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.
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:
Itemized deductions for business expenses including home office space, technology expenses, marketing, and other related business expenses
State and local tax incentives aimed at small businesses and local investment
Tax deferral and payment programs designed for small businesses
Credits designed to spur business investment or to offset the cost of property taxes
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.
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.
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:
Public-facing commercial real estate like restaurants and retail spaces
Industrial and professional spaces
Single family rentals
It’s also a good idea to look at the opportunities available through crowdfunding and other real estate investment platforms, since that is another way of receiving income from real estate investments with their own tax opportunities and complexities.
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:
Locate diverse opportunities that involve both rental income and sale income
Identify the available tax obligations and the deductions that exist to mitigate them
Identify other overhead and operating expenses
Calculate the term of the investments
Use these items to calculate your internal rate of return
Compare rates of return to find your best investments for the time being
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.
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.
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.
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.
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.
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.
Real 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.
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.
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.
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.
If you want to own real estate but do not want to be a landlord, then real estate crowdfunding may be for you. You will be able to participate in the cash flows and capital appreciation of the project, but will not have the responsibility of day to day management. It can be a win-win for both the crowdfunder and the investor.
But as this form of real estate investment gains traction, certain questions are being raised.
A real estate syndication is almost always taxed as a partnership and investors are typically classified as “passive” investors. This results from the investor not being actively involved in the management of the property. The sponsor (or syndicator) is the one who is providing the management expertise and is involved in the day to day operations of the property.
So what does it mean when you are a passive investor? Even though you may be getting a preferred return, you may still find that the investment is generating a tax loss as a result primarily of depreciation deductions. As a general rule, the deduction for a passive activity loss is limited in each tax year to income derived from a passive activity.
However, if the syndication is generating passive income it will be taxed at the taxpayer’s marginal tax rate. But remember that this income can also be used to offset passive losses. Many investors may have cumulative passive losses relating to rental real estate that have been carried forward for years. With a syndication generating passive income, this can allow the investor to “free up” these passive losses and use them to offset the income from the syndication. Interest and dividend income is not considered passive income, so for an investor with passive losses this form of investment can offer benefits that stock and bond investments will not.
So what do you do if you have passive losses that you are not able to offset against other income? If you find yourself with losses that you are currently unable to deduct as a result of passive loss limitations, there are a few strategies that you should consider.
Invest in rental real estate that generates passive income. Considering the low interest rate environment these days, you may decide to invest in rental real estate that you are sure will generate net income even after considering depreciation deductions.
Invest in income generating passive business activities. You could consider investing in an operating business that you have no material participation in. Assuming that the business operations generate taxable income that will be allocated to you, then you can use that income to offset the passive losses from the other activities.
Increase participation in loss activities. For a crowdfunding investment this may not be possible. But depending on the investor’s involvement in the activity, it may be possible to turn the passive activity into an active activity by increasing your hours of involvement so that you may meet the material participation rules. If you can accomplish this, you may be able to bypass the passive loss rules and fully deduct any losses in the current year.
Generate gains from the sale of other passive activities. Passive income will typically include gains from the sale of an interest in a passive activity or property that was used in a passive activity. The gain typically is not considered a passive activity if, at the time of disposition, the property was utilized in an activity that was not considered a passive activity in the year of sale.
Decrease your involvement in active income activities. You may have a business activity that you currently materially participate in that is generating active income. Accordingly, you could consider limiting your participation (or involvement) in this activity.
Understanding passive activity rules can be difficult. As you can see, there are a few ideas that you should consider if you have passive activity loss limitations. But these strategies can be complex, so make sure that you consult with a CPA or tax professional prior to implementing any of the strategies.
Tax and Legal Advice Disclaimer: AlphaFlow and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.