As real estate partnerships begin, evolve and ultimately dissolve, far too many involved parties lose track of assets, allocations and debt. It is crucial to ensure proper record keeping when entering into or managing any type of partnership.
When the real estate partnership ends, how should profits be divided? Who gets the remaining assets (i.e. cash or property)? These questions and more are sure to pop up if you aren’t properly managing your financial records. To ensure your real estate partnership is on the right path, there are some simple steps to take that can prevent uncertainty and in the worst case scenario, a day in court.
First, there is the agreement itself. Each year, read and understand the Partnership Agreement (“PA”) or Operating Agreement (“OA”). Always request signed copies of any amendments to the agreements for your records and make sure to keep track of your partners and how much they own in the real estate partnership. If something other than cash was contributed to the partnership, you will need to know the tax basis and fair market value of all non-cash items at the time they were contributed into the partnership.
Determine how items of income/loss or gain/loss and distributions are allocated to the partners. In many instances, there are different allocations for distributions of cash flow vs distributions of capital proceeds. The same can be said for allocations of cash flow income and loss vs capital income and loss.
Confirm that the allocations of the PA or OA have a substantial economic effect. There are certain provisions under IRC Sec. 704(b) (“704(b)”) that must be met for a real estate partnership to have a substantial economic effect. Other items of note to look for in the PA or OA is whether there is a preferred return, guaranteed payments, definitions and liquidating distributions. All of these could be detrimental to your finances.
Second, confirm that the partnership has its own set of books & records and you have clear entry separation. By not combining the notations and records with the books of any other legal entity or agreement, you’ll minimize the opportunity for confusion. And should you need to quickly discover who was allocated what, finding the information will be quick and orderly.
Next up, always make sure your bookkeeping is tracked and up to date when it comes to any scheduled or agreed-to plan. Take the time to confirm each year that all entries that affect your books are in fact booked. For example, it is very common for a partnership in a tiered structure to make a distribution from the bottom tier directly to the partners of the final entity even if they skip an entity or two in the middle.
In terms of tracking throughout the year, maintain an accurate record of the cumulative tax and 704(b) capital accounts for each partner, every year. Since your allocations have to have economic effect under 704(b), you will not know if your allocations are good without tracking the balances. Even if you assume the numbers will be nearly identical year-to-year, making this assumption could prove costly.
And lastly, and perhaps most importantly, keep accurate records. While this may seem obvious, as the pace of life quickens, it can seem daunting to keep note of everything, no matter how small the update. Keep in touch with your partners to confirm address changes and/or partner deaths/transfers. More and more states are requiring nonresident withholding for partners and if a partner moves to another state, you may have a requirement to withhold. Partner deaths or transfers could trigger the need for an IRC Sec. 754 election and therefore an IRC Sec. 743 step up or step down calculation and related depreciation.
Some real estate partnerships can run for a very long time, but if these records are not kept up-to-date, it is very difficult to determine how profit and loss should be allocated each year. Should parties need to move on, it could be even more difficult to know what to do when you dissolve the entity years down the road. The best option? Work with someone who knows these complex issues inside and out. If you have any questions about setting up, managing, or dissolving a partnership, be sure to contact your tax advisor.