Tax Code Compliance

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Partnerships and Equity Sharing If you are low on cash or have cash and are low on time, a partnership or equity-sharing arrangement may be for you. Using partners to finance real estate transactions is the classic form of using other people’s money (OPM). Experienced investors are always willing to put up money to be a partner in a profitable real estate transaction. As with many businesses, talent is more important than cash. If you can find a good real estate deal, the money will often find its way to you! Partnership arrangements work in a variety of circumstances. The most common scenario involves one party living in the property while the other does not. Another scenario may involve all of the parties living in the property.

These arrangements are common among family members. Parents often lend their children money for a down payment on a house, with a promise of repayment at a later date. If the repayment of the debt is with interest and/or relates to the future appreciation of the property, we have a basic equity-sharing arrangement. Another common financing arrangement between multiple parties is a partnership wherein none of the parties live in the property. This article will discuss the basic partnership investment. Larger investments through limited partnerships and other corporate entities in a “pool” of money are known as “syndications.” These investments are generally classified as securities, so compliance with state and federal regulations is complex. Thus, syndications are generally not recommended for financing smaller projects because the legal fees for compliance with securities laws will far exceed the benefit of raising capital through multiple investors.

Basic Equity-Sharing Arrangement

The common equity-sharing arrangement involves one party living in the property and the other putting up cash and/or financing. Both the occupant and the nonoccupant enjoy tax benefits and share the profit, as described later in this article. First- time homebuyers make the best resident partners while family members, sellers, and real estate investors fill the nonresident partner role.

Scenario #1: Buyer with Credit and No Cash

A lot of potential homebuyers have the income to qualify for a mortgage loan, but only with a substantial down payment. With a small down payment, the monthly loan payments may be too high. A potential homebuyer could borrow the money for the down payment, but nobody but a fool (or a parent) would lend $25,000 or more unsecured. Furthermore, loan regulations generally do not permit the use of borrowed money as a down payment.

An equity-sharing partner could put up the money in exchange for an interest in the property. The resident partner would obtain the loan, live in the property, make the monthly loan payments, and maintain the property. The nonresident partner who puts up the downpayment money is free from management headaches and negative cash f low. After a number of years (typically five to seven), the property is sold, the mortgage loan balance is paid in full, and the profits are split between the parties. Obviously, the strategy works best in a rising real estate market.

Scenario #2: Buyer with Cash and No Credit

The second equity-sharing scenario would be a buyer with cash but an inability to qualify for institutional financing. The resident partner would put up the down payment, the nonresident partner would obtain the loan. After a number of years, the property is sold, the mortgage loan balance is paid in full, and the profits are split between the parties.

Your Credit Is Worth More Than Cash

Just because you put up credit and no cash does not mean you aren’t at risk. Cash is easy to come by, but good credit takes years to build, and only months to ruin. As I write this article, an investor friend of mine (we’ll call him Brian) recalls his first deal. Brian was a neophyte investor who was approached by an experienced investor with the following proposal: “You put up your credit to get the loan; I’ll put up the cash for the down payment.” Brian bought the property with the investor in this manner, but Brian did not manage the property. Brian received a call from the lender a year later and was informed that the mortgage loan had not been paid in several months. Brian was unable to locate his partner who had apparently collected the rents and skipped town. The moral of this story: Use your credit wisely—cash can be recouped in a few months, but credit blemishes can take years to fix.

Tax Code Compliance

Equity sharing arrangements are governed by Section 280A of the Internal Revenue Code (IRC). Labeled a Shared Equity Financing Agreement (SEFA), IRC Section 280A permits the nonresident partner investment property tax benefits (namely depreciation). In addition, the resident partner can take advantage of the benefits of owning a principal residence (namely, the mortgage interest deduction). The nonresident partner is essentially treated for tax purposes as a landlord, taking depreciation for his or her ownership interest to the extent he or she receives rent. So, for example, if fair market rent for the property is $1,000 per month and the resident/nonresident equity split is 60/40, then the resident must pay $400 in rent to the nonresident partner if the nonresident wants to take the depreciation deduction. In turn, the nonresident partner returns the rent to property expenses for which the resident partner is responsible (in this way, the cash contribution by the resident partner is not increased—it is just shifted to conform with the tax code).

If the resident does not pay rent, but rather makes all of the mortgage interest payments directly to the lender, then the investor receives no tax benefits, leaving them all to the resident. The agreement can be made in a number of ways, depending on the needs of the parties and their needs for the tax deductions. The parties must have a co-ownership agreement that complies with IRC Section 280A in order to reap the benefits of this mixed use tax plan. If the relationship is deemed a “partnership” by the IRS, then the rules of IRC Section 280A are not applicable. A highly recommended article that covers the tax implication in detail is The New Home Buying Strategy by Marilyn Sullivan, Esq., <www.msullivan .com>.

Pitfalls

A joint ownership arrangement can be problematic if the resident does not maintain the property or make the mortgage, insurance, or property tax payments. Furthermore, if the property does not go up in value, the nonresident party who put up the credit or cash may not realize any profits. Like any real estate investment, the shared equity arrangement should be approached with profit and not just financing in mind. In other words, make sure you buy the property at a good price and/or in the right neighborhood at the right time.

Alternatives to Equity Sharing

For the nonresident investor, there are several alternatives to the equity-sharing arrangement. The first is the lease option, which is discussed in more detail in the Article 8. The second is a joint venture.

Joint Ventures

A joint venture is a limited-purpose general partnership. A general partnership is formed when two or more people engage in a business with the intention of sharing profits and losses. A partnership need not necessarily be in writing, although it is generally a good idea. A joint venture is a general partnership that is limited in scope.

Thus, if two individuals agree to buy a particular property with the intention of making a profit, the two individuals are not necessarily in business to buy properties; the scope of the partnership is limited to that one venture. Under the federal tax code, a joint venture participation in a rental property does not necessarily create a partnership. So, while two individuals may co-own a rental property, they do not necessarily have to file a partnership return. However, if two or more individuals engage in multiple rental property investments, this may trigger reporting for federal tax purposes. For more information on partnership tax reporting, read IRS Publication 541 (get a free download at <www.irs.gov>).