1031 Exchanges - Thinking About Investing In Real Estate With Other People? Read this First!

Partnerships V. Co-Ownership

Many investors consider asking other investors to join them in the purchase of an investment property. This arrangement can be very beneficial because it gives the parties the opportunity to invest in property they may not have been able to afford on their own and it spreads the risks and costs out.

 They are a couple things to consider when contemplating a co-investing arrangement. Are you going to be a true partnership or are you going to be co-owners. This seems like a relatively minor distinction until you look at the big picture.

 Partnerships

Remember, that partners are jointly and severally liable for the debts and obligations of the partnership. That means that you may be liable for the actions (like encumbering the property) of your partner even if you weren't consulted (for the attorneys reading this post, I am greatly simplifying the explanation for our target audience, investors, real estate agents and lenders). The laws regarding partnerships vary from state to state.

 They are tax consequences as a partnership as well (usually beneficial). The profits and losses of the partnership "pass through" to the individual partners. Usually partners will file a K-1 partnership return where they would show the property as an asset and any profits and losses associated with it.

For 1031 purposes and other tax purposes, LLCs are treated similarly to Partnerships. There are added liability protections for the members of LLCs than are available for Partnerships

 1031s and Partnerships

When a partnership sells investment property then the partnership is the taxpayer doing the exchange. The partnership will have to acquire the replacement property(ies) as the partnership (the partners are stuck buying together). Also, if the partnership is trying to attract more investors to their property they will not be able to sell a partnership interest to a potential investor who is using 1031 exchange proceeds because a partnership interest does not qualify as investments property under section 1031. Partnership interests are personal property. However, they could sell a tenant-in-common interest in the underlying property to a potential investor.

As you can see, owning property in partnerships can be complicated and messy. If you choose to do so, please, please, please get legal advice regarding the partnership agreement to avoid headaches down the road. Make sure you plan an exit strategy and make sure everyone is on the "same page" regarding any subsequent 1031 exchanges.

 Alternative to Partnerships - Co-Ownership

Instead of investing as partners, it may be advisable to invest as co-owners to preserve each investor's right to do what he/she wants upon dissolution (cash out or 1031 exchange their interest). In that case each investor will have a Tenant-In-Common (TIC) interest in the property and upon disposition they will have the freedom to either cash out individually or engage in their individual 1031 excange.

Individual co-owners may also want to investigate creating their own LLC to hold title to the co-ownership interest.

If you choose co-ownership, you should still seek legal counsel prior to acquiring the property, to:

Draft a co-ownership/TIC agreement tailored to that properties specific attributes:

The co-ownership agreement roughly provides:

Clarification of no partnership and necessary provisions included to comport with IRC 1031;

Expense responsibilities (maintenance, prop tax);

Voluntary transfer and encumbrance provisions;

Involuntary transfer provisions (death, divorce, insolvency of a TIC);

Management responsibilities.

A memorandum of the agreement may need to be recorded.

Grant deed needs to be reviewed or prepared when they take title.

There are generally several communications required with the co-owner to clarify the inter-relationship of the owners and task responsibility as well as with each co-owners CPA and QI.

The cost for these types of agreements in the California Central Valley is about $3,000 per property to complete.

THIS INFORMATION IS PROVIDED FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY. IT IS NOT TAX AND/OR LEGAL ADVICE. INDIVIDUALS ARE STRONGLY ENCOURAGED TO SEEK GUIDANCE AND ADVICE FROM THEIR INDIVIDUAL TAX AND LEGAL ADVISORS.

Lisa A. Lambert, Esq.   877.646.1031 or LisaL@apiexchange.com

Asset Preservation, Inc. 800.282.1031 or info@apiexchange.com or www.apiexchange.com