Must-Have Terms for Your Operating Agreement

Your operating agreement isn't just paperwork—it's the foundation that determines whether your real estate investment will survive an IRS audit. Miss these critical terms, and the IRS can rewrite your entire partnership structure, potentially destroying any promoted interests or special profit-sharing arrangements you've worked so hard to negotiate.

Here's the uncomfortable truth: most operating agreements are missing language that could save your deal. Let's break down what you absolutely need to protect yourself.

Capital Account Maintenance

Think of a capital account as your partnership's financial scoreboard. It tracks what each partner has contributed, what income they've been allocated, what losses they've absorbed, and what distributions they've received.

Here's what matters: this isn't the same as your tax basis. Many business owners confuse these two concepts, but they serve different purposes. Your capital account shows your economic stake in the partnership, while tax basis determines what losses you can actually use on your personal return.

The IRS requires partnerships to maintain these accounts, but here's the kicker—most CPAs don't do this automatically. It's not typically included in standard tax preparation services, so make sure this responsibility is clearly defined in your agreement and someone is actually doing it.

Liquidation Rules That Match Reality

Your operating agreement must specify that when the partnership ends, distributions follow positive capital account balances. This sounds technical, but it's actually simple: the cash should go to partners who have economic gains, not those who have economic losses.

Without this language, you might see agreements that say distributions will be made according to "final hurdle ratios" or other formulas that ignore actual economic performance. This mismatch between cash flow and economics is exactly what triggers IRS scrutiny.

The Deficit Restoration Safety Net

This is where it gets interesting. A Deficit Restoration Obligation (DRO) allows your capital account to go negative—meaning you can receive more tax losses than you've actually contributed cash. But there's a catch: if the partnership dissolves and your account is negative, you're obligated to write a check to bring it back to zero.

Don't want that risk? You can use a Qualified Income Offset (QIO) instead. This automatically allocates phantom income to bring negative accounts back to zero. It's safer but means you might get taxed on income you didn't actually receive in cash.

Minimum Gain Protection for Leveraged Properties

If you're using debt to finance your real estate (and who isn't?), you need minimum gain chargeback language. This concept allows partners to take losses even after they've used up their cash investment, using the property's debt as additional basis for tax purposes.

Here's a simple example: You buy a $1 million property with $300K cash and $700K debt. After depreciation brings the property's book value below the loan amount, that difference becomes "minimum gain" that provides additional basis for loss allocations.

The chargeback provision ensures that if you sell the property, partners who benefited from these extra losses get allocated income to balance things out.

Why This Actually Matters

Missing any of these terms gives the IRS the right to reinterpret your partnership however they see fit—potentially up to three years after you sell a property. That promoted interest you've been counting on? Gone. Those loss allocations that saved you thousands in taxes? Redistributed.

Even without an IRS audit, sophisticated investors who understand these rules can create legal headaches if your K-1s don't match what your operating agreement actually says.

Your Next Step

Pull out your operating agreement and search for these terms. If they're missing or unclear, it's time for a conversation with both your attorney and your CPA. The cost of fixing this now is minimal compared to the potential damage during an audit.

Remember: your operating agreement should match what you promised investors. If there's a disconnect between your marketing materials and your legal documents, you're sitting on a time bomb that could explode when you least expect it.