Real Estate Investing and Out-of-State Taxation
BY Scott Lichtman, In a recent web discussion forum, the question came up about required tax filings when an RE investor participates in a property LLC operating in another state. Let’s say the investor lives in New Jersey, the property LLC is registered in Delaware, and the property itself (which could be a development, a flip, or rental/commercial) is in South Carolina. Who pays the state taxes on the profit, and where? While am neither a CPA nor lawyer, and the following isn’t official advice, I believe it will be a helpful starting point for investors. The question is particularly important if you’re investing in crowdfunding deals. Because investment amounts and absolute returns can be relatively modest compared to non-syndicated properties, any costs an investor faces when filing taxes could eat noticeably into the profits. So, how might the taxation work? In short, “it depends” but there are a number of factors you should be aware of…
First, this link notes that construction (I read this as property management as well) in another state is regarding as conducting business in that state, so ‘someone’ is paying the out-of-state/non-resident taxes should they exist.
Steven Winchester, a Partner and CPA at Citrin Cooperman, a national accounting, tax and consulting firm, indicates:
“The filing requirements for nonresident investors is contingent on the manner in which the underlying entity (the property developer’s or crowdfunder’s LLC) files its tax returns. Many pass-through entities file composite returns. The composite returns for the most part file and pay the tax that the nonresidents would have to pay. It is usually a bit higher rate. The benefit for the composite filing is that individual partner would not have to file a return in the non-resident state.”
“However, real estate generally is highly leveraged and generates losses due to depreciation, interest and other operating expenses which when held in a pass-through entity—pass out to the investors pro-rata. In this scenario a composite return would neither be practical, advised nor is it the common practice. The investors would, if their tax picture dictates, utilize those passive real estate losses against other income generated from other passive real estate activities.”
Winchester continues: “An additional state tax filing is not difficult.” It could take a firm one to a couple of hours of effort to prepare, proof and electronically file a basic return in another state. However, if the crowdfund or other real estate investment is only going to yield you a few thousand $ or less in profits, and you’re covering accounting costs, then the extra charge for out-of-state investing is worth factoring into your return calculations.
“However, the administrative cost to individuals could be prohibitive if the fund/partnership invests in many states and puts the onus on its partners to take responsibility for deciding whether they want to file in all the states notwithstanding the obligation to do so.” [This shouldn’t be an issue with single purpose LLCs set up by crowfund sites for each project]
That’s the general principal, but as with all interesting tax questions, the true answer may be “it depends.” Steve says “there are many nuances and scenarios.” Another CPA has advised a leading RE crowdfund venture, Patch of Land, that “It will partly depend on what activity the LLC is actually conducting. It will also depend on if the investor has any other activity in the state. It will also probably depend on exactly which state the taxpayer resides.”
Patch of Land‘s AdaPia D’Errico and the firm’s advisor kindly shared this “it depends” feedback: “Consider in California entity that formed an LLC to make short-term, real estate, rehab loans. Many of the owners/investors in the LLC reside outside of California. Because more than 90% of the assets/activity are securities/loans, this qualifies the LLC as an ‘investment partnership’ in California. As such, the interest income allocated to non-California residents is only taxable in their home state (unless they already have a filing requirement in California). If they already have to file in California they will have to include income from this partnership on their California return…but then will get a credit on their home state return for taxes paid to California on this income.
Net-net: It would be ideal for crowdfund sites to advise as best possible on how each deal is set up, particularly whether the property’s LLC plans to file composite returns on behalf of non-residents. Even though the investor will still have personal factors that could impact the outcome, the crowdfund’s advice would make the research a little “less taxing…”