Crowdfunded real estate investment has been creating quite a buzz in the real estate investment world over the last few years. From the beginner-friendly Fundrise to the larger, more robust Crowdstreet, there’s a crowdfunding platform for almost any investor.
Crowdfunding offers significant advantages, including low barriers to entry, stability of investment, and the possibility of regular cash flow without hiring a landlord or hiring a property manager. Of course, no investment has a guaranteed investment return (ROI), but crowdfunded real estate is well diversified and relatively stable.
But what are the tax implications of crowdfunded real estate investment?
It’s wise to consider the tax ramifications before you make your first deal. Your ranking as an investor (accredited or unaccredited), the crowdfunding platform you choose, the property you invest in, and how you earn profits can all affect taxes you pay.
Non-accredited investors: direct taxes at your regular tax rate.
Accredited investors and non-accredited investors may be taxed differently on crowdfunded investments, depending on the specific arrangement. While it’s easier for a non-accredited investor to file, profitable crowdfunding could leave you with an undesirable tax liability.
Non-accredited investors participate in so-called ‘debt deals.’ In debt deals, investors act as lenders to real property investors. They do not own property and do not qualify for any tax benefits.
Any interest you earn on the funds as a non-accredited investor is taxed as regular income on the IRS form 1099-INT.
This means that you will pay taxes at the same rate as any other income you receive from a job or contract position where you receive a W-2 or 1099. The marginal tax rate in 2019 is 10 per cent – 37 per cent for individuals who have made more than $510,300 or couples filing together with a combined income of $612,350 or more.
If you earn more than $1,500 in interest, you will need to prepare Schedule B with the names of the payers and the amount of interest. There is one caveat to crowdfunded real estate interest: if you invest in multiple funds, you can add them to a single 1099-INT, reducing at least some of the paperwork that comes with filing taxes.
When filing, make sure that you deduct any penalties you have paid for early withdrawals from any investment in order to reduce your tax bill.
Unfortunately, you can not deduct business expenses related to your investment in real estate as a non-accredited investor. You can not also file at the rate of capital gains any qualified dividends; they are taxed as regular income.
Tax benefits for accreditation
If your goal is to earn substantial income as a real estate investor through crowdfunding, you’re going to want to become an accredited investor.
Since investors are accredited by showing a net worth of more than $1 million and earnings of $200,000 or more in the last two tax years, it’s a strong goal to shoot if you’re a beginner investor.
But tax benefits are just one of the advantages; many of the top crowdfunding real estate platforms only work with accredited investors. When accredited investors use a crowdfunding platform, they participate in what is called an equity deal. If you invest in an equity deal, you will receive shares that represent property ownership, which entitle you to rental income and capital gains income if it is sold by the business entity that holds the property.
This income can be taxed in a number of ways, depending on the investment structure, how long you hold the property, and other factors.
This is where it ‘s going to get complicated.
This article provides some pretty detailed guidance on what tax implications you might expect for crowdfunded real estate investment. But, of course, it’s best to check with a tax accountant — preferably one who specializes in real estate investment firms — to guide you.
With the simple part (tax for non-accredited investors) out of the way, let ‘s look at the tax implications of crowdfunded REIs for accredited investors. Ready, huh?
Tax implications of equity partnerships in crowd-funded REIs
When you invest in crowdfunded real estate investment deal as an equity investor, you will receive a K-1 (1065) tax form documenting income or losses incurred 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 by the next business day if March 15 lands on a weekend or holiday. For example, K-1 forms for the tax year 2019 should be received by March 16 , 2020, since March 15 is a Sunday. When you pay your personal income tax, you will use the information on the K-1 form.
Understanding the form of K-1 (1065)
It is important to ensure that you receive your K-1 form in time to file your personal income tax by April 15. K-1s are often one of the last tax papers that you will receive because of the amount of work that goes into preparing them.
The form K-1 is similar to the form W-2 or 1099. It shows your share of the partnership ‘s earnings, losses, deductions and credits. The income reported on the K-1 only needs to be earned by the partnership and not necessarily distributed.
This is where it can cause problems. You could owe taxes on money that is not liquid or available for you to spend. If you have substantial income from your crowdfunded partnerships, you could be paying more tax money than you actually received.
If you file a K-1 for your investment, you will also have to file an IRS Form 1065, U.S. Return of Partnership Income, with your personal tax return. Form 1065 is your partnership tax return. There may be similar forms in individual states.
If you pay a tax accountant to file for you, the accountant may charge more if you also need to file Form 1065; it is an additional tax return that requires more time and work from the accountant. You’re going to want to factor that cost into your business expenses.
Remember, the LLC does not pay taxes; it is considered to be a pass-through entity. The owners of the partnership shall pay taxes on their income (or deduct any losses) on their personal income tax forms. The taxes you pay on the income of the LLC depend on the type of real estate agreement.
Fix-and – flip investment: Fix-and – flip investment (property sold in the first year of ownership) is taxed as regular income. You may be eligible for certain deductions related to your investment, which we will cover below.
Rental income: If your investment generates rental income, you will receive quarterly payments. This income is treated as a capital gain and is subject to tax at 0%, 15% or 25% depending on your tax bracket. Whatever your bracket, capital gains are taxed at a lower rate than regular earnings. You can also use capital losses from previous years to offset your capital gains by lowering your net taxable income across the board.
In addition, you can deduct depreciation and other expenses to further offset your purchase-and-hold property income.
Likewise, any income from the sale of a rental property (or a fix-and-flip that lasts longer than one year to be sold) is also taxed at the rate of capital gains.
At first glance, it might seem that investing in buy-and – hold properties provides the most tax advantages. But whatever direction you take, you will find tax advantages for crowdfunded real estate investments that you may not find with other investments, including property investments where you are the primary investor.
Tax advantages of crowd-funded real estate
Crowdfunded investments offer a number of tax advantages. For example, crowdfunded investments:
- are taxed as passive activities (no self-employed taxes due)
- Allow passive gains to be offset by passive losses,
- are eligible for deductions for depreciation,
- It can be financed through the IRA, and
- They are taxed at the rate of capital gains.
Take advantage of crowdfunded real estate
With all these options, it can be hard to make sure you get the most tax benefits out of your crowdfunded investment. Take these steps to make sure you get as much as you can:
Crowdfunded real estate is a passive activity, so you don’t have to file self-employed taxes.
You will not receive a 1099-MISC form reflecting your income. This also means that you don’t pay this income to Social Security. That’s something to consider when it comes to retirement planning, but in reality, your investment income should provide a stronger nesting egg than Social Security would ever have been.
In the same way , make sure that you report rental income and money from the sale of property held for more than 12 months as capital gains, not at your regular marginal tax rate.
Offset your passive loss income
If you have passive losses — even in previous years — you can offset your passive gains against those losses in order to reduce your overall tax liability. This applies to losses on the stock market as well as losses on other investment properties.
If you have suffered passive losses from bad 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 reducing your tax bill by diversifying through crowdfunded real estate investment.
Take advantage of deductions for depreciation
You may want to deduct depreciation expenses in order to further offset your capital gains. Fortunately, it is easy to calculate the depreciation of crowdfunded investments; 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 properties, including single-family rentals and multi-family rental units. Commercial properties have been depreciated for 39 years. Appliances and building assets may be deducted over the expected lifespan of the items or upgrades.
The holding company will calculate the depreciation on the basis of your taxable income from the property and share those numbers to be included in your tax returns.
Keep in mind that when the holding company sells the property for profit, you may be responsible for the recovery of the depreciation of your taxes. Some crowdfunding platforms allow 1,031 exchanges that allow you to roll your investment income into your next property.
Consider using your IRA to finance your crowdfunded investment
Whether you are involved in equity or debt, you may be able to tap into your IRA for a crowdfunded real estate deal. Be aware, however, that an equity agreement may be subject to unrelated business taxable income (UBTI). If the UBTI is more than $1,000, you will have to report it as income.
On the other hand, debt deals usually do not generate capital gains or business income — only interest-based income. Interest income will be reported through your tax-deferred retirement account, not your personal income tax return.
For those who aren’t career real estate investors, using your IRA to fund crowdfunded IRAs is a great way to help your retirement dollars grow. And if you’re a career investor, you can use your IRA to fund debt deals and diversify your retirement income while staying in a familiar arena.
Common deductions to reduce your tax bill as a crowd-funded real estate investor
Equity deals with quarterly distributions (cash flow) can be taxed as income. In the case of purchase-and-hold investments, the cash flow can be offset by depreciation and other deductions, which can lead to losses. In addition to using passive losses to offset capital gains from crowdfunded investments, you can also reduce your taxable income through other deductions. These include the following:
- Expenses on interest,
- Operational expenses, and
- Net operating loss.
As a partner in a crowdfunded investment deal, you’re not paying interest on loans directly. But the LLC passes these expenses on to the shareholders, and they are reflected in the K-1 form. Make sure you deduct them from your gross income.
Operating expenses for passive investors come in the form of fees. These fees should be included in the contract before you make any investment. Common examples of fees shall 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 the closing costs of a residential mortgage, these charges cover the final sale of the property.
- Construction management fees: In the context of 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, usually for rental properties. They can also cover the costs of marketing and selling a fix-and – flip investment.
There are also other costs related to the rental property that are passed on by the holding company to investors as a reduction in profits:
- Maintenance and operating costs: paid by the LLC with costs passed on to other investors, these charges 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 to investors as a deduction from K-1 income.
- Insurance: Every property requires homeowner’s insurance, and these fees are deducted from the net operating income of a crowdfunded investment in real estate.
Fees may add up, but the good news is that they are all deductible from your taxable income — either on your personal tax return or as a deduction from your investment income on your K-1 form.
In addition , depending on how you file, you may be able to make use of other business deductions as part of your investment business. While not directly related to crowdfunded real estate income, these deductions may reduce taxable income and overall tax liability.
Deductions may include depreciation on other properties, operating expenses for your other properties, marketing, continuing education, employees’ salaries and benefits, and any other expenses associated with your investment property business.
Net operating loss
Of course, you’re going to invest with the aim of making money. But if a rental property or a fix-and-flip begins to operate at a loss, that loss can offset passive earnings and other taxable earnings.
Crowd-funded REIs and state taxes
Each state has different tax laws in relation to investment income and passive income activity. In most states that collect state income tax, you will need to factor in your K-1 income as well as any other income, such as W-2, 1099-MISC, and 1099-INT.
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 is that not double taxation?
Yes, but that’s why you’re allowed to claim your non-resident state tax as a credit on your state tax return.
Unlike deductions that reduce only 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 investment in your country — and possibly also in the state where you invest — can help ensure that you report your income properly and take all the credits and deductions you deserve.
Helpful tips on reducing your tax liability for crowdfunded real estate
As you can see, understanding the tax implications of crowdfunded investment is not easy. If you are an accredited investor, you will want to discuss the ramifications with your accountant before entering into an agreement.
If you are 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 are an accredited investor, you can follow these tips to avoid getting hammered with a big tax bill:
- Understand what kind 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 IRA money to invest in debt deals to take advantage of the tax deferral of investment income.
- Hold investments for more than one year so that you can report income as capital gains, which are typically taxable at a lower rate than regular income.
- Make an exchange of 1031 through a crowdfunding platform that allows it.
- Please ensure that you file Form 1065 on time, with your personal tax returns, so that you do not pay penalties or fees.
Crowd-funded 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.
The “Unfair Advantages” of Real Estate just got a lot better.
Investing in real estate has always been one of the most effective ways to achieve financial independence. It’s because it offers incredible returns and even more incredible tax breaks.