Tax implications of equity partnerships in crowdfunded REIs
When you invest in crowdfunded real estate investment deal as an equity investor, you’ll receive a K-1 (1065) tax form, which documents income received or losses experienced as part of a business partnership -- in this case, an LLC.
Partnerships are required to distribute K-1 forms by March 15 of the following year, or the next business day if March 15 lands on a weekend or holiday. K-1 forms for the 2019 tax year, for instance, should be received by March 16, 2020, since March 15 is a Sunday. You’ll use the information on the K-1 form when you pay your personal income taxes.
Understanding the K-1 (1065) form
It’s important to make sure you receive your K-1 form in time to file your personal income taxes by April 15. K-1s are often one of the last tax papers you’ll receive because of the amount of work that goes into preparing them.
The K-1 is similar to a W-2 or 1099 form. It shows your share of the earnings, losses, deductions, and credits from the partnership. Income reported on a K-1 need only be earned by the partnership and not necessarily distributed.
That’s where it can cause problems. You could owe taxes on money that's not liquid or available for you to spend. If you have substantial income through your crowdfunded partnerships, you could pay more money in taxes than you actually received.
If you’re filing a K-1 for your investments, you’ll also have to file IRS Form 1065, U.S. Return of Partnership Income, with your personal tax returns. Form 1065 is your tax return for the partnership. Individual states may have similar forms.
If you pay a tax accountant to file for you, the accountant may charge more if you also need to file Form 1065; it's an additional tax return that requires more time and work from the accountant. You’ll want to factor that cost into your business expenses.
Remember, the LLC doesn't pay taxes; it's considered a pass-through entity. The owners of the partnership pay taxes on their income (or deduct any losses) on their personal income tax forms. The taxes you pay on the income from the LLC depend on the type of real estate deal.
Fix-and-flip investments: Fix-and-flips (properties that are sold within the first year of ownership) are taxed as regular income. You may be eligible for certain deductions related to your investment, which we’ll cover below.
Rental income: If your investment generates rental income, you’ll receive quarterly payments. This income is treated as a capital gain and is subject to taxation at 0%, 15%, or 25%, depending on your tax bracket. Whatever your bracket, capital gains are taxed at a lower rate than regular income. You can also use capital loss from prior years to offset your capital gains, lowering your net taxable income across the board.
In addition, you can deduct depreciation and other expenses to further offset your income on buy-and-hold properties.
Likewise, any income from the sale of a rental property (or a fix-and-flip that takes longer than a year to sell) is also taxed at the capital gains rate.
It might seem, at first glance, that investing in buy-and-hold properties provides the most tax advantages. But whichever direction you take, you’ll find tax advantages to crowdfunded real estate investments that you may not find with other investments, including property investments where you're the primary investor.
Tax advantages of crowdfunded real estate
Crowdfunded investments offer several tax advantages. For instance, crowdfunded investments:
- are taxed as a passive activity (no self-employment taxes due),
- let you offset passive gains with passive losses,
- are eligible for depreciation deductions,
- can be funded through an IRA, and
- are taxed at a capital gains rate.
Taking advantage of crowdfunded real estate
With all these options, it can be tough to make sure you're getting the most tax benefits out of your crowdfunded investment. Take these steps to make sure you're getting as much as possible:
Crowdfunded real estate is a passive activity, so you don’t have to file self-employment taxes.
You won’t receive a 1099-MISC form reflecting your income. That also means you aren’t paying into Social Security with this income. That’s something to consider when it comes to retirement planning, but, in reality, your investment income should provide a more solid nest egg than Social Security ever would.
Similarly, make sure you're reporting rental income and money from the sale of property held longer than 12 months as capital gains, not at your regular marginal tax rate.
Offset your income with passive losses
If you have passive losses -- even from prior years -- you can offset your passive gains with those losses to reduce your overall tax liability. This goes for stock market losses as well as losses from other investment properties.
If you’ve been carrying over passive losses from bad stock investments, an investment property deal gone wrong, or other crowdfunded investments, use them to offset your capital gains and lower your tax bill. Strategic planning goes a long way to reduce your tax bill when you diversify through crowdfunded real estate investments.
Take advantage of depreciation deductions
You may want to deduct depreciation expenses to further offset your capital gains. Fortunately, calculating depreciation for crowdfunded investments is easy; the holding company does all the work for you.
As with most real estate investments, depreciation is recorded over 27.5 years for residential rental property, including single-family rentals and multi-dwelling units. Commercial properties are depreciated over 39 years. Appliances and building assets may be deducted over the expected lifespan of the items or the improvements.
The holding company will calculate depreciation based on your taxable income from the property and share those numbers for you to include on your tax returns.
Keep in mind that when the holding company sells the property at a profit, you may be responsible for depreciation recapture on your taxes. Some crowdfunding platforms permit 1031 exchanges that let you roll your investment income into your next property.
Consider using your IRA to finance your crowdfunded investments
Whether you're involved in equity or debt, you may be able to tap into your IRA for a crowdfunded real estate deal. Be aware, though, an equity deal may be subject to unrelated business taxable income (UBTI). If the UBTI is greater than $1,000, you'll have to report it as income.
On the other hand, debt deals typically don’t generate capital gains or business income -- only income derived from interest. The interest income will be reported through your tax-deferred retirement account, and not on your personal income tax returns.
For those who aren't career real estate investors, using your IRA to finance crowdfunded IRAs is a great way to help your retirement dollars grow. And if you are a career investor, you can use your IRA to fund debt deals and diversify your retirement income while staying within a familiar arena.
Common deductions to reduce your tax bill as a crowdfunded real estate investor
Equity deals that have quarterly distributions (cash flow) can be taxed as income. On buy-and-hold investments, cash flow can be offset by depreciation and other deductions, which can lead to a loss. Along with using passive losses to offset capital gains income from crowdfunded investments, you can also reduce your taxable income through other deductions. These include:
- interest expenses,
- operating expenses, and
- net operating losses.
As a partner in a crowdfunded investment deal, you aren’t directly paying interest on the loans. But the LLC passes these expenses on to shareholders, and they're reflected on the K-1 form. Make sure you’re deducting them from your gross income.
For passive investors, operating expenses come in the form of fees. These fees should be reported in the contract before you make any investment. Common examples of fees include the following:
- Acquisition fees: This money, 1%–3% of the total deal, goes to the holding company to cover their work in finding and investing in the property.
- Selling fees: Similar to closing costs for a residential mortgage, these fees cover the final sale of the property.
- Construction management fees: In a fix-and-flip or buy-and-hold rehab project, this fee compensates the holding company for its role in managing the rehab process.
- Asset management fees: These fees are related to property management costs, typically for rental properties. They may also cover the costs of marketing and selling a fix-and-flip investment.
There are also other costs related to a rental property, which the holding company passes on to investors as a reduction in profits:
- Maintenance fees and operating expenses: Paid by the LLC with costs passed on to the other investors, these fees cover routine maintenance of the property, such as landscaping and snow removal costs, electricity and other utilities, and unscheduled repairs.
- Property taxes: Again, the LLC pays these fees and passes the costs on to investors as a deduction from K-1 income.
- Insurance: Every property requires homeowners’ insurance, and these fees are deducted from the net operating income in a crowdfunded real estate investment.
Fees can add up, but the good news is they're all deductible from your taxable income -- either on your personal tax returns or as a deduction in your investment income on your K-1 form.
In addition, depending on how you file, you may be able to take advantage of other business deductions as part of your investment business. While not directly related to crowdfunded real estate income, these deductions can reduce taxable income and overall tax liability.
Deductions might include depreciation on other properties, operating expenses for your other properties, marketing, continuing education, employee salaries and benefits, and any other expenses associated with your real estate investment business.
Net operating losses
Of course, you enter any investment with the goal of making money. But if a rental property or fix-and-flip begins operating at a loss, those losses can offset passive gains and other taxable income.
Crowdfunded REIs and state taxes
Each state has different tax laws when it comes to investment income and passive income activity. In most states that collect state income tax, you’ll need to factor in your K-1 earnings as well as any other income, such as W-2, 1099-MISC, and 1099-INT income.
If you invest in a property that’s not in the state where you live and show any income from that investment, you’ll need to file a non-resident state income tax return, as well as that state's version of a tax return for partnership income.
You also need to claim that income on your own state’s tax returns.
But isn’t that double taxation?
Yes, but that’s why you’re allowed to claim your non-resident state taxes as a credit on your state tax return.
Unlike deductions, which only reduce your taxable income, tax credits put money directly in your pocket as dollars off your tax bill.
Working with a tax accountant who specializes in real estate investments in your state -- and possibly also the state where you invest -- can help ensure you’re declaring your income properly and taking all the credits and deductions you deserve.
Helpful tips for reducing your tax liability with crowdfunded real estate
As you can see, understanding the tax implications of crowdfunded investments isn’t easy. If you’re an accredited investor, you’ll want to discuss the ramifications with your accountant before entering the deal.
If you’re an unaccredited investor, just remember to declare your 1099-INT income and deduct any penalties for early withdrawals to reduce your net income.
If you’re an accredited investor, you can follow these tips to avoid getting hammered with a big tax bill:
- Understand what type of investment you're making; equity deals have different tax implications than debt deals.
- Actively seek out investments with passive income, such as rentals, to offset passive losses.
- Consider using money from an IRA to invest in debt deals to take advantage of tax deferment of investment income.
- Hold investments for more than a year so you can report the income as capital gains, which is typically taxable at a lower rate than regular income.
- Make a 1031 exchange through a crowdfunding platform that permits it.
- Be sure to file Form 1065 on time, with your personal tax returns, so you don’t pay penalties or fees.
Crowdfunded investments can be a great way for new investors to dip their toes in the water. Seasoned investors can diversify through crowdfunded real estate deals and enjoy a number of tax advantages that can benefit your investment business -- and your bottom line.