Summary: This is part two of our two-part series on partnerships. In part 1, we discussed the pros and cons of partnerships. In part 2, we cover partnership agreements and some of the things you’ll want to consider—especially when crafting the document. We end this two-part series with a discussion about a form of ownership called tenants in common. This form of ownership will give you more flexibility and options should you decide to exit.
[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
In this two-part series, we deep-dive into partnerships. In part 1, we covered the pros and cons of partnerships. The following is a summary of what we cover in part 2:
- Key elements of a partnership operating agreement. You can discuss these in detail with your partner and put together a solid agreement.
- Tenants in common is a form of ownership. In real estate, this gives you an opportunity for a clean exit of your investment. This is what we’ve done. We have the flexibility to use a 1031 exchange to invest in our share of the property. Also, we will have the opportunity to 1031 exchange out of the investment if we decide to exit the partnership.
Partnership agreements
Let’s dive into some of the key elements of partnership agreements. Note that this isn’t meant to be comprehensive. Therefore, you’ll want to work with a competent real estate lawyer to help you craft the entire agreement.
Outline roles and responsibilities
We recommend that you have a discussion up front about roles and responsibilities. Be crystal clear about who is doing what. Ideally, you put this in writing. This is very easy to overlook or gloss over.
Maybe one person is primarily responsible for handling interior renovations. While the other is responsible for dealing with the day-to-day issues and working closely with the property manager. Perhaps one person is responsible for the bookkeeping and paying the bills. While the other is responsible for developing and implementing systems and processes. Examples of systems and processes include: developing a schedule for checking fire alarms and carbon monoxide detectors and checking with the property managers to ensure that all renters have purchased renter’s insurance.
The most important aspect is that the roles and responsibilities seem fair to both parties involved. Both partners need to agree on this up front. Otherwise, the partnership is going to break down later. One party is going to resent the other for not doing their share.
Discuss potential points of disagreement
For those who haven’t ever been in a partnership before, it may be challenging to come up with a list of scenarios where potential disagreements can arise. We encourage you to take the time to develop this list. Conduct online searches about common points of disagreement or speak to people who have been in partnerships before.
Let’s cover a few issues that have come up for us in the past so you have a starter list.
One issue that has come up for us in the past is when one partner couldn’t come up with funds for a capital call. Over the years, my friend and partner ended up owing me over six figures. We had no mechanism for dealing with this. Fortunately, we are good friends. As a result, we easily came up with a payment plan. However, you can see how this could head towards disaster quickly.
One way we dealt with this in a recent partnership agreement was to apply an 18% annual interest rate on any money owed. This might seem steep! However, it’s meant to discourage the other party from entering into an agreement if they feel that they might not be able to keep up with capital calls.
Another common point of disagreement is when one party feels the other isn’t doing their share. Issues usually arise when the parties fail to outline clear roles and responsibilities. When one party just doesn’t follow through on what was agreed upon, issues arise. This is obviously a challenging situation. Occasionally, the only mechanism is to exercise one of the exit options you created for yourself (see the section on Create Exit Options).
Come up with a plan for handling disagreements
One common issue when you only have two partners is that they naturally split up their share 50/50. This is fair and equitable. The issue is that there’s no way to break a disagreement. For some, the only way to break the impasse is to go to mediation or at worse litigation. So this makes your plan for handling disagreements even more important.
Being part of a major disagreement that would require mediation or litigation might be hard to imagine. This is a common perception in the beginning of any partnership. So, I can’t stress enough how important it is to plan for a major disagreement.
So what are some options?
One is to create an exit plan. I’ll cover this in more detail in the next section. Making it easy to get out of a partnership is one way to handle a disagreement.
Another option is to come up with mechanisms for handling disagreements up front.
Partnership agreements often have a requirement that disputes first go to mediation before litigation. However, you can also build in additional mechanisms like resolving a dispute with a neutral third party.
We recently served as an arbitrator for a dispute and facilitated an agreement. Both parties provided their perspective and we offered some suggestions for resolving the dispute. We mostly listened and ensured that both sides maintained level heads and mutual respect for each other.
One other mechanism we have seen work for some is to use a “coin flip” to resolve disputes. In the end, this is a pretty unattractive way to resolve a dispute. There is no opportunity for a middle ground. However, the existence of a “winner take all” solution could serve as a deterrent. Both parties will be encouraged to resolve their dispute before leaving it to chance.
Create exit options
As mentioned earlier, giving partners an easy way out of a deal is one way to resolve disputes. However, there are many other reasons why you will want to create exit options.
One is in the event of death or disability. Another is divorce. If you don’t have mechanisms for handling these issues, you may find yourself unexpectedly with a new partner (e.g., the surviving spouse).
Another issue that might arise is one partner having to leave the business for personal or financial reasons. This could happen to any of the partners involved and has nothing to do with the four D’s (dispute, death, disability, divorce).
In this situation, you’ll want to establish a mechanism for the departing party to sell their shares to the remaining party. You’ll need to have a way to value those shares. The valuation methodology should be decided upon ahead of time in order to avoid a dispute over valuation.
If you didn’t set the valuation method ahead of time, you could put in place something called a “shotgun clause.” In this situation, one party offers to buy out the other party at a certain price. The other party can either accept or buy the other party out at that same price. Both parties are protected this way. You arrive at a price that ends up being “fair” for both sides.
Using Tenants in Common for Real Estate
Up until now, we’ve been talking about ways to exit partnerships in general.
For example, if the shotgun clause is triggered, then the departing partner sells their shares to the remaining partner. If there’s a capital gain, the departing partner will have to pay a capital gains tax.
With real estate, there is something called a tenants in common (TIC) ownership structure. Potentially, this can make it easier for you to exit the partnership. Using a 1031 exchange, capital gains will be deferred.
Tenants in common is an ownership structure where the parties share ownership of the property. Each owner has full rights to access and use the property even if the owners don’t have equal shares of the property. One of the unique aspects of the TIC is that each owner can sell their share and exit the property at any time.
If you are going to buy a property using a TIC structure, you’ll want to have a lawyer draft up an agreement between the parties. Have your accountant review it as well. This is really important. If the TIC isn’t set up properly, your 1031 exchange could be invalidated.
You may also want to build in a right of first refusal when one party is selling their share of the property. Before being sold to a third party, the remaining owner will be offered the shares.
To partner or not to partner?
Whether or not you should partner is a personal decision. Careful consideration is important.
When set up the right way, partnerships can be very rewarding! However, you will want to carefully think through the pros and cons. Be diligent about establishing a partnership agreement. Consider whether a tenants in common ownership structure makes sense for you and your partner.
