Separate three things into three entities: service income into an S corporation, your GP interest into a pass-through LLC or LP, and the assets into property LLCs beneath the fund. Keep the waterfall simple, match the fund's life to the asset's business plan, and handle UBTI and state filing before you accept the capital that creates them — not after.

Part 1 — Tax is downstream from economics

Before any structure chart, get the economics right, because the tax work is built on top of them.

Alignment first. The structure should be one where the GP wins when the LPs win. Sophisticated investors read your fee load before they read your projections, and a stack of affiliated-party fees — acquisition, asset management, property management, construction, disposition, refinance — taken off the top before any LP return is the first thing they interrogate. Keep the fee load at market. Take your upside through the promote, where it is aligned with performance and, as it happens, taxed better.

Keep the waterfall simple. A preferred return and a split after it. Perhaps one hurdle. That is enough for most funds and nearly all first funds.

The alternative is what happens when someone tries to sound sophisticated: an 8% pref, non-compounding but cumulative, 70/30 to a 12% IRR, then 75/25 to 13%, then 60/40 to 14%. That structure is expensive to administer, easy to compute incorrectly, and impossible to explain on a call without losing the room at the third tier. Complexity is a cost, it gets billed to the fund, and it lowers everyone's returns.

Four share classes is a sensible ceiling — preferred, two LP classes, and GP.

Watch the pref accrual. A preferred return that accrues unpaid and compounds across a long hold can eat the entire promote. If you are holding for seven years and distributing nothing along the way, model where the promote actually lands before you agree to the terms.

Match the wrapper to the business plan.

	Closed-end fund	Open-end / evergreen
Life	Defined, typically 3–7 years	Indefinite
Exit	Sale of assets	Refinance, redemptions
Promote paid	On disposition, as capital gain	Through refinances — needs careful design
Fits	Value-add, opportunistic	Buy-and-hold, generational assets

If the plan is to build and never sell — a legitimate strategy, and how a lot of multi-generational real estate wealth was actually made — a closed-end structure with a disposition-triggered promote is the wrong wrapper. Work out how and when you get paid before the documents are drafted.

Part 2 — The org chart

Here is the structure, described in the order the money moves.

You, through a revocable living trust. Probate avoidance, not tax savings. Tax-neutral, and it belongs at the top anyway.

The asset manager — an S corporation. Every fee for services performed: acquisition, asset management, disposition, refinance, construction management, property management. This is earned income, fully subject to self-employment tax, and the S corp election shields a portion once the entity reliably nets roughly $60,000–$80,000 depending on your state.

The GP entity — an LLC or LP. Your promote and carried interest. A pure pass-through with no blocker, so income character and debt basis both reach you intact.

The fund — an LP or LLC. Where the LPs come in. Issues the K-1s.

Property LLCs beneath the fund. Usually single-member and disregarded, so no separate returns — except in states like New York and California that impose entity-level obligations regardless. Separate entities per property for liability isolation and clean financing.

Why the manager and the GP must be different entities

This is the single highest-value structural decision a sponsor makes, and it is the one most often got wrong.

A fee is compensation for services: ordinary income, self-employment tax, operating business.

A promote is a reallocation of the fund's own income under the partnership agreement. It carries the character of whatever the fund earned — a holographic image of the underlying income. Long-term §1231 gains at the fund become long-term §1231 gains to you.

Route the promote through an S corporation and you lose that in three ways at once:

• Character is blocked. Capital gain treatment — the entire point of carried interest — is converted to ordinary income at the corporate wall.
• Debt basis is blocked. Under §752 a partner's share of entity liabilities creates basis; under §1366(d) an S corp shareholder gets basis only from stock and direct shareholder loans. A $1,000,000 depreciation allocation against $100,000 of stock basis leaves $900,000 suspended.
• The exit is blocked. Distributing an appreciated interest out of an S corporation is a deemed sale at fair market value under §311(b). The promote you would most want to move into a dynasty trust is the one you cannot move without paying tax.

Fees in the S corp. Ownership in the pass-through. Always.

Read more: Should I hold my GP interest in an S corporation? · Should my management fee and my promote go to the same entity?

Build the manager as a business, not a shell

A management company that persists across funds accumulates recurring revenue, a track record and systems — enterprise value that a larger sponsor could acquire. Spinning up a new manager per deal builds nothing.

It also makes you bankable. Anyone who has applied for a residential mortgage while holding fractional GP and LP interests knows how that conversation goes. A stable operating company paying you a W-2 with several years of returns behind it is a file an underwriter can approve.

Part 3 — Getting the GP a depreciation allocation

One of the most valuable things a sponsor can do, and it has to be in the documents.

In a typical 80/20 deal, the default assumption is that depreciation follows capital — the LPs put in the money, the LPs get the deductions. But §704(b) permits allocations that differ from capital contributions, provided they have substantial economic effect.

The fairness argument that makes this saleable to LPs is straightforward: if the profits split 80/20 over the life of the deal, then splitting the losses 80/20 simply tracks the economics. It is not the GP taking something; it is the allocation matching the deal.

The leverage is remarkable. The GP contributes 1% to 5% of the capital and can be allocated 20% of the deductions.

Two things make it work:

The documents. The operating agreement has to be written for it. This is not something to discover at K-1 time.

Basis. The GP still has to clear the four gates. Basis comes from capital and from allocated debt — which is why a GP signing recourse on acquisition debt can absorb a substantial loss allocation with little or no cash invested. The allocation of recourse and qualified non-recourse debt in the fund documents determines who can actually use the deductions.

Most LPs are passive and cannot fully use depreciation anyway, which is what makes this a negotiable point rather than a fight.

A cleaner alternative to per-investor elections: bake the depreciation treatment into the share classes. Preferred investors in Class A take no depreciation allocation; Class B and C LPs take more; the GP takes its 20%. Investors self-select by class. A subscription-by-subscription election of yes-or-no depreciation gets missed, creates administrative chaos, and may lack the substance §704(b) requires.

Read more: What are the four gates every real estate tax loss must pass through?

Part 4 — UBTI, and the capital that brings it

Self-directed IRAs, solo 401(k)s and pension funds are a large slice of the LP capital stack. They also bring a problem most sponsors do not price in.

Where the rule comes from. Imagine a taco stand competing against a church-owned taco stand across the street. The church pays no tax, so it can undercut you by its whole tax rate and put you out of business. Unrelated business taxable income exists to level that: a tax-exempt entity running a commercial trade or business pays tax on it like anyone else.

How it reaches real estate. Rents from real property are generally excluded from UBTI — good news. But the exclusion does not apply to the portion attributable to acquisition indebtedness. Leveraged real estate generates unrelated debt-financed income, and almost all real estate is leveraged.

So a tax-advantaged account investing in a tax-advantaged asset can produce a tax obligation. The investor may need to file Form 990-T.

What this means operationally. If you have even one IRA or 401(k) investor, you must compute and report UBTI characteristics to them — including recomputing depreciation on the debt-financed portion. It is not optional and it is not something to discover years later.

This is a genuinely unsophisticated corner of the market. I have taken engagements to look back five years for a client's UBTI exposure and been unable to answer, because the sponsor never captured the information. Then the LP has to go and ask a sponsor who may have moved on, from a fund that may have liquidated.

In fund-of-funds structures it compounds. If you sit above three lower-tier sponsors and one of your investors is an IRA, you need UBTI reporting from all three. If they have no tax-exempt investors of their own, they have no reason to have tracked it. Push this down in the side letters at subscription, not at K-1 time.

Blockers

A private REIT. A REIT is a corporation for tax purposes, so it blocks UBTI from flowing through, but avoids entity-level tax by distributing at least 90% of taxable income. Tax-exempt investors receive a clean 1099-DIV. This is what the large players use, and it generally starts to make sense somewhere around a $10 million asset.

The compliance load is real:

• At least 100 shareholders. Private structures want one — your fund. There is a small industry supplying the other 99 through preferred shares, typically at 12% to 14%, and it costs.
• Asset and income tests requiring the REIT to be genuinely in the real estate business. Dealer property fails; a self-storage facility with a shop selling locks needs the shop dropped into a taxable REIT subsidiary.
• The 90% distribution requirement, and severe consequences for failure — disqualification, a 100% prohibited transaction tax, or penalties.

A C corporation blocker. Simpler and less efficient. The C corp pays tax at the entity level and the tax-exempt investor receives a clean dividend. Some syndicators use it. It is a real cost, not a free fix.

REIT blockers also block state tax, which is worth remembering when you weigh the compliance burden.

The ERISA 25% threshold

Separate from UBTI, and frequently misunderstood.

If benefit plan investors hold 25% or more of any class of equity, the fund's assets can become "plan assets," and you become an ERISA fiduciary — a materially higher standard of care and a materially larger liability.

Three details that matter:

• Benefit plan investor under ERISA §3(42) includes any plan subject to IRC §4975 — not only Title I plans. IRAs, Keoghs and solo 401(k)s all count. If you have been told solo 401(k)s can be treated as ordinary capital for this test, check that advice.
• The test applies per class of equity, not to the fund as a whole.
• Interests held by the manager and its affiliates are excluded from the calculation.

Most sponsors deliberately stay under 25%. That is a reasonable default, though it is a choice about liability appetite rather than a legal prohibition. A related practical point: large volumes of retirement capital arriving through Fidelity, Schwab or Pershing platforms often trigger an audit requirement of their own.

Part 5 — Multistate filing

The overhead nobody prices into the fund budget.

Owning property in a state creates a filing obligation there — everyone expects that. What surprises sponsors is that an investor's state of residence can create one too, independent of where the property sits. Take an investor from a state with that rule and you have added a return, an apportionment computation, and a depreciation recalculation under that state's conventions.

Three regimes exist, and knowing which applies determines what your investors have to do:

Regime	What the fund does	What the investor must do
Withholding	Withholds tax on the nonresident's allocable income and remits it	Files their own return in that state; claims the withholding
Composite	Files one return covering electing nonresident partners	Generally nothing further in that state — filing requirement satisfied
PTET	Elects to pay state tax at the entity level	Usually satisfied, but may still file to claim credit

Composite returns are attractive but not universally right. An investor with income from your Missouri deal and a loss from another sponsor's Missouri deal may need to file individually to reconcile the two — a composite election can leave money stranded.

PTET regimes were created to work around the federal SALT cap by converting an itemized deduction into an entity-level business expense. Note that OBBBA left PTET itself unchanged but raised the SALT cap and then phases it down, so any election made on pre-2025 reasoning should be revisited.

Two practical points for sponsors. Early on you take every dollar you can get, and you should — but know that certain investors raise the fund's overhead, and that cost is billed to the fund and reduces everyone's returns. And in fund-of-funds structures, lower-tier managers often will not give you the apportionment detail you need to produce accurate K-1s. Get that obligation into the subscription documents.

Read more: Which states will my fund have to file in?

Part 6 — Distributions, refinances and other traps

"Refinance proceeds are tax-free" is only usually true. Whether the debt is recourse or qualified non-recourse determines who gets basis for it. Distribute cash from a recourse refinance where the basis stayed with the GP, and you may be handing LPs a distribution in excess of basis — taxable. Often it is fine, because they have depreciation and basis history absorbing it. Sometimes it is not.

Distributions in excess of basis are taxable, and this bites most often late in a deal's life, after capital has been returned and depreciation has ground basis down.

Foreclosures and title transfers are taxable events, and generate a tax bill precisely when there is no cash to pay it.

Year two is where investors get surprised. Front-load depreciation in year one and the same property in year two, with normal depreciation and improved operations, can throw off taxable income. Investors who were told "you'll have losses" should also be told when that stops.

The short version

• Three entities, three jobs. S corp for fees, pass-through for the GP interest, property LLCs for the assets. Never mix the first two.
• Simple beats clever. A pref and a split. Four share classes at most. Complexity is a cost billed to the fund.
• Write the depreciation allocation into the documents. A 20% allocation on 1–5% of the capital is the best-value line item in the LPA, and it is unavailable retroactively.
• Handle UBTI and state filing before you take the capital. Both are far cheaper to design for than to remediate.
• Match the wrapper to the plan. Decide how and when you get paid before the documents are drafted.

Frequently asked questions

How should a real estate fund be structured for tax efficiency?
Three separate entities: an S corporation for fee and service income, a pass-through LLC or LP for the GP interest and promote, and property LLCs beneath the fund holding the assets. Keeping fees and ownership in separate entities preserves both income character and debt basis.

Why shouldn't the GP entity and the management company be the same?
Because an S corporation blocks three things at once: the character of promote income, debt basis under §1366(d), and tax-free removal of the interest later under §311(b). Fee income benefits from the S corp; ownership income is damaged by it.

How many share classes should a fund have?
Four at most — preferred, two LP classes, and GP. Each additional class and waterfall tier increases administration cost, computation risk and the chance of a dispute, and those costs are billed to the fund and lower everyone's returns.

What is UBTI and does it affect my fund?
Unrelated business taxable income is tax owed by otherwise tax-exempt investors on income from a commercial trade or business. Rents from real property are generally exempt, but the portion attributable to acquisition debt is not — so any leveraged fund with IRA or 401(k) investors must compute and report it.

Do solo 401(k)s count toward the ERISA 25% threshold?
Yes. Benefit plan investor under ERISA §3(42) includes any plan subject to IRC §4975, which covers IRAs, Keoghs and solo 401(k)s, not only plans subject to ERISA Title I. The test is applied per class of equity, and manager and affiliate interests are excluded.

Will my fund have to file in states where my investors live?
Possibly. Some states create a filing obligation based on partner residency alone, independent of where the property is located. Confirm the current rules state by state before accepting capital, since each additional state adds a return, an apportionment computation and a state-specific depreciation recalculation.

Structure once, correctly

Nearly everything on this page is decided in the weeks before a first close, and most of it is expensive or impossible to change afterwards. Moving an appreciated GP interest out of the wrong entity means paying tax to relocate your own asset.

James Bohan has been on both sides of this — Big 4 alternative investments, CFO of a private equity debt fund with over $1 billion in originations, and a fourth-generation developer running his own portfolio. Stonehan's fund practice covers structuring, K-1 delivery, fund bookkeeping and CFO-level advisory.

Book a free 15-minute consultation. Bring your org chart, your LPA, or just the deal you are about to launch.

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James Bohan, CPA · Founder, Stonehan Accountancy, P.C. · Coeur d'Alene, Idaho · CPA since 2011 · MRED, University of Southern California · Fourth-generation real estate developer · Former CFO of a private equity debt fund with $1B+ in originations · Contributor to Hunter Thompson's Raising Capital for Real Estate

This article is educational content and is not tax advice. Fund structuring should be undertaken with your CPA and securities counsel. Provisions cited are current as of publication; state and PTET rules change frequently.