Losing Interest or Don’t Always Trust Your State K-1

SALT Chat

09.17.18 | SALT Chat

As my marketing department knows, SALT TALK is often written at the very last minute.  The reason being is that I like to capture current events, whether that be the latest news or what I am currently experiencing.  Hence the subject of today’s blog.

The phone call starts like this:

Wayne, I have a Florida resident that just received a New York K-1 with $7 million of interest income in the New York source column.  He is just a passive investor in an entity that made one loan.  The property might be in New York, but I am just not sure.

Now maybe in some cases the state sourcing doesn’t seem like such a big deal.  But as all my readers know, Florida has no income tax and if our investor is expected to write a check to New York, there is going to be no offsetting Florida credit.

As my readers also know, interest income is often treated as earnings from an intangible asset that is taxed only in an individual taxpayer’s state of residence.  In this case Florida, which translates to no tax due.

The rules are getting more and more confusing.  Market based sourcing rules in some instances have said that interest should be sourced to where the loan for the underlying asset is.  In the simplest case, interest earned on a mortgage for real property located in State X should be sourced to State X.  Things can get a little more interesting and complicated when a trade or business is involved and the interest income is related to funds used in operations.

One of my partners stripped the question down to its essence when he simply stated:

WAYNE (caps intentional to signify justified agitation), can’t you just tell me if the sourcing rules even matter or come into play if there is clearly no trade or business?

Fortunately in the case at hand I was able to answer that for a New York individual nonresident taxpayer, the sourcing rules shouldn’t be relevant when clearly the loan is not part of a trade or business.  It is key to remember that the trade or business issue is not always so clear, states are continuously changing these rules (constitutionally valid or not) and even the type of entity receiving the interest could in fact change the answer.

The moral of the story: You can’t always believe your K-1.  In fact, a quick phone call to the accountant who prepared the entity return resulted in an acknowledgement of the issue and the offer to send an amended K-1.

If my story raises questions for you, contact me at WBerkowitz@BerdonLLP.com or your Berdon advisor.

Wayne Berkowitz, a tax partner and head of the State and Local Tax Group at Berdon LLP, advises on the unique requirements of governments and municipalities across the nation.