To structure a real estate fund, you make a short list of decisions in a fixed order: form a limited partnership with an LLC acting as general partner, set the tax treatment and the waterfall that moves cash from the fund to investors and to you, draft the three documents that bind everyone to those terms, decide whether you need to register as an investment adviser, and fit the sale of fund interests into a Regulation D exemption before the first dollar comes in. Everything else is detail hanging off those choices.
Pick the Entity: LP With an LLC General Partner
The default vehicle is a limited partnership with two classes of partners. The general partner runs the fund, sources deals, manages properties, and decides when to sell. Limited partners put up capital and stay passive, and that passivity is the trade for liability protection: a limited partner’s exposure stops at the amount invested.
The general partner carries unlimited personal liability for the partnership’s obligations, which is why the general partner itself is almost always a separate limited liability company. That gives the people actually running the fund two layers of protection: the LP shields the investors, and the LLC shields the managers who sit behind the GP. The managing members of the GP LLC owe fiduciary duties to the fund, including duties of care and loyalty, and those duties are spelled out in the operating agreement.
How the Fund Gets Taxed
A limited partnership, and an LLC that elects to be taxed as a partnership, does not pay federal income tax at the entity level. Profits, losses, deductions, and credits flow through to each partner’s personal return. The partnership files Form 1065, and each partner receives a Schedule K-1 showing their share of income and deductions for the year.1Internal Revenue Service. Partnerships This avoids the double taxation that hits C corporations, where earnings are taxed at the corporate level and again on distribution.
An LLC taxed as a partnership follows the same rules, with each member receiving a K-1.2Internal Revenue Service. LLC Filing as a Corporation or Partnership Importantly, income allocations do not have to track ownership percentages. The partnership agreement can push more income to the sponsor once certain return thresholds are met, and the IRS will generally respect those allocations if they have substantial economic effect under the tax code. This is what makes the waterfall possible.
A REIT is a different animal and generally not the right choice for a first fund. It can accept capital from a much broader investor base, including the public markets, but it must distribute at least 90% of taxable income every year, have beneficial ownership held by at least 100 persons starting in its second tax year, and satisfy ongoing asset and income tests.3Internal Revenue Service. 2025 Instructions for Form 1120-REIT The compliance load makes REITs impractical for most smaller funds.
Design the Economics: Fees, Carry, and the Waterfall
Sponsor economics typically follow a “two and twenty” model. The sponsor charges an annual management fee of roughly 2% calculated on either committed capital or assets under management. The basis matters. A fee on committed capital generates revenue from day one; a fee on invested capital only applies to money actually deployed into deals. The fee covers staff, legal, and accounting whether or not the fund is making money.
The performance side is carried interest, commonly 20% of profits. Carry only kicks in after investors receive their preferred return, so the sponsor earns nothing extra on underperforming investments. That alignment is the core pitch.
The Four Waterfall Tiers
A waterfall sets the sequence in which cash leaves the fund. There is no universal formula, but most waterfalls move through four tiers.
- Return of capital. Investors receive 100% of distributions until their original investment is fully repaid.
- Preferred return. Once capital is returned, investors receive a fixed annual return, typically 7% to 9%. The sponsor earns no performance compensation until this hurdle is cleared.
- Catch-up. The sponsor then receives a disproportionate share of the next distributions until their cumulative take matches the agreed carry percentage.
- Carried interest split. Remaining profits split at the agreed ratio, commonly 80/20.
American Versus European Waterfalls
The biggest structural choice is whether carry is calculated deal by deal or across the whole fund. Under an American waterfall, the sponsor collects carry as each property is sold. Sell a property at a large gain early and the sponsor takes 20% even though later deals may lose money. Under a European waterfall, the fund must return all investor capital and pay the full preferred return across the entire portfolio before the sponsor sees any carry. Institutional investors usually insist on a European waterfall or something close to it.
Funds using an American waterfall almost always include a clawback. If early carry turns out to exceed what the sponsor was entitled to on a whole-fund basis, the sponsor has to give it back. Collecting a clawback from a sponsor who has already spent the money is hard, so some funds require the sponsor to escrow a portion of each carry distribution until final liquidation.
The Three-Year Rule on Carry
Under Section 1061, capital gains allocated to a carried interest qualify for long-term capital gains rates only if the underlying assets were held for more than three years, not the standard one year.4Office of the Law Revision Counsel. 26 US Code 1061 – Partnership Interests Held in Connection With Performance of Services Gains on assets held three years or less are recharacterized as short-term and taxed at ordinary income rates, even if the sponsor has held the carried interest itself for decades.5Internal Revenue Service. Section 1061 Reporting Guidance FAQs If the strategy involves two-year renovations or any shorter-hold play, build the tax hit into the model.
Build In the Investor-Specific Tax Traps
Different investors have different tax problems, and the fund structure has to anticipate them.
Tax-Exempt Investors and UBTI
Pensions, endowments, foundations, and IRAs are generally exempt from income tax, but a leveraged real estate fund breaks that. When a tax-exempt investor holds an interest in a fund that uses debt to acquire property, a portion of the income becomes unrelated debt-financed income under IRC Section 514 and triggers unrelated business taxable income.6Internal Revenue Service. Unrelated Business Income From Debt-Financed Property Under IRC Section 514 The taxable share is calculated from the ratio of acquisition debt to the property’s adjusted basis. For an IRA, UBTI above $1,000 triggers a filing obligation and a real tax bill.
The code does not distinguish between general and limited partners for UBTI. A limited partner’s share of income from leveraged real estate is taxable to the same extent as a general partner’s.7Internal Revenue Service. UBIT – Special Rules for Partnerships Certain qualified organizations, including trusts under IRC 401(a), can use the Section 514(c)(9) exception for debt incurred to acquire or improve real property, but the exception has detailed fund-level requirements.
Foreign Investors and FIRPTA
When a domestic partnership disposes of a U.S. real property interest, it must withhold tax on the gain allocable to any foreign partner.8Office of the Law Revision Counsel. 26 US Code 1445 – Withholding of Tax on Dispositions of United States Real Property Interests The general withholding rate is 15% of the amount realized on a direct disposition by a foreign person.9Internal Revenue Service. FIRPTA Withholding Funds with meaningful foreign capital often insert a blocker, typically a domestic C corporation, to shield foreign investors from FIRPTA withholding and from having to file U.S. returns. The trade-off is that the blocker reintroduces entity-level tax, so decide this before marketing to foreign LPs.
Draft the Three Core Documents
Three documents form the legal backbone of the fund. Cutting corners on any one creates sponsor liability and investor confusion.
Private Placement Memorandum
The PPM is the fund’s primary disclosure document. It describes the investment strategy, the specific risks, management team biographies, the fee structure, the waterfall, and how the fund will value its assets. It also functions as a liability shield: disclosing material risks up front cuts off claims that investors were misled.
Limited Partnership Agreement
The LPA (or operating agreement in an LLC-structured fund) is where the rules actually live. It covers capital call procedures, distribution mechanics, transfer restrictions, voting rights, and the circumstances under which the general partner can be removed. Most agreements include “bad boy” carve-outs that strip the GP of liability protections for fraud, intentional misconduct, or unauthorized guarantees.
Pay close attention to capital call defaults. When a limited partner misses a capital call, the standard consequences are dilution of their interest, punitive dilution that costs them more than the straight math would, or conversion of the unfunded amount into a loan at above-market interest. Enforcing vague default provisions against a well-funded LP is an expensive fight, so write the consequences explicitly.
Subscription Agreement
Each investor signs a subscription agreement to enter the fund. It collects the information needed to verify accredited investor status and includes representations about sophistication and ability to bear loss. Under federal rules, an individual qualifies as accredited with a net worth above $1 million excluding primary residence, individual income above $200,000 in each of the prior two years, or joint income with a spouse or partner above $300,000 in each of the prior two years, with a reasonable expectation of reaching the same level in the current year.10U.S. Securities and Exchange Commission. Accredited Investors Holders of certain professional certifications, including the Series 7, Series 65, or Series 82, also qualify regardless of income or net worth.
The subscription process is also where AML compliance happens. Collect government-issued ID numbers, physical addresses, and dates of birth for individuals, then screen against sanctions lists and politically exposed persons databases. For entity investors, identify anyone holding 25% or more of the investing entity and verify a control person. Monitoring continues throughout the fund’s life.
Register, or Qualify as Exempt, as an Investment Adviser
Managing a pooled real estate fund makes the sponsor an investment adviser under federal law. Whether you have to register with the SEC turns on assets under management. A manager that advises only private funds and runs less than $150 million in the United States can operate as an exempt reporting adviser under Section 203(m) of the Investment Advisers Act.11eCFR. 17 CFR 275.203(m)-1 – Private Fund Adviser Exemption An ERA still files an abbreviated Form ADV within 60 days of relying on the exemption and submits annual updating amendments within 90 days of each fiscal year end.12U.S. Securities and Exchange Commission. Form ADV General Instructions
Cross the $150 million threshold and the manager must register as a full investment adviser, which brings written compliance policies, a designated chief compliance officer, and the custody rule. Advisers to pooled vehicles can satisfy the custody rule’s account statement obligation by delivering audited financial statements to all investors within 120 days of the fund’s fiscal year end.
Fit the Offering Into a Securities Exemption
Selling fund interests is selling securities. You either register the offering or fit within an exemption. Nearly every private real estate fund uses Regulation D.13U.S. Securities and Exchange Commission. Regulation D Offerings
Rule 506(b) Versus 506(c)
Under 506(b), you can raise unlimited capital from accredited investors and up to 35 sophisticated non-accredited investors, but you cannot use general solicitation or advertising. Under 506(c), you can advertise publicly, but every investor must be verified as accredited through independent documentation such as tax returns, bank statements, or a letter from a broker-dealer or CPA. Self-certification is not enough under 506(c).13U.S. Securities and Exchange Commission. Regulation D Offerings
Form D and Blue Sky
File Form D with the SEC within 15 days after the first sale of securities.13U.S. Securities and Exchange Commission. Regulation D Offerings Missing that window can bring administrative penalties or threaten the exemption. State notice filings, commonly called Blue Sky filings, are separate; most states require them in every jurisdiction where an investor resides.14Investor.gov. Blue Sky Laws NASAA’s Electronic Filing Depository is the centralized platform for submitting those filings and paying fees.15NASAA. Electronic Filing Depository
Bad Actor Disqualification
Rule 506(d) bars a fund from using Regulation D if any “covered person” has a disqualifying event in their background. Covered persons include directors, executive officers, general partners, managing members, anyone holding 20% or more of the fund’s voting equity, and anyone paid to solicit investors.16eCFR. 17 CFR 230.506 – Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering Disqualifying events include criminal convictions related to securities transactions within the past ten years (five years for the issuer itself), SEC disciplinary orders, and certain state regulatory actions.17U.S. Securities and Exchange Commission. Disqualification of Felons and Other Bad Actors From Rule 506 Offerings Run background checks on every covered person before the first closing. Finding a disqualifying event after you have taken money is a problem no amount of legal work can cleanly fix.
Criminal Exposure
A willful violation of the Securities Act of 1933, the statute that governs fund offerings and registration exemptions, carries up to five years in prison and fines of up to $10,000.18Office of the Law Revision Counsel. 15 USC 77x – Penalties Sponsors who fabricate track records, misrepresent performance, or misappropriate capital face real prosecution.
Open the Account and Start Investing
After the filings are in, open a dedicated bank account for the fund entity using its EIN. Keep it entirely separate from your personal and operating accounts. Commingling fund assets with personal funds is a fiduciary violation and the fastest way to lose both investor trust and regulatory standing. Once the account is open and initial contributions arrive, the investment period begins.