The Tax Implications of Real Estate Crowdfunding Investing
As tax season approaches, here are some general guidelines for crowdfunding investors.
In previous articles, we’ve looked closely at the benefits of real estate crowdfunding, including low minimum investments ($5,000 for PeerRealty investors), the ability to pick individual properties in which to invest (in contrast to REITs), access to rental income and/or capital gains without hands-on participation, and the diversification (in terms of asset class and geographical distribution) that real estate investing adds to a traditional portfolio of stocks and bonds. We now turn our attention to the tax implications of crowdfunding for real estate investors. After all, the bottom line on any investment is not the money you earn, but the money the government lets you keep.
Keep in mind that the actual tax situation of a real estate investment depends on the way the deal is structured, and complex deals can have complicated tax rules. We can provide a general framework for understanding the tax implications of these types of investments, but keep in mind that you should rely on your tax advisor for individualized advice.
Crowdfunding for real estate platforms generally offer one or both types of deal structures:
- Equity deals: The investor receives shares representing prorated ownership of the property. The shares give investors the right to receive rental income and/or gains (and losses) from the sale of the property. The taxation on the gains may occur as either ordinary income or capital gains, depending on how the investment entity is structured (discussed below) and whether it is flipped within a year of purchase.
- Debt deals: The investor does not have an ownership stake in the property (unless the deal goes bankrupt, in which case creditors may seize the property), but rather assumes the role as a lender. Distributions are classified as interest income and taxed as ordinary income, and are not eligible for the capital gains rates on qualified dividends.
A crowdfunded property may be structured as a C corporation or as a pass-through entity, either a limited partnership (LP) or limited liability company (LLC). The great majority of crowdfunded properties are pass-throughs, meaning that investors, and not the entity, pay the income taxes generated by the property. C corporations are subject to double taxation, once at the entity level and again at the shareholder level.
We’ll concentrate on entity deals for LPs and LLCs, since this is the type of crowdfunding entity you are most likely to encounter (and the type offered by PeerRealty). These are private entities, exempt from SEC registration. Investors receive tax statements called K-1s - a federal one and a state one for each entity – that lay out the annual income, deductions, credits, gains and losses arising from the investment. Interest income may also be reported on Form 1099-INT.
Income from these pass-throughs is classified as passive, meaning it is taxed separately from regular investment income (portfolio income). This has three implications:
- The income is taxed at your ordinary marginal tax rate.
- Any losses can be used to offset other passive (and only passive) gains and income, thereby lowering your overall tax liability. Portfolio losses cannot offset passive gains/income, and vice versa.
- Profits from passive activity is not subject to self-employment tax.
Wouldn’t it be nice to receive tax-free profits from your crowdfunded equity investments? Well, we can’t promise that, but there are multiple tax deductions available to real estate crowdfunding equity investors:
- Depreciation: The entity records annual depreciation expense over a set number of years to offset the original cost of the property. Depending on the type of real estate, the depreciation period is 27.5 years (for residential property) or 39 years (commercial property). Investors receive distributions in which the depreciation expense has already been deducted. This reduces the net distribution and frees the investor from messing around with depreciation calculations. Note: depreciation also reduces the book value of the property, meaning that if and when it is sold, the profit on the sale (sale proceeds minus book value) will be higher and create a larger tax obligation (or smaller tax loss).
- Interest Expense: Interest paid on mortgages or other financing arrangements is deductible. This expense will be listed on your K-1, and it further reduces your net tax burden.
- Operating Expenses: All the expenses associated with owning a property, such as maintenance, property taxes and management fees, are deductible.
- Net Operating Losses: If the property generates excess deductions, it will pass along a net operating loss that can be used to offset other passive gains or income.
Capital Gains Treatment
The capital gains tax rates are 0%, 15% or 20%, depending on your gross income. These favorable rates are available for gains on property held for at least one year. This rules out “flip” property held for less than one year, in which the gains are taxed as ordinary income. You can apply capital gains to offset capital loss carryovers from previous years, thereby lowering your current net tax obligation.
Here are a few other tax considerations related to crowdfunded properties:
- Many folks are curious as to whether a self-directed IRA can, or should, own a crowdfunded deal. The answer is maybe. Debt deals, and equity deals that provide only rental income, are generally free from unrelated business taxable income (UBTI), an excise tax applied to business income exceeding $1,000 received by an IRA. UBTI is what prevents IRA-owned businesses from having a tax advantage over non-IRA competitors. Also note that if you invest in buy-and-hold equity deals, you lose the capital gains tax break on properties held in an IRA – all distributions from a traditional IRA are taxed as ordinary income. Roth IRA distributions are generally tax-free.
- State tax may be imposed on profits and income. The rules vary from state to state, and may differ between debt and equity deals.
- Certain real estate crowdfunding deals can be specifically structured to allow Section 1031 treatment -- you should check this with your tax or legal advisor.
Note: The information presented in this article is for general information only, and is not to be construed as actual tax advice. PeerRealty is not a tax or legal advisor, so make sure you consult your own advisor regarding any tax-related issues.