligible for tax deferral. Using the violin “trade up” comparison, under the 2017 Tax Act, the violin could be traded for a larger one, but it would not be possible to “trade up” the bow or case.

Most real estate sales include the sale of at least some personal property: from refrigerators in an apartment complex to common area furnishings in an office building or maintenance equipment in a shopping center. Most of that personal property can be depreciated over just a few years or sometimes, expensed entirely under what is known as a Section 179 Deduction[1] which allows a limited amount of capital expenditures to be deducted entirely in the year in which they are made. Therefore, by the time the personal property is sold with the real estate, it likely has a zero basis. As a result, under the 2017 tax law, any amount of the sale price allocated to the personal property is very likely to be taxed either as capital gains or recaptured depreciation.

On the bright side, for many real estate asset classes, either there isn’t much personal property or the personal property doesn’t have much value in its used condition. For instance, even if there are 150 refrigerators in an apartment complex, if each of them is six or seven years old, the sale price isn’t going to be very high, so the resulting taxes won’t be material. However, there are situations where a real estate sale might include more valuable trade fixtures, equipment or machinery, for which a reasonable sale price allocation would result in significant taxes.

Where the potential tax liability for a sale involving both real estate and personal property is significant, careful planning can help to reduce the tax burden of these tax law changes. Strategies to explore include the following:

Consider leasing personal property. Payments made for a true lease (one that is not a disguised sale or installment purchase) can be deducted when made, providing a similar tax liability to depreciation (or a Section 179 deduction). Of course, with a lease, the lessee would not acquire any ownership in the personal property. If the lessee plans to sell the real estate to which the personal property relates and dispose of the lease obligation at the same time, the lease would need to be assumable by the buyer of the real estate or cancellable.

Offset Capital Gains Against Capital Losses. If the taxpayer has capital losses, then many capital gains can be offset against those losses so that no tax is paid. Because real estate assets may be held inside of a separate legal entity, the capital gains and capital losses must be allocable to the same ultimate taxpayer for this strategy to be effective.

Assign Property Values to the Personal Property Upon Sale. There is a natural tension between buyers and sellers when there is a sale of mixed real estate and personal property. Buyers tend to want to purchase price to be as heavily allocated to personal property as possible, both because they can depreciate personal property more quickly and because in some states, a high allocation to real property may result in an increase in real estate taxes or a high transfer tax bill.

Sellers sometimes agree to the buyers’ values in order to move forward with the deal. However, the reality is that many times, used personal property has little to no value in the marketplace – if you look on craigslist for instance, a used refrigerator or other appliance in good condition may sell for no more than 15-20% of the new value, and many times, the personal property sold with investment real estate has been heavily used. Proper valuations of the personal property can result in a smaller portion of the purchase price being allocated to personal property subject to capital gains taxes.

On a related note, the 2017 Tax Law may have adverse consequences for professional violinists. Suppose a professional violinist starts with a nice, $10,000 modern Italian violin, which has appreciated to $40,000 over a period of many years while the violinist saved up to “trade up” to a $150,000 Vuillaume[2] violin.  Under the 2017 Tax Law, this violinist is out of luck; since a violin is personal property, under 2017 Tax Law that violinist now may have to write a check to the IRS for the gain on the sale of the $40,000 Italian instrument acquired for $10,000 many years before.


[1]  The 2017 tax law also modified the Section 179 deduction limitation so that many taxpayers will be able to expense up to $1 mil. per year in capital purchases instead of depreciating those items over time.

[2]  Music Geek Fact: Jean-Phillipe Vuillaume was a 19th century French violin maker. He started his career in the shop of Francis Chanot, who had a reputation for forging violins. Before long, Vuillaume was copying violinists made by Stradivari and Guarneri del Gesu, two 18th century Italian master violin makers, whose instruments were already quite valuable. Vuillaume’s skill was so great that some of his instruments reportedly were mistaken for the originals. Vuillaume turned away from forgery and instead produced violins he acknowledged as copies (the difference between forged and copied violins being only whether the lack of authenticity is disclosed).  Ironically, after Vuillaume won violin competitions in his own right, violins bearing his name became some of the most commonly forged (or shall we say “copied”) in the late 19th century. Today, a Vuillaume might sell for more than $250,000, with his copies of the famous “Messiah” Stradivari violin being among the most desirable.

©   2017 by Elizabeth A. Whitman

For more information, please contact Elizabeth A. Whitman at (301) 664-7713 or

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC.