Particularly for larger investments, it sometimes makes sense to enter into a formal or informal partnership. The strategies below offer a starting point when considering such a strategy. The scenarios in no way offer advice or guidance or opinions on tax or legal strategy. Before making an investment of any form in a partnership arrangement, appropriate legal and accounting advice should be sought from licensed professionals.
Investing Partnership Strategies
In a partnership situation where we the Partner is sole financier, there are a number of structures, depending on relationship to Partner, and type of investment:
Scenario 1: Family funded
- In this scenario, we are not on title, and in exchange for services throughout the ownership period, we are entitled to one or more of: financial compensation for finding the deal, financial compensation for duties performed, future net appreciation $ for duties performed.
- Compensation/Taxes: For net appreciation, once home sells, you and Partner must agree on exactly WHAT net appreciation means. Typically future sales price minus original sales price minus long terms capital gains taxes on future sales price (this simplistic approach eliminates the complexities of the various tax rates your Partner will pay upon sell of the property). Compensation could be paid to you in the form of non-taxable gift contributions (in 2006, a person can give $12k to anyone tax-free once per year-IMPORTANT NOTE-money given to either related party has to be out of the "goodness of their heart" and not in exchange for anything. Tax implications: None for us, since the $ they give us will already have long-term cap gain taxes taken out.
Scenario 2: Partner funded-we are not on title and have no interest
- In this scenario, the Partner has funded project and is entitled to all deductions and tax write-offs. In exchange for Y services, we are entitled to X% of appreciation upon sale. In this scenario, we do not own an interest in the property, thus are not Partners by IRS definition.
- Compensation/taxes: Upon sale, Partner can pay us pre-tax dollars, and claim them as an operating expense (thus raising their basis). For us, the $ is then treated as ORDINARY INCOME! So where we would essentially be paying taxes at long-term cap gain rates in the above Family scenario (~15%), we are now paying at 30%+. So why not just have the Partner 'gift' us as in the Family scenario? When two unrelated parties have a contract in place (services in exchange for X), a Partnership exists between them, whether a formal Partnership was created or not. Moving $ around tax-free in a Partnership is generally frowned upon by the IRS.
Scenario 3: Partner funded-we are on title as TICs and have Partnership
- In this more complicated scenario, Partner funds project, and we are both on title. In exchange for Y services, Partner pays us X% net appreciation (or whatever) upon sale. In this situation, we have a Partnership by IRS definition (since we both have an interest in the property).
- Compensation / taxes: In this scenario we are trying to avoid paying taxes at ordinary income tax rates on our cut of the appreciation (a 'la the partner cutting us a check in the scenario above). So now we are Partners (we need to form a Partnership), and in our operating agreement, we dictate that Partner has rights to all rents received, all deductions, etc (see below). Also in this scenario, we can only deduct losses up to the amount of our basis in the property, therefore paying a portion of operating expenses without owning anything would not be deductible.
- Upon sale of the property the amount that we would be taxed on (as receiving X% of the appreciation) would be taxed the same way as the gain on the sale (i.e. personal property recapture at ordinary income rates, real property recapture at 25% and capital gains at 15%) because all of the gain would have to retain its original character. Otherwise people would structure these deals so that they would only have to claim 15% capital gains rates. Using the phrase "X% of appreciation" as opposed to "X% of gain" (the two are not the same thing) would not change how you report the income.
- As a non-financial Partner, our capital account [in the Partnership] would be handled just like any other. What we put into the business would increase our capital account, our share of the income or loss (in this case zero until the sale) would increase or decrease the capital account and any distributions would decrease the capital account. In the way WE want to set this up, our capital account would not change until the property sold. Then it would increase by our share of the income. If we take that money out of the Partnership then our capital account decreases. Even if we don't take the money out of the Partnership we would still be taxed on our share.
- Other considerations in this scenario, we must form a Partnership, do taxes, etc. Costs will be roughly $500 to have CPA form Partnership (not incl. Partnership Agreement), $450 for year-end accounting. In the Partnership agreement, we must include a number of 'Special Allocations' that prove 'substantial economic effect':
- Income/expenses taken by Partner
- If property sold, appreciation divided as x%/y%
- The partnership must maintain its capital accounts in accordance with the rules found in section 1.704-1(b)(2)(iv) or the treasury regulations. (This is the section of the regulations that lay out how contributions, distributions, etc are handled. The attorney who writes the agreement should know about this).
- Upon liquidation, liquidating distributions must be made in accordance with the positive balances in the partners' capital accounts.
- If after liquidation any partner has a deficit in his/her capital account, he/she must be unconditionally obligated to restore that deficit.