Real estate remains one of the most popular and lucrative investment strategies for accumulating long-term wealth. In addition to creating a steady residual income and portfolio diversification real estate offers a number of tax advantages. Ranging from commercial real estate investments to Real Estate Investment Trusts (REITs) and private placement investments, real estate provides big state income tax benefits to investors. This results in considerable tax savings and even tax sheltering. In this article, we will discuss the state income tax benefits to real estate investors and how they can capitalize on them.
What is a state income tax?
The United States has a multi-tiered income tax system. So here, the federal, state, and sometimes local governments impose taxes on a taxpayer’s individual income.
State income tax is a direct tax that the state levies on income earned in that state. Like federal tax, state income tax is self-assessed. Such taxes are also used to fund state budgets rather than the federal government.
Most taxpayers live and work in a single state. They must file a resident state income tax return on all the taxable income they earn in that state. However, taxpayers who earn taxable income in a separate state must generally file state income tax returns in their state of residence regardless of which state or country the income originated.
Similarly, in the majority of the states, taxpayers must pay income tax on their earnings in the state even if they are non-residents. For instance, if someone lives in New Jersey and works in New York City, they must pay taxes in both New Jersey and New York. Moreover, wherever they will earn a sizable amount of their income will be the taxpayer’s tax home.
In the case of non-residents or part-year residents, private placements investments impose two state tax returns. Taxpayers should pay one tax in their state of residence and the other in the state where they earned the income or loss from the investment. Therefore, real estate investors are forced to pay multiple taxes on one income.
Hence, before investing in private placements, real estate investors must research the incentives and deductions they are eligible for.
State income tax credits
As discussed earlier, an investor who operates in a state other than the state of their residence, both the states will tax the source income. Therefore, the investors are subjected to double taxation. As the name suggests, double taxation implies paying taxes twice on the same amount of earned income. Thus, to avoid double taxation issues, some states have entered into reciprocal agreements to not tax the same income.
In these cases, most states provide a tax credit to the other state. For instance, if an investor resides in Texas but he invests in a private placement in California. So, the investor has to pay state income tax to California on the income they earn from the investment. Therefore, to avoid double taxation Texas will give the investor a state tax credit for the taxes paid in California from that investment.
This credit is generally applicable on the amount of the state tax paid to the non-resident state. Also in some cases, the non-resident state’s income tax rate is more. Then the credit is applicable on the amount of tax the taxpayer would have paid in their resident state.
However, if someone makes an investment in a state with an augmented income tax rate than their home state, they will end up paying taxes at an inflated rate. Therefore, as a general rule, investors must check on the income tax rates in different states.
Real estate investments in states with no income tax
In addition to accessing state tax credits, real estate investors also consider investing in states with no income tax. Furthermore, if an investor resides in a state with no income tax, they will simply pay tax to the state where their investment is located.
Currently there are seven states that do not tax individual income. These states are as follows:
- South Dakota
In addition to this, New Hampshire and Tennessee do not tax earned income. Instead, they do tax interest income and dividend income.
One of the greatest advantages of investing in States with no income is the opportunity to avoid double taxation. Moreover, states that offer a favorable tax system become a hotbed for growing population and employment opportunities. In fact, the American Legislative Exchange Council (ALEC) notes that in the last 10 years, the states with the lowest income tax rates witnessed a 109% greater population growth than those with greater tax rates. Apart from this, the job growth in such states grew by 130% too. Subsequently, such booming markets prove to be a prosperous epicenter for real estate investments. Therefore, state income tax benefits also impact the standard of living in a state positively.
State income tax considerations for REIT investors
REITs distribute dividend payments to the investors that constitute capital gains, ordinary income, or returns on capital. Hence, the REITs send Form 1099-DIV to the investor’s dividends and capital gains each year. Since the dividends act as the ordinary income for the investors, they only need to pay state taxes on this dividend and capital gains in their state of residence.
Although investing in real estate sounds like a good idea, It does carry concomitant tax burdens. Therefore, state income tax benefits protect real estate investors from double taxation and reduced income.
However, to avoid allocating a sizable amount of their income in state taxes, investors must carefully analyze the tax infrastructure of various states before portfolio diversification. This is because investing in disparate properties in multiple states with a higher tax regime may increase the general overhead costs. It is prudent to consult with an experienced tax advisor who is well versed in income tax regulations of the various states. Furthermore, the guidance of a competent tax consultant will enable the investors to find ways to minimize their overall tax bill.