Disclaimer: I am not a legal or tax professional, and all matters of real estate partnering should go through either legal or tax professionals (or both) before being implemented.
I hear the question quite a bit: How can a partnership be structured for investing in rental properties? I assume I get this question a lot because if you’ve read many of my articles, you know that I have used an investment partner for a lot of my properties. So I figure, why not just tell you exactly how my partner and I are structured so if you are thinking about doing it for yourself you have a little more clarity on how it can work?
A Starting Point for Structuring Partnerships
Before I tell you how I’ve structured things with my partner, I want to give you a quick backstory as to how I came up with the structure, mostly because if you are pondering partnerships at all, this may help. Basically you are going to get two structuring options for the price of one!
I was in Las Vegas at a self-storage convention (when I thought my life path was going to be owning a self-storage facility rather than being a real estate investor), and I met a guy there who was in town from Miami. This guy owned a couple businesses, and it didn’t take long for me to realize that he could be a wealth of information. I got on the topic of telling him that I knew someone who was interested in going in on a self-storage facility with me, but I had no idea what kind of partnership to offer — what would it even look like? What kind of splits? What kind of investment requirement?
Here’s the structure he suggested to me:
Your investor puts down the money required to buy the business, then you give him 30% off the top of the NET each month and then split the remainder 50/50 until he is paid back, at which point the split then goes to 50/50 straight.
I was intrigued! He went on further to say it can be very incentivizing to the investor because that 30% goes a long way, and then it’s free money after that. And it’s of course a good deal for me because I’m making free money the entire time. I had to say — he had a point! I stuck this idea in my back pocket and thought about it often, and then when it came time for me to take on an investment partner, I pulled it out of my back pocket!
Rental Property Partnership Structuring Options
So there’s the first way to structure a partnership: 30% off the top of the NET, then 50/50 split after that. I was so excited about how awesome this sounded that I couldn’t wait to do the math when an investor partnering potential came around. However, I ran into a hiccup.
Being the spreadsheet nerd that I am, I started working all of the math for my first potential rental property purchase and my newfound favorite partnership structure in quite a bit of detail in Excel. I knew the numbers on the property (anticipated cash flow, income vs. expenses, purchase price, etc.), and I tried to apply the 30/50/50 split to it. I ran into a major problem. That 30% off the top then 50/50 split bit led to negative cash flow! I don’t remember how exactly, but basically the numbers didn’t work. I thought, oh no, my magical partnership structure proposal is in the water! I tried every which way to make it work, but it just wasn’t happening.
I continued working on it, trying everything I could pull out of my hat, and I finally came up with a logical solution. So, remember that one method — the 30/50/50 method — because it could be very useful on some partnerships. And now here is one that works for smaller-dollar investments:
On my first little rental property I wanted to buy, a lonely little (adorable) $55,000 single-family house in the suburbs of Atlanta (oh, the days of those prices!) that was going to rent for $975/month, I just couldn’t make that 30/50/50 split work because it led to negative cash flow. Here’s what I did find that would work, though, and it did because my partner and I still operate several rental properties under this exact partnership.
- Partner puts in the cash required for the down payment and the closing costs; I take out the mortgage and do the work.
- We split the NET (profit or loss) 50/50.
- If we sell the property, we split the NET (profit or loss) 50/50.
- Equity is always split 50/50, including appreciation and any possible refinancing.
- I provide my investor with a statement and direct deposit every month.
- We both report the 50% income (or loss) on our personal taxes.
- Our partnership is legalized through a legally documented Partnership Agreement (no LLCs, etc.).
Pretty simple, huh? All I needed to adjust from the 30/50/50 thing was the 30% off the top part. But wait, why would that deal be enticing to an investor? That 30% off the top to pay him back for his initial investment seems kind of important, no? The answer is: Yes, it is important. It’s an important enticement. When you are talking about high-dollar investments, like commercial level, i.e. an investor is going to be putting down a mega chunk of change, that 30% off the top may be critical to offer in order to convince anyone to buy in. But at the residential level, it’s not as critical.
But wait. What’s in it for the investor in this straight 50/50 deal? Good question. The theory of this split is it’s a 50% investment for the person willing to put up the cash and a 50% investment for the person willing to take the risk. My partner’s name is not on the property, so if anything happens to it, he is not liable. So him putting up the cash constitutes a reward of 50% of the NET income, and my accepting all of the liability and also doing all of the work and management for the property (although minimal since we bought turnkeys) constitutes the other 50%.
Further Points to Consider
If you aren’t convinced this is a balanced enough split (money vs. risk split), here are some further points to consider with regard to why this may be an enticing deal for the money partner:
Read The Rest On BiggerPockets.
Does the agreement need to be drawn up in the state where the property is located or where one or both of the people live?
Do you have a suggestion of an attorney to create an agreement?
Not sure on that one. I’d ask the attorney. The only attorney we have experience with is Bryan Ngo from Fortis LLP in California (if you don’t live in CA, certainly try to find non-CA prices for an attorney if you can…). http://www.fortislaw.com/attorney/