How real estate partnerships work: The pros and cons

If you’ve thought about buying an investment property to grow your portfolio, 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.

Investing in a real estate partnership has many benefits, but the strategy isn't for everyone. You’ll have to judge if the risks and tax implications outweigh your potential profits.

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 property. Typically, partnerships are categorized as either active (also called general) or passive (also known as limited). Active partnerships are where all parties are equally responsible for day-to-day management, while passive partnerships are used as a means to raise capital from investors who are not as involved.

For instance, if you have extensive knowledge of the market and your friend has the capital required to invest, you could be poised for a successful limited real estate partnership.

Tax implications of a partnership in real estate

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 share of the profit.

For example, if you have a rental property partnership with one partner that garners $20,000 in total profits, you'll pay individual income taxes on your share, let’s say 50%. That means you pay taxes on half of the profit, $10,000. With sole ownership of real estate, you're required to report the property's net income on your normal tax return (Form 1040), and you’d pay taxes on the full $20,000.

Partnerships differ from sole ownerships, as they are required to file an entity-level tax return (Form 1065) and report the income of each partner with a K-1. Every partner in the investment will then receive distributions of income annually.

Real estate partnership agreements 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're considering ownership interest in a property, let’s compare real estate limited partnerships to general partnerships to help you decide which one would better suit your needs.

Real estate limited partnerships (RELPs) vs. general partnerships

When comparing real estate limited partnerships (RELPs) to general partnerships, you must understand the 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. Limited partners are sometimes referred to as silent partners, meaning they invest capital in exchange for a portion of the profits.

The financial liability of a limited partnership relies primarily on the general partner. The limited partners' liabilities depend on their level of investment and involvement in the partnership. These investors are known as limited partners because they have 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 as limited partners.

General partnerships

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.

Unlike RELPs, general partnerships don’t 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. If the other partners don't have the means of covering the damage, their personal assets can be seized as payment.

The pros and cons of real estate investment partnerships

Like any strategy, there are advantages and disadvantages to real estate investment partnerships. One of the keys to a successful partnership is finding the right person to work with. A partner who balances your strengths and weaknesses can help you avoid potential pitfalls that might arise. You can also improve your chances of success by understanding the pros and cons of these partnerships.

The pros

Here are the main pros of real estate partnerships.

Larger investment

As previously mentioned, partnerships offer a higher return than other types of real estate investments. This means that partners can have the opportunity to earn a higher return for the amount of capital they invest.

Work with partners

Working with other professionals can have many benefits. 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 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.

Payment flexibility

Another benefit to a real estate investment partnership is payment flexibility. This means that partners can choose how much capital they want to invest. Partners can also decide 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. Income and losses are passed through each investor and claimed on their own personal income tax returns.

The cons

Now, here are the main cons of real estate partnerships.

Potential for conflict

Sometimes tension can brew 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 and could lead to regular arguments.

Disproportionate level of involvement

One of the main reasons some partnerships are not effective is that 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’re contributing more to the venture without receiving a fair share of capital in return.

Misaligned expectations and unclear boundaries can also create confusion, making it difficult to divide the investment's benefits equally among all investors. Not properly defining each partner's responsibilities may frustrate some of the more involved partners and make them feel as if their profit potential is being limited.

Early termination

Finally, another drawback of a real estate partnership investment is if a project is unsuccessful, your partner might want to exit the agreement early. Investing in real estate, like other types of financial ventures, can be risky. If your investment fails to make a profit or you have a falling out with your partner, you might have to dissolve the partnership before you’re ready.

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, take an honest look at what you and your partners could contribute to the investment. Start with a brainstorming session to identify your 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 are and how each partner can help. Make sure all the gaps are filled. When you’re done, talk about how you and your partners would price your skill sets and determine each partner's 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 partnership. It’s used to hold investors accountable and to outline 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 the profits, work and investments.

3. Form a corporate entity

When you’re ready to form your business, 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, responsibilities and what is expected of them. To ensure success, everyone must have clear expectations about their duties from the start.

Taking time for this step at the beginning will help prevent problems down the line. But don’t expect perfection from your group. You may face some conflicts along the way, but the key to ensuring success and avoiding these problems 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 fewer issues in the future.

How to get out of a real estate partnership

As previously mentioned, many risks 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. But keep in mind, your means of buying out your partner is based on your assets or ability to get a loan.

For many partnerships, if getting a loan isn’t feasible, you'll have to sell the property and split the proceeds.

Sell and dissolve

With a limited liability company (LLC), it’s most common for partners to sell the building, split its proceeds and then dissolve the LLC. If you choose this route, work with a lawyer to get 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 scenario, 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.

The bottom line: Vet your real estate partner before investing

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. And once you’re ready, start an application for mortgage financing to help you and your partner purchase your investment property.