Private funds/reporting

[Drew McKinney]

Hello all,

When one receives private funds from say two different parties 50k each to buy a 100k property for example.  Friends and family will say are the investors.  Does this need reported or claimed anywhere for the irs? I guess my question is does the irs or sec care that you're depositing large amounts of other people's cash into your bank account before close or is that what the escrow and closing officer is used for so that you don't have to put those funds into your account and draw attention per say?

Thanks!

Drew

[Jon Holdman]

How is this money being handled?  Are these two investors making loans to you or an entity you control?  If so, then these loans should be documented with promissory notes and (assuming they're secured by the property you purchase) deeds of trust or mortgages (whichever is used in your state.)  At the end of the year, you will give these lenders 1099's for the interest you've paid.  They will report this on their taxes as income and pay tax on it.  All the initial paperwork will be signed and filed at closing.

Now, it sounds like they are just handing over $50K each to you or your entity and then you're buying the property. This is a partnership, even if you do no additional paperwork at all.  At the end of the year, the partnership files an IRS return and sends K1 statements to each of the partners.  The partners use the K1's to prepare taxes.

If that's what you're doing, you are, strictly speaking, "selling securities".  And, yes, the SEC is interested in such things, along with your state securities commissions.  Or, really I mean the states where your investors live.  Now, if the three of you are all best friends and have agreed about what to do, you may get away without the proper paperwork.  The costs are high, and raising $100K through a formal partnership is not enough to justify the paperwork.  Figure $10-25K in legal costs to set up a proper private placement.  Nevertheless, you do want to have a solid operating agreement that outlines the terms of the deal and how the partnership operates.  For example, having $100K to buy a $100K house is one thing.  What about closing and operating costs?  Cash reserves?  What if one of the partners dies, gets married or gets divorced?  Gets sued and loses?  Needs cash?  What if the partnership needs cash and none of you can kick it in?  The operating agreement is a complex and essential document.  If the three of you cannot spend hours hashing this out to everyone's agreement, you're not going to be able to do it WHEN things go bad.

Problems are inevitable.  Folks often go into this assuming things will go smoothly.  Then, when problems crop up, they're unprepared to deal with them.  You ABSOLUTELY MUST take the view right now that bad things will happen.  At this point, you're all on friendly terms.  That may not be the case down the road.  You may well end up in court and the judge will want to see the operating agreement to decide what to do with you.  If you can't have these hard discussions now, you won't make it when problems crop up.

You mention "friends and family".  Realize that there is a chance these deals will totally collapse.  I would only take money from friends and family if I was prepared to work two jobs and live under a bridge to pay them back if the deal goes south. Are you prepared to do that?  Deals DO go bad.  I have a big chuck of money, same as what you're discussing, tied up in a deal that is almost a guaranteed total loss.  Are you prepared to sit at family gatherings with someone you cost $50K?