Over the past few months, I’ve been spending a lot of time helping investors navigate the world of passive real estate investing. While it’s critically important to avoid bad deals, understand the return metrics, and identify great opportunities, there are other implications such as ‘Taxes’ which investors must be aware of and can have a great impact on an investment.
In this post, Paul Sundin, a tax strategist who works with clients all over the world on real estate, syndication, and crowdfunding, answers 10 tax questions for real estate crowdfunding investors. The tax implications of private real estate deals can be confusing, Paul breaks it down in a concise, and easy to follow structure, that addresses the main questions investors need to be aware of.
As crowdfunding for real estate continues to increase in popularity, certain tax questions arise. But understanding the tax implications can be difficult. Deals can be structured differently and many of the structures can be complex to understand.
The goal herein is to specify some of the important tax questions that real estate crowdfunding investors face. By no means are the issues easy to understand, but at least they can provide a framework for investors to discuss with their tax advisors.
#1 – What Type of Deal Are You Investing in?
Most crowdfunding portals offer two types of deals: (1) debt deals; and (2) equity deals. Both can have different tax consequences, so understanding what type of deal can be critical to understanding the tax ramifications.
An equity deal is 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. The property could be a “flip” or a buy and hold.
But in a debt deal, the investor owns an interest in a promissory note issued to a real estate entity that is looking for financing on a project. The note is collateralized by real estate and investors do not have an equitable interest in the property. They are merely acting like a lender 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. Understanding the type of deal is critical to understanding the tax consequences, so let’s tax a closer look.
#2 – How am I Taxed?
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.
#3 – What are the Tax Advantages?
Tax advantages can vary depending on the deal structure. Real estate crowdfunding can offer the following advantages:
- No self-employment taxes. Since rental real estate is a passive activity there are no employment taxes on any profits you make from your investment.
- Favorable long-term capital gains rates. For equity deals, capital gains are usually taxed at a rate of 15% (with certain limitations) for investments that have been owned or held for longer than 1 year.
- Favorable depreciation deductions. As discussed further later, even though investors may receive cash distributions, there will be depreciation deductions that will ultimately reduce the taxable income that is passed through to the investor.
- Passive activity rules. Equity crowdfunding deals will generally generate passive income that will be taxed at the taxpayer’s marginal tax rate. But this income can also be used to offset passive losses. 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.
#4 – How Does Depreciation Work?
Almost all real estate investors have heard of depreciation. In fact, many understand the basics of calculating depreciation. However, when it comes to real estate crowdfunding, investors often get confused as to how depreciation is recorded and passed through to investors.
Depreciation is a non-cash expense. It represents a tax deduction that allows for the recovery of the cost of certain property. It is essentially an annual allowance for the theoretical wear and tear and deterioration of the property. In a typical equity deal, depreciation is calculated at the “holding” company level, not by the individual investor. The holding company will record depreciation using a straight-line basis over 27.5 years for residential rental property (single family homes, apartment buildings) and 39 years for commercial property (office buildings, etc). A shorter useful life is assigned to items such as appliances and other building assets.
Since depreciation is recorded at the holding company level, the investor does not need to be concerned about recording depreciation. As a result of depreciation expense, taxable income that flows through to the investors is lower. This is a major benefit to real estate crowdfunding investors. Fortunately, real estate crowdfunding investor’s don’t need to be concerned with any specific calculations.
#5 – Are there any State Tax Considerations?
State tax issues for real estate crowdfunding can be tricky. One of the questions that often arises is whether investors are required to file tax returns (and pay income tax) in the states where the real estate is located or in their state of residency.
As a general rule, when a partnership conducts an active business or has source income in a given state, that state will require the individual partners to file state tax returns and to pay income tax on their respective share of the partnership income regardless of what state they reside in. But each state can have different rules for debt deals as opposed to equity deals. In addition, taxpayers typically must report all of their income in their state of residency and pay tax accordingly. But to avoid double tax they generally get a credit back for taxes they paid to another state.
#6 – What tax forms will I receive at the end of the year?
For an equity deal you will generally receive a Schedule K-1 at the end of the year. These are used by LLCs being treated as partnerships to report each investor’s share of the partnership’s income, deductions, credits, etc. Form 1099-INT is the tax form used to report interest income. Depending on deal structure, debt deals may also issue a Schedule K-1.
Copies of Schedule K-1 and Form 1099-INT will be filed with the IRS. These amounts must then be reported on the investor’s personal tax return.
#7 – Can I use a self-directed IRA?
The simple answer is yes in most cases. If an investor has an LLC interest that is held in a retirement account (traditional or Roth IRA, 401(k), etc.), then the amounts reported on the Schedule K-1 or Form 1099-INT are not reported on the investor’s personal tax return.
Please note, however, that investments within a retirement account do require additional considerations, some of which do have tax consequences. For example, IRAs and certain other tax-exempt entities with more than $1,000 of gross qualifying “unrelated business taxable income (UBTI)” are required to file a tax return using Form 990-T. The retirement account will typically only owe taxes if its UBTI is greater than $1,000.
#8 – Can I do a 1031 exchange?
Internal Revenue Code Section 1031 provides an exception and allows real estate investors to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Unfortunately, most real estate crowdfunding transactions will not qualify for a 1031 exchange.
While partnerships themselves can qualify for 1031 exchanges, interests in partnership do not. In substance, they merely reflect ownership of an LLC that hold title to real estate which is not consistent with a true exchange of real estate.
However, there can be certain types of real estate crowdfunding investments that are structured specifically to allow for a 1031 exchange. If you seek such an investment, make sure you discuss the issue with crowdfunding portal or a tax or legal professional.
#9 – Any Tax Strategies I Can Utilize?
Depending on your tax situation, there are a few strategies that you could consider.
Utilize self-directed IRAs for debt deals. As discussed, since debt deals generate interest income they will typically not be subject to UBTI. This may not be the case for equity deals. This makes investing in debt deals more attractive in a retirement account.
Generate favorable capital gains treatment on equity deals. Since long-term capital gains are taxed at favorable rates, investing in buy and hold crowdfunding deals can offer advantages outside of a retirement account.
Generating capital gains to offset capital loss carryovers. Many investors may have substantial loss carryovers relating to prior stock losses. Generating capital gains may allow you to utilize the prior losses to offset current gains.
Generating passive income to offset passive losses. Certain investors may have passive activity losses that they have not been able to utilize. Since equity deals are generally treated as passive activities, net income (or capital gains) can be used to offset the carried over passive losses.
Many of these strategies can be complex, so make sure that you consult with a CPA or tax professional prior to implementing any of the strategies.
#10 – Do I Need an Accountant to do my Taxes
Investing in real estate crowdfunding transactions can add complexity to your tax filings. Filing your own tax returns in multiple states (if necessary) and reflecting the proper credits and state allocations can be challenging.
In many situations, you could file your own tax return but you still may not have the ability to effectively tax plan. In addition, many tax professionals will review your tax return for “red flags” to mitigate any IRS issues. I would recommend that you consider the services of a tax professional to not only assist you with your tax filings, but to advise you of the tax implications of the investments you make.
Understanding real estate crowdfunding tax rules can be difficult, but it is imperative to the crowdfunding investor. Investors have to consider a wide range of issues, including deal structures, passive activity rules and state tax implications. Prior to investing in any deal, you should make sure to discuss the tax issues with your CPA or tax professional.
One thing is for sure…investing in real estate crowdfunding deals will make your tax situation a little more complex. However, considering the other advantages to many deals it may certainly be worthwhile.
I want to thank Paul for putting this together. Through his years of working with individual real estate investors and syndicators, he knows what’s important and how to protect his clients. If you’re a new syndicator looking for a seasoned CPA, I highly recommend you touch base with Paul.
Paul Sundin is a CPA and tax strategist. He works with clients from all over the world on tax planning and tax preparation. Specific areas of focus include real estate, crowdfunding, syndication, and nonresident aliens.
Learn more about Sundin & Fish and connect with Paul here – www.sundincpa.com