Historically, state and local taxes on commercial real estate developments and their managers and investors have been fairly straightforward. Obviously, real property taxes and, in some cases, personal property taxes applied to these projects. Property managers rarely considered sales and use taxes, since real estate construction and related services usually were not taxable.
States often did not require nonresident owners of real estate projects to file income tax returns, particularly if they were passive investors such as limited partners. When states did mandate tax returns for nonresidents, the income or loss of the venture often was assigned only to the state in which the project was located.
The state and local tax environment for real estate developers has changed gradually yet dramatically in recent years. Most states now require income tax returns from nonresident owners, regardless of whether they are only limited partners or nonmanaging members of limited liability companies (LLCs). Bloomberg BNA’s 2013 Survey of State Tax Departments revealed that 37 states now require nonresidents who have ownership interests in partnerships or LLCs that conduct business within their borders to file state income tax returns there.
As the reach of state tax authorities has gotten longer, they have adopted aggressive methods to ensure that nonresidents pay the taxes owed. In many jurisdictions, the LLCs and partnerships commonly used for real estate projects are subject to complex withholding tax rules. Thirty-two states require withholding by partnerships and LLCs on income attributable to nonresident partners and members.
In addition, the process of determining how much income or loss to report to a state has grown more complex. The traditional method, which was based on a development’s geographic location (that is, separate accounting), has been largely replaced by a formula that combines the activities of a partnership’s or LLC’s projects in all or a select group of locations and apportions the total net profit or loss among the states where real estate operations are conducted. While this could be advantageous if loss projects are combined with profitable ones, it often can produce higher state taxes. Further, states like Ohio, Tennessee and Texas have enacted taxes on income, gross receipts or other bases that apply directly to partnerships and LLCs rather than to their owners.
States also have dialed up their resources for enforcing sales and use tax rules. While real estate services usually are not subject to sales tax, select revenue streams like parking or providing repair services might be taxable. Wisconsin, for example, taxes parking receipts while Texas imposes its state sales tax on repairs to commercial real estate. Real estate developers and property management companies should not be lulled into thinking that sales and use taxes do not apply to them, even if their properties are located in states that do not tax their services. States place the burden of monitoring purchases for properly applied sales tax upon the purchaser as well as the seller. When businesses buy goods like office supplies or computer hardware without paying tax, they must self-assess consumer use tax and report it to state and, possibly, local tax agencies.
Personal property tax reporting obligations should not be overlooked. Personal property such as equipment, furniture and fixtures and leasehold improvements are taxable in more than 40 states. Failure to file local returns can lead to “omitted property” assessments for prior year taxes. Proper fixed asset accounting and periodic analysis of personal property assessments can produce significant tax savings.
Unclaimed property audits represent another growing source of revenue for states. Unclaimed property is defined as amounts owing to an individual or a business that have not been transferred to or claimed by them. Examples include the uncashed payroll checks of former employees and rent deposits not returned to former tenants. Financial assets of this nature must be turned over to state officials after a specified time period elapses. Many businesses are unaware of unclaimed property reporting laws, do not file state returns and fail to turn over the unclaimed assets to state authorities.
Until recently, unclaimed property audit activity was confined to larger states like New York and California. Delaware, however, also has been very aggressive because of the unclaimed property jurisdiction it has over the many companies incorporated there. Now, more states are increasing their enforcement activity. In an attempt to capture new revenue, they are hiring contingent fee auditors who have virtually unrestricted power to examine records from prior years and assess businesses for unreported unclaimed property. These assessments can be very large, because a business is liable for 100 percent of the amount that is deemed unclaimed property, which often is based on estimates.
New taxes and enforcement efforts by state and local governments require a heightened awareness on the part of commercial real estate businesses. Failure to adequately plan for these taxes can significantly impact a project’s rate of return. These taxes and enforcement efforts also can lead to significant exposure for tax, interest and penalties and can require financial statement reserves for real estate businesses that require audits under generally accepted accounting rules. Such reserves will affect the selling price of a business, and certain liabilities like sales and use taxes will attach to the assets under successor liability laws. Exercising some foresight and establishing accurate state and local tax compliance mechanisms will help manage these risks.