Navigating the complex landscape of state tax filing can be daunting for DST investors. However, understanding why you should file in every state where your tangible property is located is critical—not just for compliance, but to protect your deferred tax benefits.
Understanding the Filing Requirement
In most states with income tax, non-residents are not obligated to pay taxes on income from tangible assets. For example, if you live in California but earn interest from a bank account in Colorado, you may not need to file a Colorado tax return. The picture changes dramatically when it comes to tangible assets like rental properties or DST investments.
Tangible vs. Intangible Assets
When you own a tangible asset, such as real estate or a DST (Delaware Statutory Trust) investment, the state where the property is located generally requires you to file a tax return. Filing correctly ensures that your DST is treated as real property rather than an intangible asset. This distinction is crucial because only tangible assets qualify for a 1031 Exchange, which allows you to defer capital gains taxes.
The Risks of Not Filing
Failing to file state tax returns when required can have long-lasting consequences. If you neglect to file, the state’s statute of limitations on tax assessments does not begin. This means that even years after the property has been sold, the state could still assess tax liabilities. One case involved investors who hadn’t filed returns for a property owned for a decade; even after selling, millions of dollars were still at risk because some investors failed to meet their filing obligations.
Protection Against Future Assessments
By filing in each state where your DST is located, you avoid the risk of dormant tax issues re-emerging. This proactive approach not only secures your deferred gains but also ensures that any tax credits for taxes paid to non-resident states are appropriately applied. Typically, you won’t end up paying double tax; you’ll only pay the higher of the two state tax rates—either your resident state or the non-resident state.
Protection For Your 1031 Exchange
If you choose not to file tax returns in states where you own property, you’re essentially asserting that the income you receive from that property is not derived from tangible real estate. This distinction is critical because, to qualify for a 1031 exchange, the property must be considered tangible real property.
While this may seem like a minor technicality, taking this position on your tax return could, in theory, jeopardize the validity of your current exchange and potentially impact future exchanges as well. Given the risks, we strongly recommend erring on the side of caution and filing non-resident state tax returns for your Delaware Statutory Trust (DST) ownership whenever practical. Doing so helps safeguard the integrity of your 1031 exchange and ensures compliance with state tax regulations.
Strategic Benefits for Your Investment
One of the major advantages of filing in non-resident states is the ability to structure your depreciation schedules advantageously. For example, consider a scenario where you sell a property in California with a significant gain and then reinvest in a property in Utah. While California might defer the gain for federal and state tax purposes, Utah will treat your basis differently. By filing in Utah, we can adjust your depreciation schedule to shelter most or all of your income from non-resident state taxes.
Balancing Compliance and Practicality
Our general recommendation is to file state tax returns in every state where you own DST property. While this is a sound approach, some investors may hold DST interests in five, ten, or even more states. So, what should you do in these cases?
The decision often depends on the size of the investment and the investor’s unique circumstances. While we can’t advise against filing, there are situations where we present investors with the option: If you want to file in all these states, we can—but it will cost an additional $X,XXX.XX.
In practice, many investors opt not to file in every state because the additional cost outweighs the perceived benefit. While we advocate for a cautious approach, we also recognize that practicality plays a role in each investor’s decision.
Our Exchange Planning Service
To help you navigate these complexities, our exchange planning service provides comprehensive support. We guide you through the filing process, prepare the necessary state tax returns, and run various depreciation models to determine the most beneficial strategy for your situation. With our assistance, you can maintain compliance without incurring additional tax liabilities, ensuring your DST investments are optimized for both growth and tax efficiency.
Conclusion
Filing state tax returns in every location where your tangible assets reside is not just a bureaucratic necessity—it’s a strategic decision that safeguards your investment and deferred gains. By treating your DST as real property and using tailored depreciation strategies, you ensure that you’re fully compliant and positioned to maximize your tax benefits.
Frequently Asked Questions
1. Why do I need to file tax returns in states where my DST is located?
Filing in each state confirms that your DST is treated as tangible real estate, ensuring it qualifies for a 1031 Exchange and that any tax credits are properly applied.
2. Will filing in multiple states mean I pay double state taxes?
No. Typically, you only pay the higher of the two state tax rates. When you file in non-resident states, your resident state will usually give you a credit for taxes paid elsewhere.
3. What happens if I don’t file a required state tax return?
If you don’t file, the state’s statute of limitations doesn’t begin, meaning they can assess taxes at any time—even years later—potentially resulting in substantial liabilities.
4. How does filing affect my depreciation schedule?
Filing in the state where your DST is located allows us to structure your depreciation so that you can shelter more, or even all, of your income from non-resident state taxes.
5. What services do you offer to help with this process?
We provide a full suite of services including state tax return preparation, guidance on depreciation methods, and tailored exchange planning to ensure compliance and optimal tax benefits.
