Q.: I have just signed a contract to buy a house. I plan to renovate it, and sell it at a profit. A friend has indicated that he would like to join me in this venture, and he is prepared to contribute half of the up-front costs. I am interested in having my friend as a business partner, but we do not know how to take title to the property. What’s your suggestion?
A: : Before I answer your question, I have to ask you some questions: do you — or your friend — have any experience in renovating a house? Are you prepared to lose your entire investment should this deal go sour? Do you understand that you will have to give the mortgage lender your personal guarantee in order to get the loan, and that means that your other assets may be at risk.
It is true that real estate has been a very good investment for many people, and that prices have been escalating in the last few years. But most sophisticated investors understand that the real estate market is not recession proof. Interest rates can go up, making it less attractive for buyers. And market values can go down.
Before you jump into this venture, you must do your homework. You should also talk with your financial and legal counselors to make sure that this is the kind of business you can afford.
Enough said: now lets answer your question.
The very first thing you should do is to reach agreement with your friend on the mechanics of this partnership, and reduce these agreements to a written document — to be signed by both of you. You should each have separate legal counsel to advise you on this agreement. While you may be friends, the time to reach agreement is while you are talking with each other, and not when you are fighting over the profits — or the losses.
Is this really going to be a fifty-fifty deal? Are you both going to be contributing equally — with both money as well as time — to complete the renovation? Do you plan to sell the house with or without a real estate agent? Will you be using a general contractor to do the work or will you be acting as the GC.
Keep in mind that this is not a simple situation. There are many issues which have to be resolved — and you should try to resolve as many problems as possible before you go to closing.
For unmarried people who own property, there are two ways you can hold title. The first is called “tenants in common” and the second is “joint tenants with right of survivorship.” For married couples, there is a third title approach, namely “tenants by the entireties”.
Under the first approach — tenants in common — each of you would have a divisible interest in the property. Let us assume in your case that each of you will have a 50 percent interest in the property. If one of you dies, his or her interest in the property will go to a probate estate, and if you have a Last Will and Testament, your share of the property will be distributed in accordance with the instructions spelled out in that Will.
It used to be that Probate — especially in the District of Columbia — was a cumbersome, slow process. However, legislation enacted by the Council of the District of Columbia a few years ago has greatly simplified the process.
If title is held as joint tenants with right of survivorship, then on the death of one of the joint tenants, full title will vest in (go into) the survivor. The survivor would own the entire property, without having to go to Probate Court.
If this was not a business venture, then these would really be your only choices: tenants in common or joint tenants. However, there is another form of ownership which I strongly recommend in your situation, namely a Limited Liability Corporation. (LLC).
Perhaps the only real purpose of a corporation is to insulate the corporate owners from personal liability. There is a legal doctrine which states that unless the corporate owners have commingled their personal finances with the corporate books, or have not complied with the formalities required for a corporation, the owners cannot be help personally responsible or liable for the actions (or inactions) of the corporation. We lawyers refer to this as the inability to “pierce the corporate veil”.
However, there are major drawbacks to corporate status, specifically dual taxation. Oversimplified, the corporation is taxed on its profits, and the owners are then taxed on the income they take from the corporation.
Many years ago, in an attempt to resolve this dilemma — especially for the small business person — Congress created what is known as the “Subchapter S Corporation” (the name comes from the location of this law in the Internal Revenue Code).
A sub-S corporation (as it is called) preserves the corporate liability shield, but avoids the double taxation. The sub-S merely files an Information Return with the IRS; it pays no tax. Instead, the profits and losses are passed through directly to the owners of the corporation.
Subchapter S Corporations flourished for a number of years. But about 10 years ago, some clever tax attorneys came up with the concept of a Limited Liability Corporation. The LLC had the same benefits as a SubS — i.e limitation of personal liability and no double taxation — but it also had one additional benefit. There was considerable less red tape involved in the creation of an LLC.
To be a valid Subchapter S, there are a number of legal hoops which are required, and you have to file certain documents with the IRS. On the contrary, to be a valid LLC, all you have to do is meet the filing requirements of your State law and pay the filing fee. It is relatively easy to do.
Today, most investments such as you are planning are held in the name of an LLC. You should, of course, consult your own financial advisors, since I can only provide you with general advise.
If you do create an LLC, there are at least three important things to keep in mind:
- do not commingle your personal finances with those of the LLC. If you have to lend money to your LLC, make sure that you treat the loan as if it were coming from an outsider. Paper the transaction; sign a promissory note from the LLC to you. If you start to mix your money with that of the LLC, you may lose the protection of the “corporate veil”;
- owners of an LLC are called “members”. Anytime you sign a legal document on behalf of the LLC, make sure you add the word “member” after your name. Once again, you want to separate yourself personally from your ownership of the LLC, and
- if you are successful with this venture and want to do another project, you must create another LLC specifically for this project. Why? If your original LLC still owns the first house, it is an asset of this LLC. If there are legal issues involved with the second property, and if someone gets a court judgment against the LLC, both properties will be at risk.People have made money on these real estate ventures, but people have also lost a lot of money. Be careful, and make sure everything is done legally correct.
Written by Benny L. Kass