Sometimes you need partners to get deals done in this business. We talk to people almost daily that want to get involved with real estate but do not have the resources to do it, especially as lending gets tighter. Last year I wrote an article about using partners and how I see many partnerships created for the wrong reasons and of course how those partnerships end in disaster. Well this month I want to stress the importance of partnerships for the right reasons and HOW to do it. Specifically we are going to be talking about credit partners and if this is done incorrectly it could be considered illegal.
You have heard me say it ten thousand times, I am not an attorney and nothing in this article represents any kind of legal advice. I am simply sharing my experience and what my understanding of these arrangements.
Now that that’s out of the way let’s get to it. A credit partner will most often be needed and used for long term financing. In a good partnership every partner will add and receive value. A credit partner helps the partnership get the financing. A typical credit partner gets the loan and may provide some consulting to the partnership while the other partner(s) find and manage the deals. They would then split the profits however they see fit. Both parties in this arrangement participate and benefit. The credit partner helps get the deals done with the money and or financing while the other partner(s) provide the expertise, time, and labor.
As many of you know it is getting really hard to get financing. If you are self employed many lenders will turn you down even if you CAN document income, and no documentation loans are a thing of the past. You can make good money, have 800 credit scores, and plenty of cash in the bank and still get denied. Some of us need credit partners if we are going to continue to build a portfolio of properties.
There are right and wrong ways to create this partnership. Here are three good ways to do this:
LLC – As long as the partner does not need to show the full amount of the rent to qualify for additional loans an LLC is probably best. It is the cleanest and easiest for the accounting. It is probably also the safest for both parties.
Joint Venture (JV) – If the credit partner will need to show rental income to qualify for loans in the future it is best to have the property show up on their schedule E on their tax return. Schedule E is the rental property schedule. This is where it gets confusing. They will need to show the full amount of the rent and the full amount of the liabilities and will need to pay you your profit as a management fee or consulting fee which will also show up on the Schedule E. This will all need to be spelled out in a joint venture agreement.
Sublease or lease/option – Another clean way to do this is to have the credit partner rent to you and you sublease to the tenant. The lease agreement would spell out that you pay the mortgage and expenses first and the balance is split. Doing it this way will make the property show up on both tax returns. If you do it this way, be sure to talk to CPA about the depreciation of the property and who will be taking that benefit. You can add an option to your lease to spell out the terms when you both decide to sell the house.
Any of the ways will work as long as the credit partner is receiving a portion of the profits. What you don’t want to do is have them finance the property and be out of the deal. The most common example of this is after they finance it they deed it to you and you pay them a fee. This is considered straw buying and is illegal. Never pay a fee to use someone else’s credit! If they sign on the loan they need to be involved with the deal and be responsible for that loan. This is also a bad idea if you plan to do multiple deals with the same partner. The loan will be on the credit report and will affect the debt to income ratio making it harder for them to qualify for a loan in the future. If it is on their credit report they should show income on their tax return to offset the liability.
On a separate note, there were several investors in Denver paying to use people’s credit. Some of them ended up getting into financial trouble and the houses went into foreclosure hurting the credit of the signer on the loan. Don’t ever accept money to be someone else’s straw buyer!!
Use partners and use them with caution. Partnerships are a great tool to help everyone involved build wealth but they must be done correctly.