Crowdfunding for real estate continues to gain momentum. As a result, certain important tax questions arise. One such question relates to dealing with state tax consequences on equity deals and whether investors are required to file income tax returns (and of course pay income tax) in the states where the real property is located or in the taxpayer’s state of residency. This can be a complex area.
Federal Tax Consequences
First, it is important to understand federal tax issues. Most real estate crowdfunding entities utilize state chartered limited liability companies (or “LLCs”) that are most likely taxed as partnerships. The LLC files a partnership tax return that includes the revenues (or income) and expenses of the entity. The partnership itself does not pay tax at the federal level. It merely passes through the profits or losses of it’s operations to the partners based on the allocation in the operating agreement. At the end of the year, the partnership will issue a K-1 to the partners to assist with their respective tax returns. This part is relatively straightforward.
State Tax Consequences
Now that we understand the federal tax issues, let’s take a look at state tax issues. These can be a bit more complex. Generally speaking, when a partnership actively conducts business activities or has “source” income in a specific state, that state will tax the individual partners. In most situations, the partners are required to file state income tax returns and pay tax on their respective share of partnership income. It does not matter what state the partners reside in. In addition, taxpayers must generally report all their income (regardless of where it was earned) in their state of residency and pay income tax.
With both states taxing the source income, it would seem to give rise to double taxation. So to avoid any double taxation issues, the state of residency will typically provide a credit for taxes paid to the other source state. The result is the taxpayer may end up paying a tax rate that is comparable to the state with the highest tax rate.
So as a general rule, the real estate crowdfunding investor may need to file a tax return in any state that the crowdfunder has real estate operations or activities. But there are some exceptions and exclusions to consider:
- When you consider the 50 states in the U.S., there are 43 that impose a state income tax. In these state you will typically be required to file, but in the 7 states with no income tax you will generally not have to file a tax return. It is important to note that some states do impose transfer taxes and other tax assessments.
- Many states do have a little known alternative to paying tax at the partner level. They will allow the partnership to file a tax return and pay tax on behalf of the partners based on what is called a composite (or “group”) filing. This tax is normally calculated at the highest state tax rate and does not provide for graduated tax rates. This is typically not a favorable option.
- Each state can have minimum filing requirements. As an example, many states will not require you to file a state return unless you have earned a certain amount of source income in the state (say for example $2,000). If the nonresident investor has earned less than this specified amount he or she would not have to file a tax return in that state.
To add another layer of complexity, many states impose withholding requirements on pass-through entities such as partnerships. So a partner who does not reside in the state in which the real estate is located may find that some of the cash distributions are being withheld by the partnership entity and remitted to the source state. Once the investor files a state tax return he will often have a portion of the withholding refunded to him. However, this withholding ensures the collection of tax at the state level.
States can differ on how the withholding is calculated and remitted. Many calculate it based on the amount of distributable income as evidenced by the state K-1 rather than the actual cash distributions made. States also can differ on when the withholding payments are made – annually or quarterly. Some states that have a withholding will not require it if the partner’s pro rata share of income is less than a set threshold amount (as an example $1,000 to $3,000).
But if you are overly concerned about filing and paying tax in many states, there are a couple points to consider. As a result of depreciation expense, the partnership’s taxable income will often be lower than cash distributions you will be receiving. You may find that your K-1 even reflects a loss. So many real estate crowdfunding investors may realize that they are not paying taxes to a source state and conceivably not required to file a state tax return (aside from reflecting a net operating loss carryforward).
So if you invest in a crowdfunding real estate syndication, how do you know if you are subject to taxes or withholding in a given state? The answer is not as tough as you may have thought. A state specific K-1 will be issued to the partners which will reflect their applicable share of state sourced income and withholding. But make sure that you engage a CPA or other tax professional who understands state specific tax issues for partnerships.
Understanding state tax issues relating to real estate crowdfunding can be tough. As an investor, please ensure that you do your own due diligence and consult with an experienced CPA or tax professional to ensure that your state income tax filings are accurate and complete.
When it comes to crowdfunding real estate, there are many questions surrounding state taxes. In a partnership, the sponsor may be required to make distributions to cover investor state tax liabilities. Many states have recently tightened regulations on how and when withholding is required at the partner level.
One issue that investors don’t often understand is that if they are a partner to a specific project in a state they may have tax liabilities and filing responsibilities in that state. Even though an investor may not live in a specific state, since they are subject to pass-through income tax provisions, each state will generally tax them based on source income generated in that state. So one common question of investors in syndications is whether or not they need to file a tax return in each of the state that the syndication operates in. Well the answer is…it depends.
Remember that an investor in a syndication is a partner in the operating entity. In general, if a partnership has operating activities in a given state then that state has the right to tax the partner on his or her share of partnership income. So in theory you may find that you would need to file in any state that the syndication has real estate operations. However, each state has separate minimum filing requirements. For example, many states will not require you to file unless you have earned a certain amount of income in the state (say for example $2,000). So if you have earned less than this amount you would not have to file a return in that state.
As a result of depreciation, your taxable income will likely be substantially lower than any distributions you may receive, so many investors would not be subject to state filing requirements. For the investor, make sure that you verify both resident and non-resident filing requirements as they often can vary from state to state. When you receive your K-1 package at the end of the year it will have the amount allocated to each state. This part of the process can be difficult, so that is where the use a tax professional can help.
To further complicate the issue, several states are now imposing withholding requirements on pass-through entities for investors. So for partners who live outside of the state in which the real estate is located they may find that some of their distributions are being withheld by the partnership and remitted to the state. Once they file a state tax return they will often have this money refunded to them (or possible owe more in tax). However, they will still have to file a state tax return further complicating their tax situation.
When there is a state withholding requirement, partnership agreements will typically allow the sponsor to offset the state withholding amounts against distributions otherwise made to investors. Often when the partnership is not passing through income to investors, the withholding is not required. But if there is a withholding requirement and no distributions are being made to investors, the agreement will often allow the sponsor to offset any withheld amounts against future partner distributions or even require that investors pay the required amount to the operating entity.
Tax withholding is also required at the federal level (by the IRS) for foreign partners. With the increase in foreign investors in US real estate, this is becoming a big issue in recent years. A partnership that has income effectively connected with a U.S. trade or business (or income treated as effectively connected) must pay a withholding tax on the effectively connected taxable income that is allocable to its foreign partners. The withholding tax rate for effectively connected income allocable to non-corporate foreign partners is 39.6%, but remains at 35% for corporate foreign partners, for tax years beginning after December 3, 2012.
Understanding State Taxation of Tangibles & Intangibles
Federal tax law is difficult enough to understand. But state tax law can be even more cumbersome, especially considering the variation from state to state. Upon closer examination though, there are some general themes that one can examine as it relates to state taxation. The goal herein is to examine a few of these differences.
First, let’s understand that most states have some form of individual income tax. However, below is a list of the seven states that do not have an individual income tax. Some states do impose other taxes and assessments:
- South Dakota
In addition, the following are states with limited income tax:
- New Hampshire (only taxes interest, dividends and business profits)
- Tennessee (only taxes income received from stocks and bonds)
For states with an individual income tax, the state of domicile will generally tax an individual based on worldwide income. However, that same state will generally only tax a nonresident based on in-state sources. To avoid double taxation, the state of residence will often provide a credit paid to the nonresident state.
Tangibles and Intangibles
Since states will typically tax a trade or business operating in the state (including a real estate holding), many states have determined that income from assets that are managed for long-term capital appreciation and income do not rise to the level of a trade or business, which is different from short term trading activities.
When we examine investment activities and try to understand how they are taxed at the individual level, we need to examine the differences between “tangibles” and “intangibles”. Tangibles are typically defined as real estate activities, tangible personal property, compensation for services and business activities (a CPA firm, a real estate brokerage, etc).
But intangibles are classified as something different. They represent a right or possession of a nonphysical or abstract nature that has value, or a financial asset that has no intrinsic value but that represents value. Intangible property includes but is not limited to patents, copyrights, licenses, trademarks, business goodwill, covenants not to compete, securities, bonds, notes, and insurance policies.
Now that we understand the difference between tangibles and intangibles let’s understand how they are taxed. Tangible assets are consider source income and are normally taxed by the state in which the property is located. However, intangibles (such as promissory notes) are often not taxed by a source state and taxed by taxpayer’s state of residence.
Partnership Tax Issues
Partners in partnerships have similar state tax questions. When individual taxpayers invest in partnerships that have operations in multiple states, there is always the question of whether the taxpayer is subject to tax in the states where the partnership has activities or generates income. If a partnership operates an active trade or business, the state will generally impose a tax on the partner based on their share of the income generated in the state.
Investment partnerships can be a different issue. If a partnership’s activities are limited to merely investing the capital of its partners and not actively engaging in business activities, there has been some debate as to whether the investment activity creates state filing responsibilities and related tax liabilities for the partners. This type of partnership is defined as an “investment” partnership.
There are many states that have initiated safe harbor provisions that protect certain types of investment partnerships and non-resident partners from state taxation. Each state will apply these rules differently, but the goal is generally to protect investors in partnerships that invest specifically in intangible assets. The list of states is as follows:
- New Jersey
- New Mexico
- New York
- North Carolina
Many states have used the term “qualifying investment securities” which is defined by a specific list of intangibles. Most statutes of course exclude real estate from the list of qualifying investments. Accordingly, if real estate is owned by a investment partnership it would typically disqualify it should income from the real estate or cost of the assets be 10% or more of the overall partnership income or assets, respectively.
Investors need to consider state taxation issues as it relates to tangibles and intangibles. Consideration should also be made when funding an investment partnership. Be careful because states can apply the issues discussed in this article differently. If properly structured and operated pursuant to state requirements, an investment partnership can limit exposure to multistate tax issues. However, state taxation is always subject to change, so make sure that you discuss any specific state tax issues with a qualified CPA or tax professional.