When an investor makes an investment into a limited liability company (LLC), he or she is typically taxed as a partner in a partnership. Form K-1 is issued by the partnership to the investor and it reports net income (loss) and certain other items related to the investment in the partnership. Since a partnership is generally not subject to taxation, members of the partnership are typically required to report their share of the partnership’s financial results on their individual income tax return.
A Form 1099-INT is commonly issued in a debt deal and it is used to report interest income generated from lending activities, such as investing in promissory notes. A 1099-INT, as contrasted from a K-1, would broadly involve no ownership interest in real property.
If an investor meets one of these exceptions they will typically NOT be receiving a 1099:
1) Interest income for the year is below $10;
2) Payments are made to a: corporation, a tax-exempt organization, any individual retirement arrangement (IRA), Archer medical savings account (MSA), Medicare Advantage MSA, health savings account (HSA), a registered securities or commodities dealer, nominees or custodians, brokers, or notional principal contract (swap) dealers.
The IRS requires, generally, that form 1099-INT be provided to each recipient by January 31 of each tax year. Form K-1 is not required to be furnished to each investor until April 15th of each tax year. Starting for the 2016 calendar tax year, Form K-1 will be due on March 15th. However, an extension is allowed that will extend this date until September 15th.
Form K-1 due dates are driven by due dates for partnership tax returns, and so are due later than other tax forms an individual commonly receives. But most crowdfunding entities understand that investors demand Form K-1 as soon as possible. The problem is that many crowdfunding partnership returns are dependent on tax information furnished by other parties (specifically the sponsor).
Many crowdfunding investment companies provide required tax documents via a secured client investor portal. This eliminates problems commonly associated with mailing such forms.
A Form K-1 may report different items, including ordinary and rental income, interest, dividend and royalty income, and capital gains or losses, just to name a few. Each of these items is subject to specific rules of taxation and dependent on the individual investor’s personal tax situation.
Investors in an equity deal can be taxed differently depending on the type of deal. A “flip” deal will typically be taxed as ordinary income, while a buy and hold will typically receive “net rental” real estate income or loss along with capital gains treatment upon disposition. The payments investors receive on debt deals are typically classified as interest income and taxed at ordinary rates. Long-term capital gains will be taxed at rates of 15% to 20% depending on your tax situation.
Investors in equity deals are also typically subject to passive activity rules. These rules can be complex and may limit the immediate deductibility of any losses. Interest income is considered portfolio income and is not subject to the same restrictions.
The tax treatment by individuals for items reported on a K-1 can be complex. Investors are encouraged to consult their tax advisor for further clarification.
You should not file your personal tax return until you have included all required tax forms. If file your tax return prior to receiving any or all of K-1 forms, you should amend your tax return as soon as possible to reflect all the accurate forms. Be aware that you may face additional tax due, plus interest and penalties. You should consult a qualified tax professional to discuss filing requirements.
Distributions shown on line 19 of your Form K-1are not considered income. These distributions are typically not taxable, unless they are in excess of basis. Instead, report as income (or losses) those items shown as such on your K-1. Typically, cash payments arising from a real estate equity deal represent partnership distributions under U.S. tax law and most state and local jurisdictions. Sometimes they are incorrectly referred to as “dividends.”
Partnership distributions in general are not taxable because investors are taxed on their allocated share of partnership income. In limited circumstances, they may be taxable if the amount of distributions exceeds an investor’s basis in the partnership.
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.
If a partnership (including an LLC filing as a partnership) has income that is effectively connected with a U.S. trade or business, it is required to withhold on the income that is allocated to its foreign partners. This withholding tax requirement does not apply to income that is not effectively connected with the partnership’s U.S. trade or business. The goal of course is to ensure that the IRS collects tax from nonresident aliens in case they fail to file a tax return and, accordingly, pay any tax that is due.
The IRS allows foreign partners to certify to the partnership certain deductions and losses that will be applicable to the current year. In addition, a nonresident alien partner can also certify to the partnership that the partnership investment is (and will be) the only activity of the partner for the partner’s taxable year that gives rise to effectively connected income, gain, loss or deduction.
In general, equity investors in real property will be subject to state income tax in the state where the property is located, provided that state imposes income tax. Typically, the controlling factor is the state where the investment property resides, not the state where the investor resides.
Assuming a state imposes income tax, there are three main scenarios for withholding and filing requirements:
1. No state withholdings are made by the partnership and the individual partners are required to file state tax returns and to pay income tax on their respective share of the partnership income.
2. The partnership withholds state income tax on behalf of the partner and remits it to the state. This withholding is then reflected on Form K-1 and the partner is responsible for filing the required tax forms.
3. The partnership withholds, remits and files all information with the state and the individual partner is not required to file or pay anything. This is called a composite or group filing.
State filing requirements are varied and often complex. We strongly recommend that you discuss your state filing requirements with your tax professional.
Every investor who held an equity interest (member or partner) at any time during the tax year should be sent a Form K-1. If an equity interest was held in by an IRA (traditional or Roth), the amounts reported on the Form K-1 are not attributed to the investor’s individual tax return, but are instead associated with the retirement account itself.
However, there can be potential tax consequences and reporting requirements depending on circumstances and activity in the retirement account. For example, IRAs and some tax-exempt entities that receive more than $1,000 of gross qualified Unrelated Business Taxable Income (“UBTI”) must file a tax return on Form 990-T. The account will typically only owe taxes if its UBTI is greater than $1,000. You should consult your tax professional to ensure compliance with all required tax filings and payments resulting from investing through IRAs.
Section 1411 of the Internal Revenue Code imposes the Net Investment Income Tax. A tax of 3.8% is assessed against certain net investment income of individuals, trusts and estates once income reaches certain thresholds.
Investment income may include, but is not necessarily limited to: interest, dividends, capital gains, rental and royalty income, income from businesses involved in trading of financial instruments or commodities, and businesses that are considered passive activities to the taxpayer. Therefore, income reported on Form K-1 or 1099-INT as well as any gain resulting from the disposition of property may be subject to NIIT.
It depends on the way the investment is structured. Form K-1 is indicative of ownership in a partnership, which partnership may produce interest income for the owner-investor. Alternatively, 1099-INT forms indicate lending investments. In both situations however, the income that is reported is typically classified as interest income to the investor.
In a common crowdfunding investment structure, equity investors are partners of a limited liability company (LLC) which will be taxed as a partnership. While partnerships are not subject to taxation directly, the income, deductions and/or credits flow through to the individual partners. The partnership will report each investor’s share of the financial activity of the partnership on Form K-1. Therefore, each Form K-1 must include a federal ID number and other relevant partner information such as name and address. So while an investor may not have taxable income in a given year, you must furnish certain identifying information required by the IRS.
Taxable income as reported to investors on K-1 may include non-cash expense, like depreciation. As a result, taxable income is often lower than cash distributions. Additionally, investor distributions paid are often determined in advance, and may be paid out with different timelines than required for income tax reporting.
A flip project will generally be taxed as ordinary income that is subject to the investor’s marginal tax rate. This is because a flip is classified as a “dealer” and is deemed to be in an active trade or business.
A long-term rental is defined as passive income and is subject to the passive activity rules. These rules allow you to offset passive income against passive losses. Any resulting net passive income will be taxed at ordinary income tax rates. In addition, upon the sale or disposition of a rental property, capital gains (or losses) will be generated that will be typically classified at a preferable long term capital gains rates.
Most commonly, real estate equity investors will see depreciation recorded on real estate rental holdings. This depreciation is recorded by the entity holding title to the real estate itself. Accordingly, this expense will result in lower taxable net income that is passed through to crowdfunding equity investors.
Investing in real estate crowdfunding opportunities will most likely add complexity to your tax filings. While filing your own tax returns correctly is possible (sometimes in multiple states as necessary), we would advise most investors to seek the assistance of a tax professional. Many investors find it much more efficient and less stressful to turn these activities over to someone familiar with the intricacies of the federal and state tax codes. A tax professional can not only assist with varied required tax filings, but also with your understanding of tax implications of the different types of crowdfunding investments available to you.
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.