Real estate crowdfunding is a form of real estate syndication. This form of investment has become more common in recent days, but investors often get confused on the tax treatment. The tax treatment is certainly different from other forms of investments, like stocks and bonds. But the issues can be simplified, so let’s take a closer look.
The first thing to understand is that an equity investor in a syndication is actually a partner in partnership. Investments in syndications will generally be considered “passive” activities. For a real estate entity there are typically two sources of passive activities: (1) rental activities (rentals of apartments, commercial buildings, retail centers, etc.), unless the taxpayer is classified as a real estate professional; or (2) a business (flips, real estate development, etc.) in which the taxpayer does not materially participate. Passive activities will generate either passive income or passive loss. Interest, dividends, annuities and gains on stocks and bonds are not considered passive activities.
The K1 that the investor receives at the end of the year from the syndication will either report income or loss (as well as other items). The investor will then include this on his or her tax return, typically following the rules for passive activities. If the K-1 reports a loss then the investor has a passive loss. Passive losses can only be offset against passive income (subject to certain exceptions).
When combining all passive activities, if the investor has a net passive loss, then the remaining net loss is effectively “suspended” whereby they are carried forward to future years and subject again to the passive activity rules. If an investor has passive income then that is taxed at the taxpayer’s marginal tax rate.
In the subsequent tax year, any passive losses that carried over can offset passive income that is generated. Be aware that the passive activity loss limitations are applied each year. Rental losses continue to carry forward year after year until the losses are used up by offsetting passive income.
However, if you have passive losses you will be able to take them at some point. Rental losses for a particular property are allowed in full (subject to other limitations) in the year in which a rental property is sold in a complete disposition to an unrelated buyer. So often you may find that a syndication investor will have a cumulative passive loss that may have been carrying over for several years. Once the property held in the syndication is sold and the syndication is closed, the investor will typically get to take the cumulative passive loss to offset other income.
Crowdfunding syndications offer one additional special tax advantage and that is favorable long-term capital gains rates. When a property (apartment building, retail center, etc.) is acquired through a syndication and is held for longer than one year, the sale of the property would typically result in long-term capital gains. These gains are taxed at a rate of 15% (with certain exceptions). Any depreciation that was deducted on the property would be subject to tax rates not to exceed 25%.
Many investors may be unfamiliar with the tax treatment of real estate syndications. If you are having difficulty, make sure that you engage a CPA or other tax professional that is familiar with syndications and will ensure that any K-1 is accurately reported.