State Composite Returns and Withholding for DST Investors

Composite returns exist for pass-through entities, and a DST is taxed as if you owned the building yourself

A composite or group return is a convenience a state offers to entities that issue K-1s: the entity files one return listing its electing nonresident owners and pays their tax on the state-source share, and those owners skip their own returns there. The owner usually gives up deductions and credits in exchange.

A DST does not fit that template. Under Rev. Rul. 2004-86 it is a grantor trust, and an owner of an undivided fractional interest is considered to own the trust assets attributable to it. The trustee reports your share on a grantor statement under Reg. section 1.671-4, not on a partnership K-1. For state purposes you look like an individual who owns a slice of a building in that state, which is why the general multi-state rules at state tax and multi-state filing for DST investors usually lead to your own nonresident return.

Two large states show the limits: New York's group return is for partnerships only, and California's excludes direct rental owners

New York's Form IT-203-GR instructions allow a group return for nonresident partners only where the filer is a partnership, including a limited liability partnership, limited liability investment company, limited liability trust company, or LLC treated as a partnership for federal income tax purposes, that has New York source income, has 11 or more qualified nonresident partners or members who elect in, and is granted approval. A grantor trust is not on that list.

California's Publication 1067 lets a business entity file a group nonresident return on Form 540NR for electing nonresident shareholders, partners or members. Those included must be full-year nonresidents, the income is taxed at the highest marginal rate of 12.3% with no deductions or credits except those attributable to the entity's activity, an additional 1% applies above $1 million of California taxable income, and the election is irrevocable once the return is filed. The grantor of a grantor trust can be included, but as an owner of a qualifying entity.

The same publication requires the entity's income to be the individual's only California source income, unless the rest is on another group return, and its example excludes an individual who also has an individually owned California rental property. A DST owner is treated for income tax purposes as owning a share of the trust's property directly. We found no FTB guidance treating a DST as an entity that can file a group return for its owners, so treat a sponsor's offer to do so as something to confirm with your CPA.

Withholding can apply to rents and to the sale, and the credit belongs to you as grantor

Some states require payers to withhold on certain payments to nonresidents. California's Form 592 instructions list rents among the payments subject to nonwage withholding, at 7% unless the FTB authorizes a reduced amount, with withholding optional on the first $1,500 of payments in a calendar year and required once the year's California source payments exceed $1,500. Whether a tenant or master tenant withholds on rent paid to a particular DST depends on the facts and the payer's position; ask the sponsor.

When withholding does happen on a grantor trust, the instructions direct the payer to list the grantor's individual name and taxpayer identification number, not the trust, because grantor trusts are transparent; the grantor reports the income and claims the withholding on their own California return. Withholding on the trust's sale of a property is a separate regime, summarised at state withholding at closing in a 1031 and states that withhold at closing.

Withholding is a prepayment, not a final tax. It usually means you must file the nonresident return to get the credit or a refund.

Your home state usually credits tax paid where the property is, so the cost is filing work more than double tax

Resident taxpayers are generally taxed on all income and given a credit for income tax paid to the state where the property sits. California's other state tax credit, claimed on Schedule S, is one example; it is not available where the other state gives the credit instead. California's group return publication adds that residents of Arizona, Guam, Oregon and Virginia who join a California group return lose the other state tax credit they could claim on an individual return, which is one reason a composite filing is not always cheaper even where allowed.

Hypothetical: a California resident owns DST interests with property in Ohio and New York. Ohio and New York nonresident returns report the share of trust income sourced there. California taxes the same income and credits the Ohio and New York tax under its rules. Run your own numbers with your CPA; credit limits vary by state.

What to ask a sponsor before you subscribe

Ask four questions in writing: in which states does the trust own property; does the sponsor file any composite, group or entity-level return for investors, and on what authority; does any payer withhold state tax on rents or distributions, and how is it reported to you; and when will the state-by-state income breakdown arrive each year.

Count states before you count trusts. Several trusts with property in the same few states can mean fewer returns than one portfolio trust spread across many. The annual forms are covered at DST tax forms and reporting.