Daily Record July 7, 2007
OWNING REAL ESTATE: THE JOINT VENTURE
By Shelby L. Cates
The joint venture, a popular form of ownership of real estate, differs from its close cousin, the partnership, in one significant respect: Joint venturers join together for a specific project rather than for an ongoing business relationship. The limitation to a single project has the advantage of assuring each joint venturer that any losses will be limited to the funds put up for the specific project. A joint venture, however, is not a legal entity, and must take the form of a general or limited partnership (most often) or as a corporation, trust or tenancy-in-common.
Whichever the legal format, the joint venture agreement should specify the precise powers of each joint venturer. Further, the limitation should be made known to third parties so they are aware of any the restrictions on a joint venturer's right to represent the venture. Otherwise, the remaining venturers may be treated as general partners subject to claims made against the joint venture assets from acts of an individual joint venturer.
Tax Status
Joint ventures are treated as partnerships for income tax purposes. Since they are not taxpaying entities, they act as mere conduits, and the income tax consequences of the operations pass through to the joint venturers, giving them the benefit of immediate write-offs of any taxable losses the venture may generate. (Losses, however, are subject to the passive loss rules of the tax code.)
Key Provisions in Agreement
A properly drafted purpose clause in the joint venture agreement should describe the proposed venture in some detail. This is particularly important if the venture's legal form is a limited partnership, since limited partners, without the right to participate in management, have no other effective way to restrain the operating partner who might change the venture's scope at a later date.
The joint venture agreement should specify a commencement date and the duration of the venture. Without these specific terms, the agreement may be considered to be "at will," in which case any venturer who acts as a general partner would have the right to terminate the venture at any time. Since under the Uniform Limited Partnership Act (ULPA), a limited partner may withdraw capital on six months' notice unless the partnership agreement provides otherwise, a joint venture in the legal form of a limited partnership should not permit this to be done.
Capital Contributions
The joint venture agreement should specify the contribution of each venturer and the time or (times) of the contribution. Each venturer is credited with a capital account equal in value to the amount of the contribution. The operating partner, who may be a developer, real estate operator or real estate broker, often contributes services or property rather than cash. If property is being donated, the status of zoning and environmental issues should be determined as well as the feasibility of the intended project.
All co-venturers will be expected to share in any existing liabilities and obligations. However, they should agree to assume only known obligations and require the operating partner to indemnify them against undisclosed obligations.
Additional Capital Contributions
During the life of the venture, it often is necessary to raise additional capital. Who will advance the funds? An obvious answer is that each partner will contribute in proportion to his or her original capital position. However, since it is often the case that some are "money partners" while others contribute property or expertise, the former may be the only ones in a position to advance the additional capital. Additional cash contributions may be treated either as loans to be repaid before any equity distributions or as additional equity that increases that partner's percentage interest.
Distributions
The joint venture agreement should carefully define "net cash flow," which is the cash that will be available for distribution. Cash flow normally arises either from operations or from a special event such as a loan refinancing. Operating cash flow often is distributed automatically according to an agreed-upon formula. Distributions from a special event may either be distributed or be reinvested in the project, with the decision being made by all of the partners or the managing partner.
Mortgage Financing
A real estate venture almost always assumes that a mortgage loan will be obtained. Ideally, a mortgage loan commitment is obtained at the time the joint venture is organized so it is clear how much equity capital will be required. If the money partner is providing funds in the form of a loan in addition to an equity contribution, the venture agreement should carefully distinguish between his or her role as lender and investor.
Voting Powers
Each joint venturer should be allocated a percentage interest representing his or her cash (or other) contributions to the venture. Management decisions may require a majority vote or some other designated percentage of the total vote.
Management of Venture
Unless otherwise provided in the joint venture agreement, all members of a general partnership (or all the general partners of a limited partnership) have equal rights in managing the venture. In a two-party venture, unanimity may be required. However, it is frequently the case in a multiparty venture that a management committee is established that has the right to make decisions on a majority or other percentage vote.
The right of a venturer to transfer his or her interest often is subject to conditions. For example, the other venturers may have the right to approve any transfer, subject to reasonable standards. Alternatively, the other venturers may have a right of first refusal to be triggered by a bona fide offer from a third party to one of the venturers or by the venturer's offer to sell his of her interest to the remaining partners or to a third party.
Shelby
L. Cates, CPA, is a senior assurance manager with Mengel, Metzger, Barr & Co. LLP and may be reached at Scates@mmb-co.com.
