State Taxation on Private Real Estate Funds

12 Replies

I'm not particularly interested in owning real estate directly, so I look at both syndications, private real estate funds, a simple REIT index fund.

I generally only invest in syndications in tax-free states or in states I'm already filing a tax return in to avoid that additional hassle.

What I'm still not 100% clear on, however, is how state taxes are treated for private real estate funds, how that changes based on whether or not a composite state income tax return is filed by the fund, whether that changes based on whether the fund converts to a REIT structure, and how that changes based on whether the fund invests in debt or equity.

I cannot find any good resources on this anywhere. Can anyone enlighten me to these issues? When are taxes due and when must state tax returns be filed? Obviously, that's going to vary a bit by state, but a general framework would be helpful. 

@Jim Dahle  

  • If a composite state return is filed then generally the income allocated to each partner in that state is taxed at the highest rate or some other set rate. This allows the convenience of not needing to file a state return for investors who otherwise wouldn't have income in that state.
  • If a composite return isn't filed then the investor has to file a return and pay nonresident tax in states that they aren't residents of. 
  • If the fund becomes a REIT then the REIT would pay state income taxes before paying out dividends.

States often follow federal for due dates but there are some odd ones out there.

@Jim Dahle

A lot of the time it's not advisable for a syndication to file composite returns because the rules for many states dictate a partner can only be on a composite return if that particular partnership's passthrough income is the partner's only taxable source income from that state.  If the partner owns an interest in two syndications that are in a state that has a rule like this, that partner is ineligible for a composite return.

Most syndicates and investment partnerships do partner withholding and report that withholding on the partner's K-1 so he/she can claim it on that state's non-resident return.

Composite returns usually mean higher professional fees from the CPA as well...

So is it different for a debt fund vs an equity fund, or exactly the same? 

And if there is no taxable income in a state (due to depreciation or whatever) or the income is low enough that a return does not have to be filed per that state's rules, is it worth still filing to carry forward losses or establish basis or whatever. 

@Jim Dahle

It depends on how you define "debt fund".

If you're talking about a syndication that is in the trade or business of investing in debt, generally there will be no difference as the interest will be considered ordinary business income and not interest income.

If you're talking about investing in straight debt and you are not in the trade or business of originating or buying and selling loans, there is no simple answer and we're now getting into the complex area of how each state decides to source taxable interest income and capital gains....

@Jim Dahle

In addition to looking at state taxation, I'd encourage you to take a closer look at how each of these investments is treated for tax purposes. REIT's act as typical Mutual Funds and hence the income on them is treated as ordinary income taxed at your W-2 rate. The income produced through syndications is not that straightforward. While it is treated as passive income/loss, it in a lot of cases will reflect in the early stages the depreciation deduction and hence producing "paper" loss on your tax return. Without going into too much detail, this is simply a reminder to look at the tax treatment of the income as well.

@Eamonn McElroy

By debt fund I mean something like a Broadmark or Arixa fund that makes a bunch of 1-2 year loans to real estate developers. Broadmark adopted a REIT structure last year. Arixa has not. The Broadmark fund I invest in lends in Utah (my state) and Colorado. The Arixa fund lends in California.

Originally posted by @Jim Dahle :

@Eamonn McElroy

By debt fund I mean something like a Broadmark or Arixa fund that makes a bunch of 1-2 year loans to real estate developers. Broadmark adopted a REIT structure last year. Arixa has not. The Broadmark fund I invest in lends in Utah (my state) and Colorado. The Arixa fund lends in California.

The partnership fund that you invest in will ultimately make the determination of how income/losses are taxed and reported by its partners/members.

Once the determination is made, the LLC/Partnership provides you with a K-1. That K-1 will provide you information that you would then use to file your tax return.

Broadmark or Arixa can make the determination that the income from the loans are portfolio in nature and not sourced to any specific state. They can also make the determination that potentially the income is sourced based on where the real estate that secures the loans.

You may be able to read through the partnership agreement and skin through the taxation paragraph or read through the prospectus to get additional information.

@Jim Dahle

To add to my previous comment. State taxation is complex since there is no uniformity among the states. 

As an investor in a real estate fund, you will be allocated your share of profits/losses from the fund.

You will have state sourced income in the states that the real estate fund does business in.

Some states allow for a "net operating loss", as such, if the K-1 provides you a loss, you can carry that loss until you decide to sell the property.

Some states require the fund to withhold on investors who are non-residents of the state.

K-1's received from funds can be complex in nature.

@Jim Dahle

General partner's/managing members and the accountants who prepare the fund make the determination of how income is categorized and then passed on to it's partners/members.

These partnership vehicles want to correctly classify the income.

Failure to do so can result in interest, penalties from the IRS/State's.
The partner's will look down on the partnership if such issues arises.

If you are an LP in a fund, you simple get a K-1 and have to deal with what is provided to you on your K-1.