How Real Estate Partnerships Work: The Pros And Cons
March 14, 2023 7-minute read
Author: Miranda Crace
If you’ve thought about buying an investment property, a real estate partnership may be a great starting point. These are limited joint ventures that invest primarily in real estate. They bring investors together to manage and financially support their mutually owned venture. There are many benefits that come with investing in a real estate partnership, but the decision is not for everyone. Let’s see if it’s right for you by getting into the details and evaluating their pros and cons.
What Is A Real Estate Partnership?
A real estate partnership is an investment strategy that integrates the strengths of two or more investors into a single investment property. Typically, partnerships are categorized as either active, where all parties are equally responsible for day-to-day management, or passive, as a means to raise capital from investors who are not as involved.
Real estate partnerships are one of the most common types of pass-through entities. Unlike corporations, pass-through entities are not required to pay corporate income tax or any other entity-related tax. Instead, their owners pay individual income taxes based on their shares of profit.
With sole ownership of real estate, the investor does not file a separate tax return, but is required to report its net income on their individual tax return (Form 1040).
Partnerships differ from sole ownerships, as they are required to file an entity-level tax return (Form 1065) and report the income of each individual partner with a K-1. All of the partners in the investment then receive distributions of income annually.
Real estate partnerships are favored over other types of pass-through entities because they can offer a high return on investment. However, as a result, real estate partnerships can also be subject to high risks.
If you have expressed ownership interest in a property, let’s compare real estate limited partnerships to general partnerships.
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Real Estate Limited Partnerships (RELPs) Vs. General Partnerships
When comparing real estate limited partnerships (RELPs) to general partnerships, it’s important to point out the key legal, financial ownership and management differences between the two.
Real Estate Limited Partnerships
A limited partnership has both a general partner and a limited partner(s). The general partner is responsible for the day-to-day operations of the venture, while the limited partner(s) serve primarily as investors in the venture. Limited partners are sometimes referred to as silent partners, meaning they invest capital in exchange for a portion of the partnership’s profits. The financial liability of a limited partnership relies primarily on the general partner. The liabilities of the limited partners depend on their investment and involvement in the partnership. These investors are known as limited partners because they have regulated obligations in the venture’s debts and liabilities, up to the amount they invested.
Many real estate professionals prefer the RELP structure because it allows experts to take control of the venture as the general partner, while the other members can just invest their capital in the business as limited partners.
With a general partnership, there are one or more partners who are considered the owners. General partners are responsible for the day-to-day management and all key decisions for the venture. Therefore, each partner has equal rights and responsibilities in regard to the venture. Unlike a RELP, general partnerships do not offer liability protections for their partners. In this case, all partners are equally liable for the venture. For example, if one partner is sued in a general partnership, all partners are held responsible. Or if one partner enters a deal and goes bankrupt, the other partners will have to cover the damage, or else the personal assets of each partner can be seized as payment.
The Pros And Cons Of Real Estate Investment Partnerships
There are benefits and drawbacks to real estate investment partnerships. But perhaps one of the keys to a successful real estate investment partnership is finding the right partner to work with. It’s important for investors to choose a partner who balances their own strengths and weaknesses. Taking this into account, let’s review the pros and cons:
Here are the main pros of real estate partnerships.
As previously mentioned, real estate partnerships offer a higher return on investment than other types of real estate investments. This means that partners can have the opportunity to earn a higher return on investment for the capital they are putting into the venture.
Work With Partners
There are many benefits that come with working with other professionals. For example, each partner brings something different to the table, so it can be helpful to create a well-rounded team that balances each other out in terms of capital, expertise and experience. Having a diverse group of partners can also represent multiple perspectives and backgrounds when making key business decisions. In addition, dividing up the workload can also be helpful for partners who want to be involved with the day-to-day operations or choose to focus more on long-term strategy development.
Another benefit to a real estate investment partnership is payment flexibility. This means that partners can choose how much capital they want to invest in the venture. Partners can also choose how they want to receive their funds. For example, one partner may want a majority of the tax benefits, while another partner might opt for receiving the free cash flow. Being a pass-through entity, there is also more liability and income and losses are passed through each investor and claimed on their own personal income tax returns.
Now, here are the main cons of real estate partnerships.
Potential For Conflict
Sometimes tension can be created if there are too many partners in an investment, each with different personalities and management styles. This can also result in a disproportionate level of involvement.
Disproportionate Level Of Involvement
One of the main reasons some partnerships are not effective is because the members don’t clearly define each partner’s duties and responsibilities in their partnership agreement. This can cause some partners to feel like they are contributing more to the venture without receiving a fair share of capital in return. This can also create confusion and make it difficult to divide the benefits of the investment equally among all investors. This may frustrate some of the more involved partners and make them feel as if their profit potential is being limited. Finally, another drawback of a real estate partnership investment is if a project is unsuccessful or a partner wants to exit early, and another partner needs to contribute additional funds.
How To Form A Real Estate Partnership
Now that we’ve given you a detailed explanation of real estate partnerships and considered their pros and cons, it’s time for a step-by-step overview of how to form a real estate partnership. Let’s take a look at the specifics and learn more expert tips.
1. Take Inventory Of Your Combined Buying Power
When forming a real estate partnership, it’s important to take an honest look at what you and your partners could contribute to the investment. Start with a brainstorm session identifying you and your partners’ strengths and weaknesses. Use this initial brainstorm to identify each of your roles and responsibilities for the investment. At this stage, it’s also important to talk about what the investment needs and how each partner can help each other. Make sure all the gaps are filled, and when you’re done, talk about how you and your partners would price your individual skill sets and determine each partners’ desired level of contribution and personal profit goals.
2. Develop A Real Estate Partnership Agreement
Next, start drafting an agreement. A real estate partnership agreement is a document that identifies the shared goals and mission of a real estate partnership. It’s used to hold investors accountable for contributing to the investment, and it outlines clear roles and responsibilities, while detailing legal protections in case something doesn’t go as planned. When drafting the agreement, think about how you and your partners want to split profits, work and investments.
3. Form A Corporate Entity
When you’re ready to form your business, it’s important to seek advice from professionals. Start by reaching out to an attorney to handle the legal matters and documentation related to your real estate partnership. Next, consult an accountant to help advise your partnership about financial matters and taxes.
4. Review, Revise And Reiterate Expectations
Once you establish the groundwork, go back and read over your real estate partnership agreement. Make sure each partner knows their roles and responsibilities and what is expected of them. To ensure success, it’s crucial that everyone sets clear expectations about roles from the start.
Taking time for this step in the beginning will help prevent problems down the line. But don’t expect perfection from your group. You might be faced with common obstacles, but the key to ensuring success and avoiding these obstacles is through open communication with your partners. If everyone knows what is expected of them and how they can best contribute to the group, there will be far less issues in the future.
How To Get Out Of A Real Estate Partnership
As previously mentioned, there are many risks that come with entering an inadequate partnership. Sometimes members of a partnership struggle to work together, and other times, a partnership can fail financially.
Regardless of the reason, there are ways to get out of a real estate partnership.
1. Get A Property Valuation
Start by getting an up-to-date valuation of the property as is. This will allow you to know what the property is worth, so you can move forward accordingly. Consult a professional to help with the valuation.
2. Determine The Best Course Of Action
Next, you have two options to consider.
Buy Out Your Partner
If you still want the property, you could potentially buy your partner out. This is determinant on your assets and your ability to get a loan. If this is not a feasible solution for you, you will have to sell the property and split the proceeds.
Sell And Dissolve
With an LLC, it’s most common for partners to sell the building, split its proceeds then dissolve the LLC. It’s important to work with a lawyer to help you through this complex stage in the dissolution process. A lawyer will be able to help you exit the partnership, while ensuring everything stated in the agreement is being followed. In some cases, one partner might sue another for breach of contract or file a partnership dissolution lawsuit. In this case, it’s essential to have a lawyer on your side.
For now, don’t get worked up about these worst case scenarios. Take time to focus on growing and strengthening your real estate partnership, and if things do go downhill, a lawyer will help you out.
The Bottom Line: Vet Your Real Estate Partner
Ultimately, the key to a strong real estate partnership is effective communication and teamwork. Don’t be so excited about your new partnership that you jump past the planning process and forget to review your expectations for the group. It’s important to determine each partner’s strengths and weaknesses before deciding on roles and responsibilities and determining goals for the partnership.
As you enter the partnership, keep an open mind and be optimistic that things will work out for you and your fellow partners.
If you’re still hesitant, that’s OK. Consider real estate crowdfunding if your gut is telling you a real estate limited partnership is not right for you.
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