Legal Ownership Structures: Partnerships

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One of the most fundamental decisions that a real estate investor must make is the legal ownership form under which they invest in real estate. Each have their own unique characteristics and associated legal rights. It is crucial for investors to know the pros and cons of each in order to best determine the most advantageous based on their financial resources, goals, etc. Important factors to consider are ease/cost of formation, taxation, liquidity, survivability, etc. In this article, I will discuss the various partnership forms: general partnership, limited partnership, and limited liability partnership through the lens of real estate investment.

This content is meant to be informational and not advisory. Readers are encouraged to consult an attorney or CPA when deciding on how to structure their investment holdings.

General Partnership

The default form of partnership that exists when two or more persons (or business entities) operate a business for profit as co-owners, each member being a general partner. Partnership agreements, drafted by an attorney, address issues such as profit and loss sharing, management responsibilities, etc.

Pros

  • Ease/Cost of Formation – There are no formal costs to create a general partnership.
  • Taxation – General partnerships are pass-through entities; meaning all income, deductions, etc. are reported on each partner’s individual tax return and cash distributions are generally tax-free to the extent they do not exceed the partner’s basis in the partnership.

Cons

  • Liability – Each partner has unlimited liability for any legal or financial responsibilities of the general partnership. As a result, each partner is fully liable for all of the partnership’s debts whether or not that particular partner incurred or approved of those debts and regardless of the amount invested in the partnership.
  • Liquidity – Because the title to the property is held by the partnership individual partners do not have ownership interests of the property, itself, but rather in the partnership. This can create an issue when one partner wishes to “cash out.”
  • 1031 Exchange – Related to the issue of liquidity, because partners in a general partnership do not actually own a piece of the real estate their interests are not eligible for a 1031 Exchange.
  • Survivability –General partnerships terminate with the death or withdrawal of one of the partners. Partnership agreements should thus account for the survivability of the partnership during the holding period of the investment.

While many general partnerships are formed by business entities that already have some level of liability protection, they are not the ideal business structure in which to invest in real estate due to each partner’s unlimited liability.

Limited Partnership (LP)

Limited partnerships consist of one (or more) general partner(s) and one or more limited partners, which can be individual persons or business entities. Limited partnerships must register as an LP. General partners are responsible for all management of the partnership and thus have unlimited legal and financial liability while limited partners acting as passive investors with no say in the day-to-day management of the business. The partnership agreements are crucial and should be drafted by an attorney.

Pros

  • Liability – Limited partners in an LP are generally only responsible for the amount each invested and are not responsible for the actions of the general partner.
  • Taxation – LPs are pass-through entities; meaning all income, deductions, etc. are reported on each partner’s individual tax return and cash distributions are generally tax-free to the extent they do not exceed the partner’s basis in the partnership.

Cons

  • Ease/Cost of Formation – LPs must register with the state and partnership agreements should be drafted by an attorney.
  • Taxation – Because of the passive role of limited partners they are subject to passive loss rules, which do not allow passive losses to offset active or portfolio income. The tax implications of sale may be different for the general partner and select limited partners and when conflicts of interest arise, limited partners may have no say in the matter.
  • Liquidity – Because the title to the property is held by the partnership individual partners do not have ownership interests of the property, itself, but rather in the partnership. This can create an issue when one partner wishes to “cash out.”
  • 1031 Exchange – Related to the issue of liquidity, because partners in a general partnership do not actually own a piece of the real estate their interests are not eligible for a 1031 Exchange.
  • Survivability –General partnerships terminate with the death or withdrawal of one of the partners. Partnership agreements should thus account for the survivability of the partnership during the holding period of the investment.

Limited partnerships can be effective ownership structures for real estate investment where limited partners provide the capital and general partners provide the expertise and management. Partnership agreements are especially important because, as is the case in general partnerships, the general partner can be a business entity that already enjoys some level of limited liability, which can protect them from the liabilities of the LP. If general partners no longer have unlimited legal and financial responsibility the incentive to be good stewards of the investment is removed.

Limited Liability Partnership (LLP)

Consisting of any number of limited partners, LLPs are typically used by professional organizations such as law firms where each investor has management rights.

Pros

  • Ease/Cost of Formation – Conversion from a general partnership to an LLP is not a taxable event.
  • Liability – Liability is generally limited to each investors’ ownership interest.
  • Taxation – LLPs are pass-through entities; meaning all income, deductions, etc. are reported on each partner’s individual tax return and cash distributions are generally tax-free to the extent they do not exceed the partner’s basis in the partnership. Because of each limited partner’s management rights, they are subject to active loss rules.

Cons

  • Ease/Cost of Formation – LLPs must register with the state and partnership agreements should be drafted by an attorney.
  • Liquidity – Because the title to the property is held by the partnership individual partners do not have ownership interests of the property, itself, but rather in the partnership. This can create an issue when one partner wishes to “cash out.”
  • 1031 Exchange – Related to the issue of liquidity, because partners in a general partnership do not actually own a piece of the real estate their interests are not eligible for a 1031 Exchange.

Limited liability partnerships are rarely used for real estate investment despite the limited liability of its partners. One of the key characteristics of this ownership structure is the management rights of each partner which make it more suited for the operation of a professional business rather than a mechanism to passively invest in real estate.

 

Source: CCIM Institute, Investment Analysis for Commercial Real Estate, January 2, 2018

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