Equity Sharing Arrangements in Real Estate Investing

eqity sharing, real estate, investing“I’ve got the brains. You’ve got the looks. Let’s make lots of money.” Take these Pet Shop Boys lyrics and apply them to real estate investing and it might read something like this – “I’ve got the deal.  You’ve got coin.  Let’s buy some property.”  This is a song sung by many real estate bird dogs looking for an investor with a bag of kibble to invest.  So how do you build your nest so no one is shoved out like the weaker sibling of a Red Footed Boobie?  Start with a solid Equity Sharing Agreement.

If you are not familiar with this term, an Equity Sharing Agreement is a written agreement between two investors, one of which has the know how and the other the money, whereupon they agree to purchase real estate together and split the profits.  The problem for many investors is their failure to put their agreement in writing so expectations are not violated.  Having dealt with a number of clients who have been on the giving or receiving end of a bad case of Can’t Remember Sh_t; the following is a list of items every investor should consider when engaging in these adventures: 

Price limits.  Limits should be set on the price of the property to be purchased and the amounts invested for any rehab work.  Often times, parties are at odds when it comes to the amount of work that should be invested to bring the property into sellable condition.  A budget must be created and strictly adhered to.  Any deviation from the budget should require unanimous consent.  If one party fails to meet its obligations then penalty provisions should provide for forfeiture of profits.

Property does not sell.  Have a plan B if the property does not sell.  Who will manage the property and what will be the fee.  I have found that utilizing a third party property manager is the preferred route to ensure each party’s interests are protected.  I have heard of several horror stories where one party kept all of the rental income and did not pay the insurance, utilities or property taxes.  This is extremely unfortunate because in many of these situations the investor with the cash is out of state and has no direct involvement with the project or the tenants.

Pay for time.  Typically the bird dog needs a bone if he is going to rehab the property.  Unfortunately, this will not come up until the property is purchased and bird dog is asking for money or he walks and the investor is unwilling to pay (explain to me again why you are entitled to 50% of the profits if I am paying for everything and you have done nothing?).  Nail this issue from the outset by determining how much work bird dog must perform free of charge and what he is paid should come off the top before profits are split.

Division of unforeseen costs.  Who picks up the tab for unforeseen expenses?  Will both parties split the costs or will investor be forced to reach further down into his pocket to see the project to completion.  Here again expectations can be torn asunder and your partnership will make great copy for A&E’s next reality show.

Amount of homeowner’s insurance coverage.  Both parties must agree to the amount and type of homeowner’s insurance coverage needed to protect the property, who will purchase it, and how the insuring agreement is worded to protect the parties. 

Allocation of tax benefits.  The federal tax laws specifically address equity-sharing arrangements.  In order to qualify for many of the tax benefits of equity sharing, there are some basic rules that must be followed.

I “no longer love you” clause.  It is a fact that business partners divorce faster than one night stands in Vegas who thought they found true love and sought confirmation from pastor Elvis.  The parties must agree upon the terms and method for one party buying out the other party’s interest if either one wants out.  This should be a set figure or on a sliding scale based on work completed.  Also, consider what will happen if the property does not sell in 120 days and there is financing in place.  How long is the investor willing to carry the project?  If bird dog can’t pay, then what will occur?  

Dispute resolution.  It is useful to prescribe the method for resolving disputes that may arise between the parties, such as through mediation or arbitration.

Rent allocation. It is sound practice to decide how or if rent is to be divided until the property sells.  Further, the agreement should cover when the property should be listed for rent if it does not sell within a reasonable period of time.

The split of the built-up equity (or loss) when the arrangement ends.  The value of the property above the mortgage balance is the equity in the property.  One of the most important aspects of equity sharing is feasting on the proceeds.  Who will eat filet and who gets the chicken should be dictated by contributions, work performed, and overall risk exposure.

This is just a sample of the provisions that any good equity sharing agreement must contain.  Do not attempt the do it yourself, approach and hire an attorney to protect your interests at the outset lest you find your song becoming “if you lack the inclination, I’ve got the crime.”

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