How Should You Divide Commercial Real Estate with Your Partners?

July 6, 2023

Understanding Real Estate Partnerships

A real estate partnership is a strategic means of holding title to and managing an investment property. This partnership typically comes in the form of a limited liability company (LLC), a limited liability partnership (LLP), or S-Corp, with each entity providing different tax benefits and implications. But, regardless of its form, the roles and responsibilities of investors in a real estate partnership are crucial. This partnership structure typically includes a sponsor or managing member who serves as the “general partner,” while the other investors take a passive role as “limited partners”.

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The Active and Passive Partnerships

Real estate partnerships can be categorized into active partnerships and passive partnerships. In an active partnership, the investors actively partake in the day-to-day decision-making process of an investment. Usually, each investor contributes an equal amount of equity, and the roles and responsibilities are divided among them equally. However, active partnerships can become challenging to manage when there are more than a few investors, leading to potential conflict.

Passive partnerships, on the other hand, are more common and typically used in larger commercial real estate deals. In a passive partnership, the general partner, who serves as the fund sponsor or manager of the LLC, runs the day-to-day activities of the investment. The limited partners play a passive role, with their gains treated as passive income. In this partnership form, the general partner’s capital is at stake during the due diligence and closing process, while the limited partners have no “skin in the game” until a deal has closed, making it highly attractive to many passive investors.

Commercial Real Estate Partnerships and Their Structures

In commercial real estate, partnerships can be structured in several ways. One popular structure is the GP/LP structure that has been in use for decades. In the 1990s, many states began to allow LLCs to hold real estate. Each state also has different requirements and tax implications for real estate-focused LLCs as well. We highly advise consulting with a Pennsylvania real estate attorney to discuss all possible scenarios.

LLCs do not technically have a general partner, but instead, are structured using an operating agreement. This agreement identifies the manager(s) of the LLC, who function similarly to a general partner in a GP/LP structure. The passive investors in an LLC are referred to as “members” rather than limited partners. Regardless of the structure, the roles and responsibilities of the general partners, limited partners, or managers and members must be clearly defined from the outset.

Real Estate Investment Trusts vs Limited Partnerships

Real Estate Investment Trusts (REITs) offer an alternative for passive investors. REITs can sell shares of its business to passive investors, providing liquidity. However, returns from REITs are treated like dividends, which carry an additional tax burden. On the other hand, real estate limited partnerships benefit from income treated at the long-term capital gains rate upon sale, assuming the partnership has owned the investment for more than a year.

Benefits of Real Estate Partnerships

Investing in a real estate partnership offers several benefits:

Scalability: By investing in a partnership alongside other limited partners, you can access opportunities that would have otherwise been out of reach.
Complementary Skillsets: A sponsor usually has a team that brings together all the skills needed to execute a successful commercial real estate deal.
Mentorship Experience: When investing in a fund or syndication, you’re investing with a sponsor who has robust experience.
Easier to Finance: Real estate partnerships often have an easier time securing financing. The general partner is responsible for lining up all financing, reducing the risk for limited partners.

Challenges in Real Estate Partnerships

Real estate partnerships, like any business venture, come with their set of challenges:

Splitting Equity: In an active partnership, it can be challenging to determine a “fair share” of equity. It really depends on the roles and responsibilities each partner commits to.
What State to Form In: Do you need to form LLCs in multiple states if you own property in multiple states?

Given the complexities of real estate partnerships and the laws in each state, it’s important to consult with a Philadelphia real estate attorney to help guide you through the process of forming, splitting, or disputing an LLC.