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.
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:
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.