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.