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Joint Ventures (or JVs) or syndications for real estate or other business ventures can be legally structured in essentially 5 ways:
a) a simple agreement where 2 or more parties jointly own an asset, or
b) a corporation that holds an asset and where shares are held by the operator (aka real estate expert) and the investor(s), or
c) in a trust, with a trustee and a trust agreement, or
d) undivided interests, or
e) in a limited partnership
What exactly are limited partnerships?
A LP is a preferred and commonly used way to structure a relationship between willing parties for a defined business venture. It is used to reduce risk, delineate responsibilities and share profits in a predetermined way. It is a well thought out, provincially regulated legal vehicle to raise capital for a venture without the expensive overhead of a public company. Each LP has one general partner ( GP ) who manages the assets and one of more limited partners.
An LP is like a marriage of multiple parties. Unlike a real marriage, it takes a sense of structure if 134 people marry. One party has the expertise for a certain business venture, the GP. The other parties have a desire to invest some of their capital for significant returns, limited risks and potential tax savings. The GP usually executes all activities of the business venture, reports regularly to the investors and shares the profits with the partners in a predetermined fashion. This is laid out in the LP agreement which states all the fees, terms, risks, timelines, equity split, split of losses and/or gains etc.
In essence, the GP-LP relationship is like a trustee-trust relationship: the trust (LP) holds all the assets, but the trustee (GP) on behalf of the trust (LP) manages the assets of the trust (LP).
Think of LPs as JVs on steroids .. or as fractional real estate !
The benefits to the investors / limited partners are:
a) limited risk - to the amount invested, even in case of a major disaster or law suit
b) clear delineation of responsibility - one party is the general partner which does all the work with a clearly defined fee structure and compensation; usually a combination of (hopefully small) fixed fees and variable, profit oriented share of profits (40% in our case, up to doubling your money, after you have received all your original investment)
c) allocation of 100% of losses for potential tax savings (usually in early years due to startup costs and depreciation)
d) clearly defined time line (up to 5 years in our case)
e) possibility to sell units to later partners at annually set prices (usually higher)
f) existing and well tested legal framework, with oversight by provincially appointed regulators
g) annual reporting
h) regular distributions, such as monthly or quarterly
Unlike a publicly traded or private company (often with a joint venture contract), capital gains, losses and/or income are flown through to the LP Unit holders in a pre-determined fashion, as described in the next section.
Tax Implications of an LP Investment - Distributions
The LP agreement that you signed (or intend to sign) provides that income and net taxable capital gains for purposes of the Tax Act will be allocated to LP Unit holders in the same proportion as distributions received by Unit holders.
Distributions may consist of the following for income tax purposes for which T5013 partnership income statements are issued, usually in the latter half of March for the previous tax year
a) distributions that are currently taxable. This portion of distributions for income tax purposes will be treated as regular taxable income (and not treated as dividends or capital gains) to each Unit holder
b) distributions that are treated as a dividend received from a Canadian or US subsidiary corporation. As such, it will be subject to a preferential tax treatment that all dividends from Canadian corporations receive (subject to the dividend tax credit)
c) distributions that represent your portion of capital gains allocated to you relating to gain on the sale of a property in the year, if any.
Please note that of the portion reported as capital gains on your tax return, only 50% of this is included in the calculation of your taxable income. The nontaxable portion of the capital gain is not deducted from the adjusted cost base of your Units.
d) distributions that are not currently taxable and will be treated for income tax purposes as a return of capital Accordingly, this currently non-taxable portion will reduce the adjusted cost base of the Units owned by each LP Unit holder. If, after deducting the return of capital portion, your adjusted cost base of your Units is a positive amount, no portion of the return of capital will be taxable. If, however, after deducting the return of capital, your adjusted cost base of your Units is a negative amount, you will realize a capital gain equal to the negative amount and your resultant adjusted cost base of your Units will be nil. LP Unit holders should consult their tax advisors with respect to any questions they may have concerning tax matters.
Risks when investing in an LP
Like any JV (in real estate or business) the GP has a lot of control over decision making. The GP and/or its shareholders or managers should have deep experience in the venture space, as well as must be trustworthy individuals as large $ amounts are at stake. All the risks are usually outlined in the LP agreement, and in our case it spans almost 5 pages. Sometimes an LP states time lines or exit options, and sometimes it doesn`t. Many reckless syndicators have exploited the innocence of the investing public as well as ridden the bouyant real estate market that camouflaged their inexperience or questionable character traits. As Warren Buffet once said "Once the tide goes out, you know who is swimming naked." Many naked swimmer were seen recently in the real estate ebb !
Tax Implications of a LP Investment - EXAMPLE ONLY
Let's use an example of an investment of $100,000 which represents 5% of an overall $2,000,000 pool of investment. With this the LP buys a building worth $8,000,000 with a mortgage of $6,000,000 and a net operating income (NOI i.e. income of the building after all expenses but before mortgage payments) of $560,000/years (7% CAP)
Of the $560,000 we pay $460,000 in mortgage payments, out of which $360,000 is interest (6% on $6M) and $100,000 in principal reduction. Hence, we have a cash flow of $100,000 or 5% of the $2,000,000 investment.
Initially, we may flow out 100% or $100,000 to investors, or 5% annually, or a quarter thereof quarterly. After you have received all your initial money back, usually after a few years; after we have sold some and/or have re-financed the rest based on a higher value, the GP takes X% of the upside as the GP`s profit share, and the remaining 100-X% is flown to investors until the LP is closed or you decide to exit.
In addition to this cash-flow you may also get a loss allocation. Unlike the income, the losses get allocated 100% to LP Unit holders, as per the offering memorandum that you signed or intend to sign. In our example, for your $100,000 investment you get 5% of the losses the LP generates.
Let's assume the buildings are worth $5,000,000 and the land is worth $1,000,000. Land does not get depreciated, just buildings. Thus, the annual building depreciation is 4% of $5,000,000 or $200,000 (if held for the entire year, less in year one). Thus, our income/loss is calculated as follows: $100,000 cash flow plus $100,000 in principal reduction minus $200,000 depreciation, i.e. we have no loss. Thus, you may get non-taxable cash-flow and a loss allocation. Frequently, these potential losses are higher in year one as the cash-flow is not yet as strong and the expenses higher due to upstart cost and building renovations.
Liquidity Events
Besides cash-flow from operations there may be major liquidity events. What is a major liquidity event: it is either a sale of a building or a re-financing of a building. If augmented by other cash-flow rich projects, possibly some condo conversion candidates, regular quarterly cash-flow is a very realistic and reliable target !
Costs and Benefits of an LP & RRSP Eligibility
Costs for a simple LP is about $1500 plus $3000 to $6000 for an LP agreement, depending on complexity. The costs are slightly higher to open compared to a corporation, but not much .. maybe 50%. Once larger groups of non-accredited investors are targetted as investors you must have an Offering Memorandum (OM) that costs between $15,000 and $35,000 to develop. The benefit is now that eligible investors in certain provinces can invest with you. Like real estate, LP units cannot[/u] be held directly in your RRSP. A separate legal structure is required to hold real estate or LP units indirectly to make your investment RRSP eligible. I may post elsewhere on the securities issues [aggregate acquisition cost, accredited investors, eligible investors, ineligible investors, exemptions, RRSP eligibility ..]
Note / Caution
This is an example only, and does not constitute tax or legal advice. Tax advice can only be given by an authorized professional such as a chartered accountant, lawyer, certified financial planner or like authority. Numbers, returns or profits are not guaranteed and are an example only.
a) a simple agreement where 2 or more parties jointly own an asset, or
b) a corporation that holds an asset and where shares are held by the operator (aka real estate expert) and the investor(s), or
c) in a trust, with a trustee and a trust agreement, or
d) undivided interests, or
e) in a limited partnership
What exactly are limited partnerships?
A LP is a preferred and commonly used way to structure a relationship between willing parties for a defined business venture. It is used to reduce risk, delineate responsibilities and share profits in a predetermined way. It is a well thought out, provincially regulated legal vehicle to raise capital for a venture without the expensive overhead of a public company. Each LP has one general partner ( GP ) who manages the assets and one of more limited partners.
An LP is like a marriage of multiple parties. Unlike a real marriage, it takes a sense of structure if 134 people marry. One party has the expertise for a certain business venture, the GP. The other parties have a desire to invest some of their capital for significant returns, limited risks and potential tax savings. The GP usually executes all activities of the business venture, reports regularly to the investors and shares the profits with the partners in a predetermined fashion. This is laid out in the LP agreement which states all the fees, terms, risks, timelines, equity split, split of losses and/or gains etc.
In essence, the GP-LP relationship is like a trustee-trust relationship: the trust (LP) holds all the assets, but the trustee (GP) on behalf of the trust (LP) manages the assets of the trust (LP).
Think of LPs as JVs on steroids .. or as fractional real estate !
The benefits to the investors / limited partners are:
a) limited risk - to the amount invested, even in case of a major disaster or law suit
b) clear delineation of responsibility - one party is the general partner which does all the work with a clearly defined fee structure and compensation; usually a combination of (hopefully small) fixed fees and variable, profit oriented share of profits (40% in our case, up to doubling your money, after you have received all your original investment)
c) allocation of 100% of losses for potential tax savings (usually in early years due to startup costs and depreciation)
d) clearly defined time line (up to 5 years in our case)
e) possibility to sell units to later partners at annually set prices (usually higher)
f) existing and well tested legal framework, with oversight by provincially appointed regulators
g) annual reporting
h) regular distributions, such as monthly or quarterly
Unlike a publicly traded or private company (often with a joint venture contract), capital gains, losses and/or income are flown through to the LP Unit holders in a pre-determined fashion, as described in the next section.
Tax Implications of an LP Investment - Distributions
The LP agreement that you signed (or intend to sign) provides that income and net taxable capital gains for purposes of the Tax Act will be allocated to LP Unit holders in the same proportion as distributions received by Unit holders.
Distributions may consist of the following for income tax purposes for which T5013 partnership income statements are issued, usually in the latter half of March for the previous tax year
a) distributions that are currently taxable. This portion of distributions for income tax purposes will be treated as regular taxable income (and not treated as dividends or capital gains) to each Unit holder
b) distributions that are treated as a dividend received from a Canadian or US subsidiary corporation. As such, it will be subject to a preferential tax treatment that all dividends from Canadian corporations receive (subject to the dividend tax credit)
c) distributions that represent your portion of capital gains allocated to you relating to gain on the sale of a property in the year, if any.
Please note that of the portion reported as capital gains on your tax return, only 50% of this is included in the calculation of your taxable income. The nontaxable portion of the capital gain is not deducted from the adjusted cost base of your Units.
d) distributions that are not currently taxable and will be treated for income tax purposes as a return of capital Accordingly, this currently non-taxable portion will reduce the adjusted cost base of the Units owned by each LP Unit holder. If, after deducting the return of capital portion, your adjusted cost base of your Units is a positive amount, no portion of the return of capital will be taxable. If, however, after deducting the return of capital, your adjusted cost base of your Units is a negative amount, you will realize a capital gain equal to the negative amount and your resultant adjusted cost base of your Units will be nil. LP Unit holders should consult their tax advisors with respect to any questions they may have concerning tax matters.
Risks when investing in an LP
Like any JV (in real estate or business) the GP has a lot of control over decision making. The GP and/or its shareholders or managers should have deep experience in the venture space, as well as must be trustworthy individuals as large $ amounts are at stake. All the risks are usually outlined in the LP agreement, and in our case it spans almost 5 pages. Sometimes an LP states time lines or exit options, and sometimes it doesn`t. Many reckless syndicators have exploited the innocence of the investing public as well as ridden the bouyant real estate market that camouflaged their inexperience or questionable character traits. As Warren Buffet once said "Once the tide goes out, you know who is swimming naked." Many naked swimmer were seen recently in the real estate ebb !
Tax Implications of a LP Investment - EXAMPLE ONLY
Let's use an example of an investment of $100,000 which represents 5% of an overall $2,000,000 pool of investment. With this the LP buys a building worth $8,000,000 with a mortgage of $6,000,000 and a net operating income (NOI i.e. income of the building after all expenses but before mortgage payments) of $560,000/years (7% CAP)
Of the $560,000 we pay $460,000 in mortgage payments, out of which $360,000 is interest (6% on $6M) and $100,000 in principal reduction. Hence, we have a cash flow of $100,000 or 5% of the $2,000,000 investment.
Initially, we may flow out 100% or $100,000 to investors, or 5% annually, or a quarter thereof quarterly. After you have received all your initial money back, usually after a few years; after we have sold some and/or have re-financed the rest based on a higher value, the GP takes X% of the upside as the GP`s profit share, and the remaining 100-X% is flown to investors until the LP is closed or you decide to exit.
In addition to this cash-flow you may also get a loss allocation. Unlike the income, the losses get allocated 100% to LP Unit holders, as per the offering memorandum that you signed or intend to sign. In our example, for your $100,000 investment you get 5% of the losses the LP generates.
Let's assume the buildings are worth $5,000,000 and the land is worth $1,000,000. Land does not get depreciated, just buildings. Thus, the annual building depreciation is 4% of $5,000,000 or $200,000 (if held for the entire year, less in year one). Thus, our income/loss is calculated as follows: $100,000 cash flow plus $100,000 in principal reduction minus $200,000 depreciation, i.e. we have no loss. Thus, you may get non-taxable cash-flow and a loss allocation. Frequently, these potential losses are higher in year one as the cash-flow is not yet as strong and the expenses higher due to upstart cost and building renovations.
Liquidity Events
Besides cash-flow from operations there may be major liquidity events. What is a major liquidity event: it is either a sale of a building or a re-financing of a building. If augmented by other cash-flow rich projects, possibly some condo conversion candidates, regular quarterly cash-flow is a very realistic and reliable target !
Costs and Benefits of an LP & RRSP Eligibility
Costs for a simple LP is about $1500 plus $3000 to $6000 for an LP agreement, depending on complexity. The costs are slightly higher to open compared to a corporation, but not much .. maybe 50%. Once larger groups of non-accredited investors are targetted as investors you must have an Offering Memorandum (OM) that costs between $15,000 and $35,000 to develop. The benefit is now that eligible investors in certain provinces can invest with you. Like real estate, LP units cannot[/u] be held directly in your RRSP. A separate legal structure is required to hold real estate or LP units indirectly to make your investment RRSP eligible. I may post elsewhere on the securities issues [aggregate acquisition cost, accredited investors, eligible investors, ineligible investors, exemptions, RRSP eligibility ..]
Note / Caution
This is an example only, and does not constitute tax or legal advice. Tax advice can only be given by an authorized professional such as a chartered accountant, lawyer, certified financial planner or like authority. Numbers, returns or profits are not guaranteed and are an example only.
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