Many new real estate investors need assistance. They may need some extra money to fund a deal, or they may want to bring someone on to help with a rehab. Regardless of why you want to partner with someone, it’s critical that you create a legal contract outlining roles and responsibilities. As such, people often ask me for help creating a house flipping partnership agreement.
To create a partnership agreement, you need to first define whether this will be a one-time or recurring partnership. Then, you need to define the house flipping roles and responsibilities for each partner. With that information outlined, a lawyer can formalize a legally-sound partnership agreement.
In the rest of this article, I’ll dive into the details of house flipping partnership agreements. Specifically, I’ll cover the following topics:
- What is a Partnership?
- House Flipping Partnership Overview
- Option 1: Long-term Partnership Agreements
- Option 2: Joint Venture Agreements for Deal-by-Deal Partnerships
- Alternatives to Partnership Financing
- Final Thoughts
Summary
What is a Partnership?
Prior to discussing house flipping in particular, I want to provide a brief overview of partnerships, in general.
Partnerships exist as both a common business structure and a tax structure in the eyes of the IRS. While these two characteristics are related, they mean different things to investors. Consequently, it’s important to understand – at a high-level – the different options you have in structuring your house flipping business. (NOTE: I’m using these overviews to expose you to some partnership considerations. However, before making a final business decision, you should consult an attorney for the legal considerations and CPA or other tax professional for the tax aspects of your partnership).
Partnership Business Structures
When two people begin working together in a business, they inherently form a partnership. Lacking a written agreement defining the terms of that partnership, neither individual will draw a salary. Rather, in this basic example, both partners would equally share the profits and losses. In legal parlance, this type of partnership is a general partnership.
In a general partnership, both (or all, if multiple) partners actively participate in a business’s operations. Unfortunately, this also means that all general partners have unlimited liability. In other words, if someone sues the partnership and wins, the partners could lose their personal assets. Related, due to unlimited liability, any partner can be sued if they default on the business’s debts.
Clearly, this unlimited liability poses a major concern to the partnership model. As an alternative, people often use a limited partnership. This model has at least one general partner (GP) – someone who actively participates in the business and faces unlimited liability. And, it will also have at least one limited partner, someone who does not actively participate in the business and likely has no say in management decisions. In return, limited partners face limited liability. Typically, a limited partner is only liable for the amount he or she contributed to the partnership.
This model is commonly used for real estate deals. A GP finds and manages a deal, and the LP – or LPs – contribute money for a portion of the deal’s profits. So, if an LP contributes $100,000 to a limited partnership, he or she only has that $100,000 at risk. Someone can’t sue and also go after personal assets.
Partnership Tax Treatment
Next, it’s important to understand the tax treatment of partnerships. According to the IRS: A partnership is the relationship between two or more people to do trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business.
And, in forming this partnership, the individual partners pay taxes individually. In other words, the IRS does not view a partnership as a separate, taxable entity (like a corporation, which is subject to a corporate tax). Instead, the profits and losses of partnerships are calculated at the partnership level and passed through to the individual partners, who in turn apply them to their personal tax returns. For this reason, people frequently refer to partnerships as “pass-through entities.” In simple terms, the partnership doesn’t pay income taxes; its partners do.
This partnership tax treatment provides a good strategy for people who want to avoid the “double taxation” of a corporation, that is, pay corporate income taxes and personal income tax on distributions from that corporation.
The Best of Both Worlds: Form an LLC
By this point in time, most new real estate investors are likely thinking: Okay Ryan, that’s interesting, but how does this all relate to real estate? I thought everyone used LLCs in real estate?
Great point! The limited liability company, or LLC, combines the best benefits of a corporation and partnership while not including the biggest drawbacks of those structures. From a liability perspective, LLCs look more like corporations. An LLC is a separate legal entity from its owners (known as members), and these owners are shielded from personal liability – as with a corporation or limited partner in an LP. So, if you operate an LLC and someone sues you, only the LLC’s assets are at risk – not your personal ones.
NOTE: Several ways exist to “pierce the LLC veil” and have someone come after your personal assets, the main two being 1) commingling personal and business funds, and 2) negligence.
Additionally, the LLC structure is extremely flexible in terms of defining roles, responsibilities, ownership percentages, and profit/loss allocations. This means that you can certainly structure an LLC to function the same way as a limited partnership, with one member (typically the managing member) responsible for a deal’s operations, and another member (or multiple members) contributing funds in return for a share of the profits.
From a tax perspective, the IRS doesn’t separately recognize LLCs. Instead, by default, multi-member LLCs receive partnership tax treatment. This provides owners the benefit of pass-through taxation (as opposed to taxation at the corporate level).
NOTE: LLCs can opt into corporate tax treatment rather than partnership treatment. Multiple considerations and consequences factor into this decision – beyond the scope of this article – so consult with your CPA prior to making such a move.
Creating a House Flipping Partnership Agreement
Having provided a general overview, I’ll now dive into the particulars of house flipping partnerships.
As a new investor, you’re probably going to need some help. Depending on your unique situation, that may be in terms of experience. For example, say you like analyzing deals and have a good head for numbers, but you’ve never swung a hammer in your life. Maybe you want to partner with a general contractor (GC), with the GC doing the work, you analyzing the deals, and both sharing in the profits. Or, maybe you just don’t have the time to focus on rehabbing fix & flip deals. Instead, you want to focus on finding and analyzing deals, with your partner responsible for day-to-day operations supervising GCs at a few different sites.
However, the most common reason why people start a house flipping partnership comes down to money. Frequently, a new investor will analyze a potential deal and realize that he needs to put some extra cash into it to make the deal happen. For instance, a hard money lender may offer you $100,000, but the deal’s going to take $120,000 to execute. In this scenario, house flippers often form partnerships, bringing in an investor-partner to provide that extra $20,000 in return for a share of the deal’s profits.
Regardless of why you decide to form a partnership, most real estate investors opt for the LLC structure when doing so. Due to the above advantages, it simply makes the most sense, regardless of whether you plan on forming a recurring partnership or simply a one-time deal.
This leads me into the next two sections. Generally speaking, two broad categories of house flipping partnerships exist: 1) long-term, and 2) deal-by-deal.
Option 1: Long-term Partnership Agreements
One type of house flipping partnership involves a long-term, recurring relationship. For example, two friends form a partnership, because they both want to get into house flipping – but neither has the time or money to seriously pursue investing alone.
Technically speaking, you don’t need a partnership agreement. Simply by beginning to work together, you have formed a partnership. However, partnership agreements go a long way towards A) clearly outlining roles, responsibilities, and expectations for all partners, B) avoiding miscommunication, and C) defining how profits/losses will be shared. Bottom line, when it comes to having a partner, it’s better to have an agreement in writing.
While an attorney will formalize the document, the partners themselves should focus on the process of building these roles, responsibilities, and terms for the partnership – helps to talk through these issues and get everyone on the same page at the beginning.
NOTE: With an LLC, this agreement is frequently referred to as an operating agreement, as an LLC isn’t technically a partnership. But, for the sake of simplicity, I’ll continue using the term partnership agreement in this article.
When building a long-term partnership agreement, the individual partners will want to sit down and, at a minimum, answer the following questions:
- What are each partner’s roles and responsibilities?
- What will each partner contribute to the partnership in terms of A) time, and B) money?
- How will profits/losses be split between partners?
These are very general questions, but they should serve as a foundation for an in-depth discussion about how this house flipping business will work. Conceptually, partners should look at outlining one of these agreements as an exercise in clearing up misunderstandings in advance. In other words, if you think something could become a problem (e.g. who’s responsible for following up on skiptrace leads?) it’s better to include it in the agreement than not. This level of detail can potentially save you a ton of frustration – and animosity – in the future.
And, after putting this all in writing, you’ll take it to an attorney who will A) ask clarifying questions, and B) formalize everything into a legal document. As a result, you don’t need to worry about how you’re outlining roles, responsibilities, and other partnership considerations – so long as you document everything, a reliable attorney will translate your thoughts into “legalese.”
Option 2: Joint Venture Agreements for Deal-by-Deal Partnerships
To be frank, I don’t recommend the above, long-term partnership model. Unfortunately, people flake, their priorities change, they don’t hold up their end of the bargain. While a partnership may seem perfect at the beginning, too frequently these businesses fall apart due to different priorities – or outright hostility – between the partners.
Instead, I prefer to establish house flipping partnerships on a deal-by-deal basis. Known as joint ventures, these are partnerships designed for a single project (e.g. a house flip deal). That way, if the deal goes well, great. If not, you’re not stuck with a long-term partner. And, from a business structure perspective, you can establish an LLC for joint ventures like this – typically referred to as a single-use entity.
As with the long-term partnership, you’ll want to formalize roles, responsibilities, and other issues in a partnership agreement. While much overlap exists in these general considerations, with a joint venture, some terms in the agreement will be specific to the deal.
Personally, I like to ask two broad questions to guide my discussions about a deal-specific partnership agreement. First, what would things look like if everything went wrong? Second, what if everything went right? Thinking about these possible outcomes, it’s easier to craft terms for the partnership.
I also like to over-document partnership terms. To me, it’s better to discuss, agree, and formalize everything up front rather than try to resolve differences once a deal’s begun. And, this has the added benefit of saving you on legal fees. If you just say to an attorney: “Draw up a partnership agreement,” he or she will need to start from scratch, charging you a boatload in the process. But, if your attorney just needs to tweak, clarify, and turn your detailed partnership terms into proper legal jargon, it’ll take far less time and, by extension, money.
Alternatives to Partnership Financing
When you bring on a partner to make a deal, you’re likely seeking gap financing. With gap financing, investors look for a way to get from what they have to what they need to make a deal happen. Accordingly, I’d be remiss to not also briefly outline other options for gap financing besides bringing in a house flipping partner.
Assume you can get a $100,000 hard money loan for a property, but you need $120,000 to make the deal happen. If you have $10,000 of your own cash, that still leaves you $10,000 short on the deal. Enter gap financing. In this example, these short-term financing solutions provide investors a way to cover that last $10,000 (or whatever that funding gap totals).
In addition to house flipping partners, residential real estate investors have plenty of gap financing options. Here are a few of the more common ones:
Credit Card Financing
Credit card companies want your money. As such, if you’re a responsible borrower, they’ll provide you pretty good personal loan options. Say you have a $25,000 limit on your credit card, but you only use $2,000 of it every month, always paying it off on time. There’s a good chance the card company will offer you a relatively low interest personal loan for the difference between the credit you regularly tap and your limit. This can be an outstanding gap financing strategy.
HELOC
Home equity lines of credit, or HELOCs, are another great gap financing strategy. Typically, investors tap the equity in their primary residences. So, assume you have $50,000 in equity in your property. A lender may not extend a HELOC for that entire amount, but even if you secure a $25,000 HELOC, this gives you a tremendous amount of gap financing flexibility. And, with HELOCs, you only pay interest on the money you draw. Once you repay the outstanding balance, you don’t need to pay interest.
Business LOC
Functionally, a business line of credit (LOC) acts the same as a HELOC. However, rather than secure the credit against your primary residence, banks use your business’s operations to secure a business LOC. Obviously, this option only exists for investors with a business. But, if you have a successful business, a LOC secured by its operations can be an outstanding gap financing option.
Final Thoughts
While I firmly believe in the value of formal partnership agreements, it’s important to note: a partnership agreement is only as strong as the people signing them. If people want to rip you off or flake on a deal, they will, regardless of the legal document. As a result, it’s extremely important to screen potential partners before a deal. Ask yourself: do I genuinely trust this person? If not, you probably shouldn’t form a partnership to flip houses.
If you want to get your start flipping houses, we’d love to help! I wrote a book, How to Get More Money Than You Can Ever Handle: A Real Estate Investor’s Guide to Funding Deals, and I’d love to send you a copy – for free! Just text me your e-mail address to 435-294-0433, and I’ll send you a copy today!
COMMENTS