The Importance of a Real Estate Operating Agreement

So, why is a Real Estate Operating Agreement important?

One of the most important documents often overlooked by real estate partners establishing an LLC entity is the Operating Agreement. This legal document governs how the members of the entity will manage the LLC.

It includes:

1. How distributions will be handled

2. The allocation of profits and losses

3. Capital contribution requirements

4. Other items needed to internally operate the entity as agreed by the partners

Since LLCs are filed with each individual state, and regulations vary from state to state, we encourage all of our clients to use legal counsel familiar with the specific state the entity will be filed in. However, as accountants, it is also important to review clients’ operating agreements because many of the items found within elaborates how the LLC will be accounted for and treated for taxes. Our goal is to ensure our clients clearly understand how their invested money will be used, recouped, and impact them come tax time.

For real estate investors, we review areas of importance related to acquiring, managing, and disposition of their property. Below are examples of five areas we typically review and detail for our clients:

1. Who is the Tax Matters Partner (TMP)? All operating agreements should establish which of the LLC members will be deemed the tax matters partner. The TMP ensures that tax filings and proper K-1s are prepared and distributed to each partner. It is important to establish the TMP so that partners in complex partnerships have one point of contact when tax questions arise.
2. What are the capital contributions & capital call requirements? When an LLC is created, having the capital needed from each partner detailed out to fund a property or business acquisition helps eliminate surprises. This is where many partner disputes arise if it is not properly laid out from the beginning. Additionally, establishing how capital calls for additional funds would be requested from partners is important so investors can anticipate necessary funds if a cash deficit were to occur. 
3. What is the priority for distributions of funds? As an asset or business generates cash, knowing the priority for the use of funds is key to understanding when an investor will receive distributions. Normally, we would like to see the funds be used to first pay off current debt & liabilities (mortgage payments, accrued interest, operating payables) then return of invested capital followed by profit distributions. This will ensure you will at least get your money back with the cash flow income first. Everything after capital is return on investment.  
4. How will the profits & losses be allocated? The percentage of ownership is normally how income or losses are allocated, however, partners can choose to adopt different allocations to provide flexibility to partners based on capital or resources they are bringing to the table. Reviewing this section is important to properly prepare or review an investor’s K-1. 
5. How would proceeds be handled in case of a dissolution? Partners don’t like discussing the topic of failing, but agreeing to how an LLC will be managed in a worse case scenario can build trust between partners and save on legal costs in the future should an asset need to be sold and funds distributed out. This area of the operating agreement should detail how cash would be handled. 

If you have an operating agreement you would like reviewed, feel free to contact us. We would be happy to review it and bring clarity to you.