Investing with Friends and Family
This article was contributed by Kenina Court, our favourite accountant and tax advisor. Kenina talks about co-investing in buy and hold properties. Short term joint ventures are a bit different and we have a separate article about what you should consider here.
With the currently high loan to value ratio (LVR) requirements for investment property, it is more likely than ever that people will want to get together with others to buy their investment property together. If you go down this track, what are some of the things you should consider?
There are two broad issues for you to consider:
- Tax and Legal Structures
Tax and Legal Structures
How should you own your property investments? What should you think about from a tax point of view? You have some of options to consider:
- General Partnership – this is the cheapest and easiest option as no formal documentation is required, just registration of the partnership with IRD. Partners can be any type of entity but most commonly, are individuals. Unless there is a formal agreement, profits and losses are distributed equally between the partners. However, there is a fish hook in that the partners are ‘jointly and severally liable’ which means any partner can be liable for anything that goes wrong in the partnership regardless of whether or not they knew about it and regardless of their share in the partnership. The partner who ends up paying is the partner who can pay regardless of the number of partners in the partnership. Needless to say, this would not be the recommended structure in a group situation.
- Company – a company, while requiring some formal documentation, should be the first type of entity to consider in a group situation. A company stands between the directors and shareholders and the rest of the world and it carries the liability, rather than the directors and shareholders. Profits in a standard company are distributed in accordance to the percentage of shares owned, whereas losses in a standard company are retained in the company to be offset against future year profits. Assuming the criteria is met, a company can apply for ‘look through company’ status which means that profits and losses are passed through to the shareholders on a pre-tax basis relative to the percentage of shares owned.
- Limited Partnership – a limited partnership has two parts to it – a general partner and the limited partners. The general partner looks after the day to day operations of the partnership and carries the liability for the partnership. The limited partners, like in a general partnership, can be any type of entity, but are not allowed to be involved in the day to day running, and as long as they aren’t, will not carry any of the liability. A limited partnership, unlike a general partnership, requires a formal limited partnership agreement and therefore, is relatively expensive to set up. This agreement says on what basis profits and losses are to be distributed.
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This part is the part that is often completely missed, simply because most people don’t think about it – what happens when things go wrong? And things will go wrong, because that’s life. Being in business with partners is very much like marriage – it’s easy to jump into bed together, but hard to separate. The old adage of plan for the worst and expect the best, is very much true in business. Sometimes, it may not even be that the business had something go wrong in it. It could be that one of the partners has had something change in their personal life that now impacts the lives of everyone around them, including their business partners.
My experience is that the hardest times are when people have done no planning for when things go wrong. Something happens and all of a sudden, everyone is trying to work out what to do. When someone's back is up against a wall it’s not the best or easiest time to try and work out what is in the best interests of everyone, particularly when it might be your back that is up against the wall.
The best way to plan is to do the thinking about what could go wrong, when you first start out together in a venture (ideally before you even start!). That is when there is nothing at risk because nothing has yet happened. Think of all the things that could go wrong or change and discuss how you would like to see them solved. It can be tough, but you get everything out on the table and you see everyone’s expectations and values. You can then see if those mesh with your own, and if they don’t, then that’s a great place to start talking.
All of this should then culminate in some sort of agreement that gets drawn up and each person signs to show that they will agree to abide by it. This agreement could be the partnership agreement or a shareholders’ agreement. There’s no rule that says it has to be drawn up by a lawyer, but you are likely to get a much better result if you do use a lawyer with experience in this area as they will make sure you have covered all the bases.
And last but not least, there is no ‘one size fits all’ for structures and agreements. People are individuals and as such, their structures and agreements should be tailored to their specific requirements. Be sure to talk with someone with expertise in this area to ensure you put in place what’s right for you.