By Jones Osborn II

The limited partnership is sometimes used for real estate investments. It has the favorable tax attributes of a general partnership, while at the same time providing limited liability for the limited partners. Sometimes the limited partners' liability isn't as limited as you might think, however.

A Typical Example. Let's look at the typical use of a limited partnership in the context of a real estate investment. Suppose that a promoter wants to form a group of investors to purchase a large parcel of land. The seller of the land might want a $250,000 down payment, with the balance payable over ten years. The promoter gets the seller to agree that the promissory note for the balance of the purchase price will be "non-recourse," meaning that the seller's only remedy in the event of default is to foreclose on the land. In other words, he can't sue anyone personally to collect on the balance of the note, he can only take back the land.

Our promoter forms a limited partnership to purchase the land. The promoter will be the general partner. He seeks investors to put up the money, each of whom will become a limited partner.

When marketing limited partnership interests, he proudly informs each prospective investor that he negotiated a non-recourse note for the deferred balance of the purchase price so that in the event (unlikely, of course) that the real estate market collapses, the partnership can simply walk away from the investment without further liability.

He also points out that each limited partner will be required to contribute his or her share of the annual payments needed to meet the payments on the non-recourse promissory note. Because these capital contributions are required by the partnership agreement pursuant to a specified schedule, each investor will have the comfort of knowing that every other investor will have a legal obligation to pay his or her share of the note when it comes due.

This sounds pretty good. Every investor will have the duty to make his share of the annual payment so that the partnership isn't left short if one or two investors decide that they don't want to make payments any more. And if things get really bad, the partnership can just decide to walk away from the investment without any further liability on the purchase money note.

When the Market Crashes. Unfortunately, there's one big problem. Let's assume that the worst happens, and the real estate market crashes. The property is no longer worth even the unpaid balance of the note. As a result, the general partner informs the investors that the partnership is dropping the property and will make no further payments. He tells them that even though they will lose all the money they have contributed, at least they won't have to keep paying the note.

The seller of the property has good counsel, however, and instead of just foreclosing on the property when the payments stop, he forces the limited partnership into bankruptcy and has a trustee appointed to assume control of the partnership's assets. Upon reviewing the situation, the trustee immediately notices that each limited partner has agreed to make certain specified capital contributions to the partnership. The trustee has a duty to collect these funds and to use them for the benefit of the partnership's creditors--in this case, the holder of the non-recourse note. So he sues the limited partners, and they have no choice but to keep paying into the partnership the money necessary to make the payments on the non-recourse purchase money note in accordance with the original schedule of required capital contributions. The unfortunate result, from the investors' point of view, is that a non-recourse purchase money note has in essence been converted into a full-recourse note that they have to continue to pay even though they would prefer to walk away from the property and take their loss.

You may be wondering if a smart general partner can avoid this problem when he decides it's time to walk away simply by amending the partnership agreement to provide that no further capital contributions are required. The answer is that sometimes he can, and sometimes he can't. If the certificate of limited partnership was filed prior to the purchase of the property, a subsequent amendment to the certificate generally has no effect on any pre-existing creditors of the partnership. In that case, the limited partners have to make the payments. There are also other theories a creditor can use to attack such a last-minute amendment. In addition, it should be mentioned that there are various defenses the general partner's counsel can employ to try to defeat the creditor's strategy. All things considered, it is difficult to say who will prevail. Each case depends on its own facts and circumstances, but the possibility clearly exists that the limited partners will be required to continue their payments.

The Lesson. If you invest in a limited partnership, look carefully at any claim that the debts of the partnership are non-recourse. If you agree to make capital contributions to the partnership, there is a good chance you will be required to make these contributions if the partnership decides to walk away from its obligations, even if those obligations are non-recourse. If in doubt, seek advice from counsel familiar with real estate, limited partnership and bankruptcy issues. Don't automatically assume that the liability of a limited partner is the same as that of a shareholder in a corporation.