Monthly Archives: March 2014

The impact of commercial real estate taxation across the 50 states

While blogging about the impact of inter-state (non-residence) taxes on real estate investments, I came across useful research on real estate taxation parameters in every state. The research demonstrates how important it is to understand the tax regime in a state you invest in, in order to predict profits.

The taxation guide is available at no cost to anyone who requests it, at Alan Blairreiadvise.com/50-state-guide by emailing admin@reiadvise.com. I spoke with its creator, Alan Blair, Managing  Partner at REI Equity Partners, which is a Connecticut-based real estate investment and advisory company focused on stable, long-term cash-flowing investments for its clients.

Highlights below include:

  1. Alan, you’ve put together a pamphlet that summarizes tax implications of operating properties in all 50 states and Washington, DC.  The research you’ve put into this is quite an accomplishment. I count 17 columns worth of taxation and customs considerations by state. What was your goal?
    Necessity was the mother of invention in putting this together. We began servicing investment clients from the US and abroad that had a nation-wide scope for acquisition criteria.  The tax information grew beyond a legal-sized piece of paper, so I went to all of the states’ websites – secretary of state, taxation, business departments – and began capturing all these parameters. It took weeks to drafts and months to complete.
    Now, this desktop reference guide helps us accurately estimate total property acquisition and disposition costs. We had a real surprise, in fact it took our breath away, when we first understood taxes and additional costs in New York, for example.

  1. How important are taxes and fees in calculating returns?
    Very important! When you compare the least favorable state for taxation of non-resident property owner income against the most favorable, it’s a difference of keeping just 87% of your profits after state taxes, versus keeping 100%, the entirety, of your profits. Some of the other taxes and fees that most investors and developers don’t think a lot about, such as mortgage tax, transfer tax, leasehold tax, can also slice significantly into returns.
    On cash flow properties, you’re interested in the spread between the cap rate and mortgage rates. As that spread begins to narrow, it’s absolutely important to sharpen your pencil and understand how much you’ll keep in the end.

  1. What is different about New York?
    Our model ranks New York as 27th out of 50 states in terms of how favorable, or in this case burdensome, the tax regime is. New York state charges 1.4% and New York City charges an additional 2.625% transfer tax upon the sale of the property. The seller bears that expense, which is above and beyond state and city income tax. New York state also levies an annual franchise tax on the asset. And, there are annual withdholdings. I haven’t even addressed capital gains taxes here.
    Let’s go further. In most states, closings can be conducted remotely.. All documents are prepared by the attorneys in advance, executed and overnighted to the title company. Once everything is in place the order is given by the lender and buyer to wire the funds to the title company who then distributes the funds to the seller. To compare, in New York, it’s customary for a closing to occur in person. The parties and lawyers appear, a representative from the title company joins, then you sign documents. To close electronically in New York, I believe you’d need to start with attorney authorizations to sign on your behalf.
  1. What other parameters do you track?
    Mortgage tax, leasehold tax, the owner’s policy premium are some of the customs levied in various states, but the amounts and expectation of whether the buyer or seller pays differs. The seller isn’t going to volunteer this information if you’re negotiating to buy a property, so you need to be aware yourself.
  1. Can an individual investor make use of this research? What about developers?
    For both groups, especially individuals, our guide is a starting point to ask the right questions. It’s an alarm bell in a sense. Then parties can use us as an advisor, or turn to their CPA or tax lawyer, to determine all the details for a particular deal.
    In terms of asking the right questions, let’s take the case of title insurance. In some states the cost is fixed and the process is fairly standard. In other situations, you would want to understand how diligently your attorney is looking after your interests by helping negotiate the title insurance cost while ensuring that your interests are adequately protected. When I recommend an investment property, the last thing I want is for all of us to be surprised about unanticipated closing costs.

  1. You’ve developed a ranking formula for the states and list the top 10 states in terms of favorable tax regime for real estate. Which states are in the top 10 and why?
    There are 5 states where you get to keep 100% of the real estate profits as a non-resident entity. There are no filings, no surprises, nothing really is required. These became our top 5; they are Florida, Nevada, South Dakota, Washington state, and Wyoming. The next five have minimal franchise/opportunity taxes are Delaware, Illinois, North Dakota, Ohio, and Texas. Compare North Dakota, which levies a 4% franchise tax against West Virginia, at the bottom of the 50 states, with a 13% tax. And franchise taxes are levied on assets and or income annually!
    Of course, taxation isn’t by any means the only criterion for selecting investment locations. It also depends on the opportunities available in the state and the deal’s terms. Texas has a lot of opportunity currently with not as many investors bidding up prices, though that window is narrowing. Illinois works for us in terms of opportunity, yet with a 1.5% franchise tax.
  1. How closely do you estimate taxes? What does your model look like?
    Property tax rates can vary based on the amount of profit, just like a marginal tax rate on income. The numbers I report in the state tax rankings are based on assumption that a property yielded $117,000 gross profit, but the underlying model adjusts for the different tax tiers.
    Institutional real estate investment firms generally use ARGUS for assessing risks and returns. It’s considered an industry standard. On the other hand, our our proprietary model focuses solely on fully-rented, existing cash-flow, retail and office commercial properties. I personally think our model is better, more insightful, for this purpose.
  1. What does your own real estate investment company focus on?
    We operate two companies. One is Real Estate Investment Advisors (REI Advisors), which represents larger investors in their search to acquire new properties. Then there’s REI Equity Management, which is the general partner in properties we own on behalf of investors. We operate both companies under the brand “REI Equity Partners”. We specialize in high-quality properties that can provide long term passive income for our investors. Often our individual investors are planning for their retirement one day. In particular, we emphasize properties such as multi-tenant retail with strong leases and tenants, and medical office space. All our investments are based on extensive financial modeling of the income potential and risk reduction considerations.

  1. Let’s consider crowdfunding for a moment, the trending model that allows a wider range of investors to get involved with real estate properties with lower minimum investment amounts than is traditional. How can they get a handle on the risks and rewards modeling for real estate?
    It can be challenging. They should start by understanding the various property classes. For example, they may have an instinctive feel for house flips, being a home owner. However development carries additional risks in terms of unexpected surprises with the land and existing property, the cost of materials, length of time to build and sell, and especially on the high-end, exposure to economic downturns.
    Compare that to high-quality commercial leases, such as multi-tenant retail. Rental properties like this are very predictable over the long term because you can read what the lease says and you can evaluate the economic strength of the tenant and the nature of the business. This type of real estate investment would be a good substitute for other types of “fixed income” investments such as bonds. Real Estate has the added benefit of not re-pricing daily with interest rate changes and valuations are not inversely related to inflation because with inflation you get rent increases, albeit with a time lag.
  1. How do you reduce risks with your commercial RE investments?
    Well-written triple net leases are key, but not every region of the country commonly see these, so you have to be selective about location. We invest in properties that are already tenanted: you know exactly who the tenant businesses are, you can read the leases, and study the traffic around the location. All the tenants in our properties are national or super-regional companies. In our last investment, the anchor tenant is Starbuck’s, and premium coffee has proven fairly resistant to changes in the economy. Starbuck’s in turn encourages traffic to, and interest in, the other spaces on the property. Other properties we have invested in are shadow-anchored by a local medical center or university or a super regional Wal-mart.
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Real Estate Investing and Out-of-State Taxation

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 I 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.

http://smallbusiness.findlaw.com/incorporation-and-legal-structures/conducting-business-as-a-corporation-or-an-llc-out-of-state.html

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…”