Question
I am involved in a real estate deal with a partner. We are getting ready to sell the property and are in disagreement about how to calculate profit. This is the story:
Partner 1 put 10% down and the mortgage is in his name
Partner 2 put nothing down but paid everything 50/50 from the day of purchase (about 6 yrs ago)
They agreed that original 10% down represented Partner 1 having 10% more interest in the property. This is documented in the co-tenancy agreement.
They were both living in the house and put a co-tenancy agreement in place along with a quit claim deed to partner 2 for 45% interest in the house.
About 2 years ago, they decided to rent the house rather than continue living there together. They started an LLC to protect personal assets and therefore did a quit claim deed (both of them deeding the property to the LLC). They also have an operating agreement for the LLC which denotes the 45/55 split in ownership as capital contributions.
They now want to sell the property. In one scenario, it is a basic sell price minus debt divided by % of interest calculation:
Today's Est. Selling Price 550,000
Est. Closing Costs (33,000)
Mortgage pay off balance (270,000)
Net Profit 247,000
Partner 1 (55%) 135,850
Partner 2 (45%) 111,150
In the second scenario, partner 1 wants to calculate appreciation (sell price - purchase price) with a 45/55 split and then look at equity (purchase price - debt still owed) in terms of $ contributed.
Appreciation:
Today's Est. Selling Price 550,000
Original Purchase Price 400,000
Est. Gain on Sale 150,000
Est. Closing Costs (33,000)
Net Proceeds 117,000
Partner 1 55% Est. gain on sale 82,500
Partner 1 55% Est. closing costs (18,150)
Partner 1 55% net proceeds 64,350
Partner 2 45% Est. gain on sale 67,500
Partner 2 45% Est closing costs (14,850)
Partner 2 45% net proceeds 52,650
Equity:
Partner 1 10% Down 40,000
Partner 1 Loan payments made 45,000
Partner 1 Equity 85,000
Partner 2 Loan payments made 45,000
Partner 2 Equity 45,000
Total Partner 1 net proceeds plus equity = 149,350
Total Partner 2 net proceeds plus equity = 97,650
So which way is the "right" way to calculate each partner's profit? The co-tenancy agreement indicates profit will be calculated the 1st way. The operating agreement is a a pretty stock template only denoting the 45/55 split in capital contributions as an exhibit. Is there any precedent for calculating profit the 2nd way?
Answer
I hold two accounting degrees (frankly from more than a little while ago). That said, this isnt accounting advice, nor is it tax advice, nor legal advice. I have done hundreds of real estate deals, ranging from deals just like this one (two partners owning a house) to large commercial transactions. There are as many ways to calculate profit sharing as can be imagined, and almost all of these ways can either be argued or have some precedent. What appears to me to be happening here is that one partner is hoping to get more of the proceeds than the original agreement called for. The more salient question, in my view, is how would a court look at this circumstance, and again, while this is not legal advice, I do have sufficient experience to say that most likely a court would respect the original 55/45 agreement as it was agreed to by the partners. That is much more dispositive of the sharing question than the accounting method. If you would like to discuss this further I am available. Good luck.
