3 Crucial Considerations When Dissolving a Real Estate Partnership
Separating from partners whether family or business is a difficult subject and one that real estate owners often inquire about. This month, I have asked Michael Landsman from Holm & O’Hara LLP to explain the three key considerations when debating separating from a real estate partnership.
There are any number of reasons to separate from a real estate partnership. One partner may need to free the capital for other purposes – such as retirement or education funding. The investment’s performance may not be living up to expectations. The property owned by the partnership may require more upkeep, maintenance, or repair than anticipated, or management responsibilities may be proving burdensome. One of the original investors may be deceased, triggering a need for the estate to distribute that asset. And, of course, there is the simple human factor that people – even longtime colleagues and friends – sometimes experience interpersonal issues.
Regardless of the reason, there are three key considerations when contemplating separation from your real estate partners:
- Tax Implications
Each of these can have a significant impact on the ability to maximize return on the original investment
Several potential tax implications are involved when separating from partners depending on the facts and circumstances of the selling partners/selling entity. While recent trends have favored holding title to commercial real estate with a limited partnership (LP) or limited liability corporation (LLC), it is quite possible that the original business entity was a less tax efficient structure, such as a C-corporation, or S-corporation.
Each one of these ownership structures is subject to different tax liabilities when an investment it holds is liquidated. In some situations, the income tax due on the capital gains will be based on the amount of time the investment property was held. In other situations, ordinary income tax may be due at the corporate level, individual level, or both. Occasionally, a sale of investment real estate may result in assessment of a combination of income and capital gains taxes. Additionally, if an investment property is sold by the estate of one of the original investors, estate income taxes may be due on that portion of the sale. In most cases, calculation of the income tax due will involve complicated basis formulas and depreciation recapture rules.
To explore further, you should:
- Consult an experienced accountant or tax lawyer to review potential scenarios and tax implications. Each partner should consult their own advisor as each is likely to be impacted differently.
- Evaluate whether a tax deferral strategy may provide longer term goals without negatively impacting more immediate needs and objectives.
- Consider whether it makes sense financially to change the investment holding structure prior to sale and whether desired timing for the separation would allow this.
Valuation is almost always a stumbling-block when it is time to dissolve a real estate partnership and sell the underlying commercial property. Absent a clear and unambiguous written agreement between the original partners, the separating partners will have to achieve consensus about how to value their individual partnership interests before they dissolve the partnership. This is not as simple as it seems, particularly when one partner resists a sale and lacks the capital to purchase the departing partner’s interest in the property. This is further complicated by the discount often applied to ownership interests due to factors such as lack of marketability and lack of control.
While valuation of a residential property can be fairly straightforward based on condition of the property, recent sale prices of comparable properties, and other indicators of “fair market value,” proper valuation of investment property can be considerably more complicated. Simple methods of valuation, such as multiplying the gross rent over a period of years, seldom capture the actual value of a commercial property as an investment. Most savvy real estate investors will want a reliable estimate of a property’s “cap rate” to predict likely income producing potential.
To explore further, you should:
- Review existing partnership governance documents, including any buy/sell agreements, to determine whether an approved valuation approach is already in place.
- Retain the services of at least two reputable appraisers with experience in valuing similar types of investment properties.
- Agree on the methodology for balancing the difference between the various appraisals.
The final consideration, which is closely related to the first two, is timing. Once the partners decide to separate, they need to decide on a plan to do so in the most cost-effective and tax efficient way possible. This may involve a frank discussion among the partners, or their advisors:
- Of each partner’s goals, needs, and ideal time frame
- A concerted effort to clear up any code violations and make sure required agency filings are up-to-date
- An examination of favorable rent arrangements that may reduce the property’s marketable value
While every situation is different, partners can expect that it will take six to 12 months to effectively prepare a property for a sale that generates maximum proceeds under current market conditions.
To explore further, you should:
- Create a rough timeline that incorporates each partner’s targets, as well as potential tax triggers.
- Inventory various physical, regulatory and financial conditions that may impact the sale price and devise a plan for correcting them.
- Revisit whether a change in holding structure may help facilitate specific partner goals, such as reinvesting the proceeds through a 1031 like-kind exchange.
Michael is the Co-Managing Partner at Holm & O’Hara LLP, a law firm focusing on real estate, business, trust and estates, and civil litigation. Michael has over 30 years of experience and completed his BA from New York University and his JD from New York Law School. Clients appreciate his entrepreneurial approach to both business and legal issues and ability to propose efficient legal solutions within an enterprise-wide context. Michael can be reached at email@example.com or (212) 682-2575.
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