RealTown Words

A partnership agreement in which one person (called the general partner) or group of persons organizes, operates, and is responsible for the entire partnership venture. The other partnership members are merely investors and have no say in the organization and direction of the operation. These passive investors, called limited partners, share in the profits and compensate the general partner for his or her efforts out of such profits. Unlike a general partnership, in which each member is responsible for the total losses (if any) of the syndicate, each limited partner stands to lose only as much as he or she invests—usually nothing more. The general partner, then, is totally responsible for any large-scale losses incurred by the investment. Note, however, that when a limited partner receives cash distributions, either upon dissolution of the partnership or during the investment period, and the partnership’s creditor obligations remain unsatisfied, the limited partner may be required to return such distributions in order to satisfy creditor claims.

The limited partnership has been popular in the syndication of real estate ventures because it permits investors with only small amounts of capital to participate in real estate projects that require much capital and management expertise, restricts their potential liability to their contribution, and permits “pass-through” of tax benefits of real property ownership.

The organizer of a limited partnership must take care that the IRS does not treat the partnership as an association taxable as a corporation (resulting in double taxation of income). An experienced real estate tax attorney should carefully draft the limited partnership agreement to assure the partnership of the appropriate tax status, in which all profits or losses pass through the partnership and are taxed only at the individual level. Partnership status thus combines the direct tax advantages of an immediate write-off of losses, if any, plus the elimination of a second tax at the corporate level.

Many states have adopted the Uniform Limited Partnership Act to regulate the formation and operation of limited partnerships. The Act requires that a certificate listing the names and investments of each participant in the partnership be filed at the business registration division or county recorder’s office. A limited partnership is not effective until a certificate is filed. Because a limited partner’s interest is personal property, his or her death does not dissolve the partnership. Also, judgment and federal tax liens against a partner do not affect the partnership property, although they may affect the partner’s right to receive profits.

Under the 1986 Tax Reform Act, limited partnerships are subject to the passive loss rules. Losses from limited partnerships can be used only to offset income from other “passive investments,” and cannot be used to shelter income from salary, interest, and dividends as under previous law. Passive investments are defined as any trade or business in which the taxpayer does not materially participate and any rental activity, whether or not the taxpayer materially participates. Any interest held by a limited partner is automatically treated as passive.

Because the sale of a limited partnership interest involves the sale of a security, it is subject to state and federal laws dealing with the sale of securities and, unless exempt, must be registered with the SEC and the appropriate state securities authorities.