You see the ads everywhere from many sponsors touting the big returns and opportunity to pool capital in a Limited Partnership or LP investment. Frequently the investment will be presented as “participate in the development”. So how do these LP investment opportunities work?
Limited Partnerships can be a great investment vehicle for making your real estate investments. Before entering these exciting opportunities, it is important to understand what they are, and how they may be beneficial to you in your portfolio.
A Limited Partnership is an agreement between one General Partner (GP) and one or many Limited Partners (LP). The GP is typically the real estate investment company that is sponsoring the deal and doing the majority of the work to deliver the returns. In exchange for this, the GP is taking on more risk including guaranteeing the debt on the project but also gets compensated for this as part of the investment offering.
For investors, similar to how corporations issue shares to purchase for ownership, you would subscribe to “units” of the LP to become a unitholder. It is called a “Limited” Partnership as your risk is limited to the capital you put into the deal. In other words if the deal didn’t materialize as expected the risk would be only the amount invested and the rest would fall to the GP. The capital raised (funding) from investors will be pooled together and invested into assets such as real estate. When the assets generate a return, it is distributed to unitholders based upon a “waterfall” formula which has a number of factors including ownership, return targets, level of risk taken etc. LP investments have a “holding period” requiring your capital to remain in the deal for a given period of time and to potentially have to provide additional capital through capital calls.
What makes Limited Partnerships a suitable investment? The following explains three of the main advantages of such an investment.
- Passive Income – In a Limited Partnership, the General Partner is typically in charge of making decisions and managing the partnership. The Limited Partners would not need to worry about planning, structuring, executing, and managing these projects, but can still reap the rewards! For example, investors can earn an income from tenants paying rent on the property they are occupying, without having to deal with maintenance, managing relationships, or collecting rent. This is ideal for busy individuals who don’t have the capacity to constantly manage all the details, but still want to capitalize on the high earning potential from investing in real estate. Most LP investments in the real estate industry will provide quarterly reporting and are required to provide annual tax slips to help make this as turnkey as possible.
- Limited Liability – Not only does the General Partner need to make decisions and manage the partnership, but they are responsible for guaranteeing the debt; they have unlimited liability. In contrast, Limited Partners also have very limited liabilities. They can only be a financial liability, and only liable up to the amount they have invested. This is because the Limited Partner does not actually have legal title to the real estate. Instead, the property is owned by the General Partner corporations, and the Limited Partnership holds a beneficial interest in the legal title of the asset.
- Tax Efficient Investment Vehicle – Limited Partnerships are called a flow-through entity, which makes them a tax efficient vehicle for real estate investments. Corporations are taxed on their income, and so are investors when their portion of earnings are received, which results in two levels of taxations. In contrast, LP investments are not taxed directly but rather only in the hands of the unitholder, resulting in just one level of taxation. In Canada, investors will receive a T5013 slip by March 31st of the following calendar year, which indicates any income (loss), capital gains, and distributions if applicable. This makes it a very simple process for investors to complete their required tax filings.
Investing in a Limited Partnership can be a great way for accredited investors to capitalize on the real estate market, without the requirement of large initial capital investment, or the time to manage these investments. However, there are lots of nuances and questions to consider when deciding on the ideal LP investment. For example, the type of LP fund to invest in, the length of the project, or any tax planning opportunities. At Finalyze CFO Services, we work with real estate investors to help them crush their financials goals with our tailored advisory, accounting, and tax services. Book a complimentary consultation with us to see how LP investments can be a great fit in your portfolio.