Consolidated K1s and state income taxes

[John P.]

I have looked at several different real estate investment funds to possibly invest some money. I won't name names as I don't think it matters.  For simplicity let's say they both invest in 5 states that do have state income tax reporting requirements.  For a small investment (let's say $100k) the incremental cost of my CPA preparing another state return takes away any value I get by the geographic diversification.  One of the funds said they do a "consolidated K1" and thus the investors do not have to file a state income tax return in those states. That sounds good to me.  The other fund said they do not do a consolidated K1 as that gets taxed at the highest rate and not all investors are at the highest bracket, have unique tax issues, etc....  Curious if anybody here has experience and/or knowledge on the consolidated K1?  Is it really as simple as by them filing that I don't have to worry about filing in those states?  TIA.

[Michael Plaks]

@John P.

This problem has been discussed here on the forum many times, never producing any consensus between tax professionals.

Let's say your fund invests in 6 states. 

State #1 - no state tax
State #2 - your home state
State #3 - state that allows a composite return, you opted in
State #4 - state that allows a composite return, you opted OUT
State #5 - state allows a composite return, but the sponsor does NOT offer them
State #6 - state that DOES NOT allow a composite return

You will receive a Federal (IRS) K1 plus five state K1s, for states #2-6 (no K1 for state #1, since it does not have state-level tax)

State #1 - no issue
State #2 - you do NOT want a composite tax return for your home state, since you must file you home state tax return anyway, and composite will mess it up
State #3 - no issue, they will take care of your state exposure

So the problem is states #4-6: either no composite returns allowed, or the sponsor does not bother with them, or you choose to opt out. It becomes your responsibility to file three non-resident state tax returns.

Biggest problem: Each state has its own rules about whether or not you must file with small K-1 amounts. These rules are very confusing and inconsistent. Tax professionals disagree on this issue.

Let's assume you determined that state tax returns ARE required for these three states. Your options are:

A. Let your CPA file them, and yes, it's expensive (typically $100-500 per state) even if your income for each state is small
B. Roll a dice by not filing these three states and hope the states will not pursue you
C. Stay away from this investment altogether