How Are Real Estate Flips Taxed?   People who buy and sell (or “flip”) real properties often call themselves real estate “investors”.  But this may not be a correct definition in the eyes of the IRS.  The IRS will often seek to determine whether these taxpayers are operating as “dealers” or “investors”.  Should you be classified as a dealer, you are deemed to be in an active trade or business.  We will discuss why this is an important distinction.

Is There Investment Intent?

Determining dealer status is often difficult.  If you buy and sell properties on a daily basis then the IRS may take the position that this is your business activity.  For example, this would be similar to a CPA who charges clients a fee for his or her services.  If the CPA does a real estate deal or two on occasion when he or she could more easily be considered an investor because the activity is not necessarily part of a normal trade. The reason why this is significant is that dealers will be subject to employment taxes at the rate of 15.3% of business profits (assuming a sole proprietorship).  This would be consistent with any other normal business owner.  In addition, dealers do not have the ability to utilize the installment method for sales of real estate.  This means that if you dispose of a property and take payments over a long period of time you will have to pay tax on the sale immediately as opposed to deferring the profits into the future.

How is Investment Intent Determined?

While it is certainly a subjective issue, the IRS looks to the “intent” of the taxpayer.  Specifically, the following criteria are often examined: Considering the above criteria, one of the most important issues appears to be the taxpayer’s volume, frequency, and consistency of real estate sales. Said differently, if you have a history of selling a lot of properties and do not have other business activities then this may weigh in favor of you being a dealer. But just because the IRS may consider you a dealer with respect to a property or certain properties, it may not make you a dealer on all your properties.  It may be advantageous to have certain flips grouped in one taxable entity (for example an LLC possibly taxed as an S Corp) and have “buy and holds” in a separate entity.  Accordingly, having a formal structure in place may allow the IRS to look favorably at the taxpayer’s investment intent.  
Paul Sundin

About the Author:

Paul Sundin is a CPA and tax strategist at www.sundincpa.com. He does tax planning for business owners, real estate entrepreneurs and individuals.
  Year Round Tax Planning For Real Estate Investors   Finding ways to manage your tax burden as an investor is never an easy task. No matter how much you research or how much you strategize, you are likely to find the complexities of managing your tax burden an ever-shifting obligation. It gets more complex if your business involves real estate investments, and while there are a lot of opportunities in real estate, tax planning is essential. If you know how to operate efficiently, you can more easily minimize your tax burden. Read on for more practical strategies, and find out how tax planning for real estate investors works.

Remember That Your Home Is A Tax Shelter

The house you live in has a few tax benefits from the moment you make it your home or primary residence. This is vital information because it is possible to occupy houses in the process of improving them, which provides you with the opportunity to deduct mortgage interest. In some areas, it even provides you with a property tax credit. There are limitations to the use of this strategy, so unless your improvements will take a long period of time, it might not work for every situation. Even so, the opportunity to invest in your own permanent home as a tax haven is always available when you work in real estate. Remember, when it comes to your home, the IRS does not tax the first $250,000 of the profit if you are single, and the benefit doubles for married couples. This alone makes improving homes and moving regularly a potentially lucrative investment strategy.

Choose Your Investment Strategy Carefully

This might seem like general advice, but it really isn’t. While it’s always true that investments require careful decision-making, strategic investment is different when you are trying to minimize your tax obligations. For starters, remember that the timing of your investment and subsequent sale can affect the tax year that it falls into. This means that you might benefit from holding properties a little longer than you otherwise might if it pushes the tax obligations to the next quarter or the next year. This can help you control the amount you must allocate in taxes each quarter. Certain kinds of investments are also incentivized with tax breaks and other opportunities at the federal, state, and local level. By selecting investments that take advantage of these opportunities, you can easily shrink your tax burden while growing your investment portfolio.

Like-Kind Exchanges

This is also called a 1031 exchange. This means that if you are rolling the proceeds of one sale into another property, you can defer the tax payments on your profit from the sale. This is a really useful strategy, because you can continue rolling profits over in a chain, buying ever more expensive properties with the proceeds. You do have to break the chain to get your investment back, at which point you will be on the hook for the taxes. In the meantime, though, the 1031 exchange allows eligible investors to basically get a zero percent loan in the form of that tax deferral.

Business Tax Strategies

It’s important to remember that your real estate investment business is a business. The income taxes you pay on your profits use the same Schedule C form as an entrepreneur who, say, runs a convenience store. That means you have the opportunity to use the same strategies other small businesses use to minimize their tax burdens. That includes all of the following:

Income Shifting

If you have any family members working for the real estate business, you want to make sure you pay them, and these expenses will be able to be worked into your overall tax plan. This allows your family to get money out of the business as personal income, and it helps reduce the overall business tax burden that you face. As with any tax analysis, always speak with your tax advisor.

Depreciation

Last but not least, remember that depreciation is tax deductible. No set of tax strategies for real estate investors would be complete without pointing this out, either. Lost value on the property usually can’t be claimed as a tax write off until it is sold. When you make improvements on the property, though, it’s often possible to depreciate them, in which case you can deduct depreciation of their value from your taxes. This is a vital strategy for many real estate investors. Tax planning for real estate investors can be a difficult task, but with the right strategies, it is easy to gain control over your tax burden. Learn all about the tax implications of real estate crowdfunding in our free eBook before you start investing. Free eBook Download   How To Optimize Your Real Estate Investments To Avoid Tax Consequences Real estate investments don’t work like any other form of investment business. They involve investing in physical properties at various stages of development. This distinction creates some unique opportunities for entrepreneurs and investors working in this industry. To get the most out of your investments, you need to understand how income from real estate investments can be earned beyond the simple act of buying and selling a home. You also need to understand how diversifying your real estate investment approach can bring you tax benefits, and which tax advantages are available for those looking to develop properties.

Diversifying Your Real Estate Income

There are two ways that most people move into real estate. Either you start by buying, improving, and selling properties or you start out as a landlord, taking care of rentals. Either way, it is a good idea to diversify your investments and to make use of both approaches. In terms of real estate investing and taxes, the income properties will create a steady cash flow that can be used to pay expenses like your contractors and your tax bills. The sales can then be used to increase your overall portfolio size and to create working capital for large investments. There are also often local incentives to provide certain types of housing or business space, especially if there are renewal or Renaissance zones in your city. Strategically taking advantage of development opportunities with those kinds of tax benefits can lower the tax obligations of your whole operation through the judicious use of one or two investment opportunities. Look for opportunities in all these areas: It’s also a good idea to look at the opportunities available through crowdfunding and other real estate investment platformssince that is another way of receiving income from real estate investments with their own tax opportunities and complexities.

1031 Exchanges

Like-kind exchanges, also known more formally as 1031 exchanges, have been a vital part of the real estate sector for years. They allow investors to defer capital gains taxes owed on the profits from a property sale into the purchase of a new property. This essentially provides an interest-free loan to the investor for the value of the taxes, which is then due when the new property is sold. The exciting thing about 1031 exchanges from a real estate investment point of view is the fact that they can be chained together. That makes them one of the most effective real estate investing tax strategies, because you can essentially continue the chain of like-kind exchanges as your portfolio grows, using the properties you are holding while they appreciate as rental income for cash flow while you wait to roll the property over to a larger investment. You will pay taxes on the rental income, but that can be managed through the use of tax programs and other deductions.

Business Expenses And Itemized Deductions

One of the reasons why it’s wise to go into the rental business as part of your tax strategy and part of your business plan is because of the opportunity to use the associated business expenses. From deducting mileage when you visit your properties to having the opportunity to count marketing expenses incurred while advertising vacancies, there are a number of opportunities that are easier to take advantage of when you have a regular day-to-day operation that is making a consistent income.

Understanding Internal Rate of Return

Internal rate of return is a measurement you can use to determine which of your investment opportunities are most likely to be the most lucrative. Its formula involves calculating the relationship between investment costs, net cash flow, and the time the investment will operate. It takes some research to calculate it correctly, but basically the higher the value, the better the investment opportunity. When using internal rate of return, it is important to know all of your tax liabilities and the available real estate investment tax deductions going into the calculation, because that knowledge is part of the calculation of your net income or profit. The lower the tax burden presented by that option, the more it will positively impact the internal rate of return.

Putting It All Together

The question becomes, with all this knowledge about the ins and outs of real estate investment, what do investors need to do to be successful? To put it all into an easy to manage process, consider the following, a step-by-step checklist for investing: It sounds simpler than it is, but having a clear guide is the best way to start organizing complex information. Make sure to learn all about the tax implications of real estate crowdfunding in our free eBook before you start investing. Free eBook Download   Crowdfunding Real Estate: Tips For Accredited Investors   If you are a real estate investor, you have no doubt heard about the benefits associated with crowdfunding real estate deals. It’s not hard to see how the system is setup to benefit investors and entrepreneurs. It provides easy access to investors who can provide the capital you need to make your next project work, and it also provides a framework for repayment that is easy to understand and manage, which would not have been possible when dealing with a large number of investors even fifteen years ago. This makes crowdfunding for real estate very efficient and easy to manage for even smaller investors.

Understanding How Crowdfunding  Real Estate Investments Work

If you are interested in backing real estate projects, crowdfunding platforms provide you with an easy way to connect to developers with investment opportunities. Crowdfunding is relatively easy to participate in, too. Investors simply sign into the crowdfunding platform to navigate through various projects. The research about the property development and the prospectus are available, and there are usually various levels of involvement with projected investment returns. There are certain platforms that provide a means for developers to independently present opportunities. In this case, the platform provides a variety of tools and features to customize the offering, including the returns being offered. Other platforms will work directly with the developer as the direct financing partner. These platforms will be responsible for presenting the investment offering to prospective investors. During the crowdfunding period, investors buy into the project for various amounts, securing their portion of the investment. One needs to understand the project’s terms and the ways they work to understand the tax implications of investing. That’s because the structure of the crowdfunding real estate opportunity and the exact rules of the platform can affect the way you realize the gain from your investment, changes to the way you get paid and affects the way you report that gain for tax purposes. A number of factors determine how you need to report income taxes, so it is important to consider all of them before investing.

Accredited Investor Crowdfunding Real Estate Tips

Here are the major aspects you need to consider as you plan your first crowdfunding real estate investment. It’s vital to know all of this before committing to any deal because your tax planning and income management are going to depend on it.

What Kind of Deal Do You Have?

Is this an equity arrangement or are you financing a loan? The income from them is vastly different, both in the timing of its delivery and in its size. Depending on your platform, you might see interest payments every quarter or every month throughout the payment period if you are backing a loan. These earnings represent income from the interest that is paid on the loan and your original investment amount – the principal – will be returned at the end of the loan period. If it is an equity deal, though, then you are unlikely to see any income until the property is sold or until it begins to lease to tenants, depending again on the nature of the investment. If the property is sold, you can plan on a lump sum in one tax year. If you receive interest, then you will have a smaller tax burden each year, but you will have to plan on paying taxes on the investment every year.

K-1 Vs. 1099 Reporting

Schedule K-1 is the income reporting schedule used to report partnership income, and it is filed by each partner. Some people wonder whether or not this is the proper way to report income from crowdfunding investments. The answer is that it is, under the right circumstances. If you enter into a formal business partnership with other investors and then back a project, you would report your portion of the partnership income on a K-1 form. Generally speaking though, when you buy into a crowdfunded investment, it isn’t like forming a partnership with friends or family and investing together. It’s more like you purchase shares of a loan, and then you receive a payoff in the form of interest earnings paid regularly over time, and a lump sum of your initial investment amount when the loan is repaid. That interest income would be reported as general income on a 1099-INT form, similarly to the way you would report other investment income.

Using A Self-Directed IRA

Individual retirement accounts can be used for investment purposes if you wish, and the taxes are deferred until the money is withdrawn at retirement. The benefit of a SD-IRA is that you can invest in many opportunities, such as crowdfunding or private equity, that are not available to normal retirement accounts, like a 401K or a regular IRA. The downsides are multiple, but they are often worth the trouble for investors: Each IRA, even those that are self-directed, must be held by a custodian. This can either be a credit union, bank, trust company or a licensed non-bank custodian. Taking time to research and ask questions when looking for a custodian is one of the ways you can get the most benefit from your investment. The advantages are almost limitless, though, because by self-directing your IRA investment, you can put your money into the investments you choose, allowing you to grow your money as quickly as your skill lets you. Take some time to learn all about the tax implications of real estate crowdfunding in our free eBook before you start investing. Free eBook Download   Tax Over the last decade we have seen a significant increase in foreign investment in U.S. real estate. With recent real estate crowdfunding options in the marketplace, it clearly makes sense that certain non-resident investors are considering crowdfunding equity investments. Let’s examine many of the tax considerations that will impact these foreign investors as they venture into this area. As a general rule, non-resident investors must consider the following: 1. They will need to consider the best entity structure for their real estate crowdfunding investments. This includes determining whether their interest is held individually or through an entity like an LLC or corporation. 2. Even if no tax is due, they will generally be required to file a U.S. tax return and in many cases a state tax return. 3. If title is being held individually, they will need an Individual Taxpayer Identification Number (“ITIN”). This is merely a tax processing number that is issued by the IRS to international folks who have a U.S. tax filing requirement. 4. If investors do not visit the U.S. at all they will normally only be taxed on U.S. source income generated from their real estate investments. But if they decide to stay in the U.S. for extended periods they may find themselves being taxed on worldwide income, so they need to be careful. 5. Investors must consider how a certain U.S. tax structure impacts their tax situation in their home country. 6. Profit distributions are subject to U.S. foreign withholding requirements unless an exception is obtained. In addition, many states have withholding requirements as well. This means that an estimated tax will be withheld by the partnership entity and will be credited to them when the required tax return is filed. 7. In addition to federal and state income tax considerations, investors must also consider U.S. estate and gift taxes. 8. The U.S. tax code establishes certain “default” rules for non-residents. But the U.S. has established tax treaties with many countries that can alter the default tax treatment. Individual Ownership vs. Entity Ownership Many non-resident investors hold title to crowdfunding real estate interests as individuals. In this situation, they may find themselves taxed similarly to U.S. individuals. Income tax rates in the U.S. range from 10% to 39.6% based on an individual’s taxable income. As a result of depreciation expense, rental real estate activities can often generate passive losses and many non-resident investors will find themselves paying at the lowest tax rates. When a syndication property is sold for a gain, it is subject to the long-term capital gains rate of 15% (subject to certain exceptions). However, non-resident investors may find that it is beneficial for them to hold title in a corporation (either foreign or U.S. based), limited liability company (“LLC”), a trust, or even a partnership. In most cases, individual ownership or ownership through an LLC taxed as a disregarded entity will result in the lowest income tax liability. However, depending on the investor’s situation, a different structure may be beneficial as a result of estate or gift tax issues. The advantages and disadvantages of each structure should be carefully analyzed with a tax professional who understands tax planning for non-resident real estate investors. Obtaining an ITIN In many situations, a foreign investor will obtain an ITIN when a tax return is filed. However, as a result of withholding requirements, real estate crowdfunding organizers will be seeking an ITIN upfront. The foreign investor will then need to obtain the ITIN prior to filing a tax return. Form W7 and proof of identity will need to be submitted. There are many documents that can prove identity, but the most common is your passport. In addition, the non-resident must include a copy of the section of the partnership agreement that displays the partnership’s employer identification number (EIN) along with demonstrating that they are a partner in the partnership that is conducting business in the U.S. Tax Treaties As discussed previously, tax treaties between the U.S. and certain countries further complicate the situation. Under these tax treaties, residents of foreign countries may be taxed at different rates, or in some situations be exempt from U.S. income tax on certain income they receive from U.S. sources. Tax treaties can and do vary extensively between countries. Additionally, the U.S. has tax treaties in effect for certain countries that cover estate and gift taxation. Summary Tax issues facing non-resident investors can be complex. Non-resident investors in U.S. real estate must ensure that they are dealing with a tax professional who understands the tax issues they face. Advice and guidance on tax planning initiatives is critical before investing in real estate crowdfunding. Free eBook Download  

Tax

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:

Withholding Requirements

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).

Conclusion

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.

Tax

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.

SkylineReal estate syndication has been around for decades. But the syndication process has evolved in recent years with new crowdfunding options. Real estate crowdfunding deals are generally classified as either “equity” deals or “debt” deals and each can have different tax implications. Let’s take a closer look at the differences.

Equity Deals

When it comes to real estate crowdfunding, much of the tax discussion has revolved around equity deals. I would define an equity deal as one where the investor typically owns shares in a limited liability company (“LLC”) that invests into another LLC that holds title to real property. The investor holds essentially an indirect equitable interest and will participate in the financial upside (or possibly downside) of the property. As such, the investor is a partner in a partnership structure.

Since equity investors are actually partners to the deal they would receive a Form K-1 at the end of the tax year which would report their share of the partnership’s income or loss. Since they are not actively involved in the day to day management of the property, they are typically classified as “passive” partners. Passive partners have special tax rules. A passive partner is taxed at the partner’s marginal tax rate on any profit that is generated. However, if the activity generates a loss the deduction typically will be limited to any income derived from other passive activities (subject to certain exceptions). But if the activity generates income it may also be used to offset any passive losses generated from other activities.

Debt Deals

But more and more deals on real estate crowdfunding platforms are considered debt deals. Essentially the investor owns an interest in a promissory note that is often issued by a flipper or developer (the “sponsor”) who is looking for short-term financing for a project. Aside from being collateralized by real estate, the note will typically provide for monthly interest payments and have a personal guarantee from the sponsor. These investors do not have an equitable interest in the property. They are merely acting like a lender in which they are providing the funds for a specific transaction and are receiving interest payments according to the agreement. This type of transaction is different from an equity deal and, accordingly, the tax implications can differ.

Taxpayers investing in debt deals are typically not partners to an operating trade or business and are merely acting as just investors. They do not get to participate in any financial upside of the property. Accordingly, the payments they receive are typically classified as interest income. They will often receive a 1099-INT at the end of the year that reflects the interest income they received, but also may receive a Form K-1 depending on the deal structure. Interest income is considered portfolio income (not passive income) and is also subject to marginal tax rates. However, portfolio income is not considered passive income and is not subject to the same restrictions.

Summary

Understanding the tax differences between equity and debt deals can be difficult. We have discussed some of the differences herein, but we need to acknowledge that close consideration of tax issues should be made when structuring any real estate crowdfunding transaction. At the outset of any deal, consultation with experienced tax and legal professionals should be made along with proper investor communications.

Ultimately investors need to carefully review any crowdfunding deal and make sure that they understand the tax ramifications. In addition, they should make sure to engage a qualified CPA or other tax professional to assist them with their tax return.

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