Advice/Resources Needed: Form a Partnership or LLC?

Question

I recently spent some time catching up with an old friend via Zoom on our various business endeavors and how our careers since college have been going.

I told him about my recent RE journey and shared my investing strategy to jump into the Sacramento Real Estate market - specifically pursuing the "house-hack" strategy for my first property (hopefully a small multi-family) and doing some minor rehab projects on the units to force appreciation in a path to progress neighborhood. I would repeat this process, and hopefully build a strong enough income-generating portfolio that would also benefit from appreciation in the neighborhoods I would choose. I told him I am currently in the process of saving up for a down payment and do not intend to really buy until the end of the following year.

He said he was very interested, and would love to go into business with me, with the intent to help expedite my down payment savings process, as he already has cash sitting on the sidelines. I told him that I had intended on creating a separate checking account for each of my forthcoming properties, and his suggestion was that we form an LLC so that we can expense items through that business.

Here is/are my question(s) for the community:

1) Should we just be a Partnership, or form an LLC?

2) What are a few key considerations I should be thinking of, when drafting our Business Contract?

3) Do you have any resources/books/websites/articles that can point me in the right direction with how to proceed with this?

Additionally - I am looking at getting approved for an FHA or the HomePossible loan, so that I could take advantage of doing a low down payment via house-hacking, which would be great, as it would also allow me to better manage the property. He has no intention of managing the property, but would just like to put money in and be a business partner for the long-run as we build up assets. What are some other things I should be considering?

Aaron W. · Answer

@Emil Pinlac From my understanding, an LLC with two unrelated members will be considered a partnership LLC. You shouldn't need to establish a partnership corporation. This is what I am doing with my partnerships. As for a contract, I would ensure you are extremely clear and have everything in writing. Hire an attorney to get a partnership operating agreement written up. Have the uncomfortable discussions now about how the partnership will be split and who brings what to the table. Communicate, communicate, and communicate. This will help avoid any disputes and misunderstandings in the future. You should each have some skill different from the other.

Good luck!

Emil Pinlac · Answer

@DJ Dawsonoof, that's another $800 a year/$67ish extra a month to budget for. I will definitely be educating myself beforehand but also consulting with a business attorney before everything is set in stone. I intend on crafting a solid contract agreement with my partner so that there'd be no confusion, and I also want to make sure to reduce our risk as much as possible.

DJ Dawson · Answer

@Emil Pinlac there are 3% down conventional loans out there as well, opens the door for you to many more properties which traditionally wouldn't qualify FHA. Also an LLC in CA is about $800 a year so account for those costs if you do intend to go that route. As @Evan Polaski stated too, exit strategy is KEY here, there no such thing as OVER communication.

Evan Polaski · Answer

@Emil Pinlac, there a couple items I see right off the top:

FHA or any owner-occupant financing will not let you take title in the LLC.  Beyond that, I would consult with a business formation attorney.  Generally, your LLC or partnership agreement, will outline who is responsible for what, how much ownership each partner has, what rights each partner has, and how disputes are resolved.  Can you refinance your partner out?  Who pays bills if there are no tenants? What about a major repair?  What happens if you want to sell and your partner doesn't? If one of the tenants destroys the place?  How are you compensated for managing the property?  Are you required to pay rent to the LLC owner?

Again, the biggest issue I see is that you have a property that will likely be in your personal name, but sounds like the intent is that the LLC benefits from the ownership.  You technically have an asset titled to you, and your friend has a piece of paper.

Basit Siddiqi · Answer

@Emil Pinlac1) Should we just be a Partnership, or form an LLC? The alternative is to own the property as tenants in common but the LLC route is better2) What are a few key considerations I should be thinking of, when drafting our Business Contract?Responsibilities of each memberIncome/loss allocation for each memberwhen will the partnership/LLC dissolveWho will be responsible for filing of partnership return / communicating with IRS/states

Aaron W. · Answer

Hi @Emil Pinlac

My partnership is a 50/50 split. My partner had little real estate experience; however, he had skills that I did not have needed for a successful business. I saw that as enough value to split this 50/50.

As for expenses, when we drafted our operating agreement, we put in the agreement that each partner would put in $10k for startup expenses. We also agreed that each partner would put in a specified amount into the partnership for property purchases and other expenses. We bootstrapped the business as much as possible and spent where it was needed or when our time was better spent on working on the business instead of in it. We opened a bank account to hold all our partnership funds and transferred additional funds into the bank account as needed and as agreed upon in our operating agreement.

As a partnership, you will be able to write off business expenses as long as you can prove they are business expenses. We do this by opening a bank account and have credit cards used only for business operations. If you have to come out-of-pocket for expenses before a bank or credit card is established, there are ways to reimburse yourself through the business to get the write off. Your accountant will be your best resource to give you guidance on how to maximize the write offs.

Hopefully, this is helpful information!

Emil Pinlac · Answer

@Katie LeporeHi Katie! Yes. I fully intend to lay out the expectations and multiple exits in the event these types of things don't work out. It's just as beneficial for them, as it is for me to draw up - we're both auditors by trade, so mitigating/reducing risk as well as proper documentation is what we live on. haha. There's a lot I am still very unfamiliar with, with regard to the LLC entity so that will be something I will need to do my own research and due diligence on. The annual tax to is definitely an added cost to consider to bake into the numbers of potential deals we might be looking at. Thanks for all your considerations on this.

Emil Pinlac · Answer

@Evan PolaskiHey man, thanks for your response and for all the considerations at the point at which we would draft our partnership agreement. But - like you said off the top - if FHA/any owner occupant financing will not let you take title in the LLC, does this mean I cannot use that type of loan at all, if I am intending to purchase it using the LLC?

Emil Pinlac · Answer

@AJ H.Hey AJ - Thanks for your response, man. Yes, I will definitely consult with a real estate attorney/small business expert attorney with regard to drafting a strong contract agreement and my potential partner - in the eventuality that we get our financials set up and we are ready to take that next step. However, I wanted to ask specifically then about your own experience with partnerships. How did you get started when you began to structure your partnership deals with partners? Do you have them set up as a 50/50 split all the way through? When you guys have to pay for repairs/maintenance expenses, how did you guys make sure to get maximize those as write-offs?

Katie L. · Answer

@Emil Pinlac

Regardless of the format you choose, you likely want to have a written agreement as to everything you do, even if you do not form an entity.  I'm not sure what type of partnership you mean if you're referring to - a general partnership or a limited partnership.  A general partnership generally provides no liability protection and all partners usually have unlimited liability.  A limited partnership allows for limited liability for the limited partners, but must have a general partner who usually has unlimited liability.  Therefore, an LLC is usually the preferred method as all members enjoy limited liability.  Do note, however, that LLCs and LPs are subject to an $800 annual tax in California but GPs are not, if that is any concern.

You will want to think of all the possible issues that could come up in a partnership and try to address these at the outset in your agreement.  You will want to decide what happens in multiple situations such as differing opinions, splitting distributions and profits, payment for services rendered to the entity, dissolution if one person wants out, transferring interests to others such as spouses or kids, rights of first refusal, etc.

*This post does not create an attorney-client or CPA-client relationship.  The information contained in this post is not to be relied upon.  Readers are advised to seek professional advice.

Advice/Resources Needed: Form a Partnership or LLC?

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