How Can I Invest in Real Estate in Tax-Free States?

How Can I Invest in Real Estate in Tax-Free States?

Posted by on May 9, 2022

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As a real estate investor, you want to choose investment opportunities that seek to maximize your return on investment (ROI) to help build wealth. One way to attempt to increase your returns on investment properties is to buy real estate located in tax-free states.

When you invest in real estate in a tax-free state, you can avoid paying double taxes on your investment. Coupled with wealth management strategies like a 1031 exchange, you may be able to retain more of your wealth for future generations.

What Is a Tax-Free State?

A tax-free state doesn’t collect state income from people who live or invest in the state. However, federal income taxes still apply. The IRS considers capital gains earned from the sale of real estate properties as ordinary income. Owning and selling property in a tax-free state helps you avoid paying state income tax on any profits or capital gains you earn from renting or selling your investment.

Currently, eight states do not collect income tax from people who earn money in the state. These tax-free states are:

  •       Alaska
  •       Florida
  •       Nevada
  •       New Hampshire
  •       South Dakota
  •       Tennessee
  •       Texas
  •       Wyoming

Why Invest in Tax-Free States?

The most significant benefit of investing in real estate located in tax-free states is reduced tax liability on any earned income and the profit you can make on your property over time.

When you invest in a tax-free state, you reduce your tax burden by avoiding making two income tax payments. If you live in a state that collects income or capital gains tax, you will have to report your real estate income and pay state taxes.

If you invest in a property in another state that collects income tax, you will also have to pay non-resident state income taxes in that state.

Remember, though, since the state you reside in does not collect income tax, you won't have to pay twice. This lower tax liability may help you increase your wealth over time, especially compared to potential earnings from investment properties in states with income tax.

For example, suppose you purchase a property in a tax-free state for $100,000 that earns $14,400 per year in rental income. If you reside in another state with a 5% income tax rate, you will pay around $3,600 in income tax over five years. This is because you are required to report and pay taxes on any income you make to your state of residence, even if it is earned from an out-of-state investment.

  •       $14,400 rental income x 5% income tax rate=$720 in income tax each year
  •       $720 income tax x 5 years= $3,600 total income tax payments

If you sell the property after five years and earn capital gains of $50,000 while living in a state with a capital gains tax rate of 5%, you’d pay $2,500 in capital gains.

  •       5% capital gains tax rate x $50,000 capital gains=$2,500 in capital gains tax

For comparison, suppose you invest in an investment property in a state that collects a 5% income tax and 5% capital gains tax. You also reside in a state with a 5% income tax rate and 5% capital gains tax. In this scenario, you’d pay $7,200 in income tax on rental profits and $5,000 in capital gains tax if you sold the property after five years.  In this example, these totals come from double taxation that you may be subject to on your income and capital gains earned over the course of five years.

The IRS allows for a $10,000 deduction on your federal income taxes for paying income tax in another state. You should work with a tax professional to determine if you qualify for this tax credit which could help reduce your tax liability and eliminate or reduce the double tax.

Without a potential IRS tax credit, however, investing in a property in a tax-free state can help you earn a bigger ROI over time. Considering the example situations above, you’d earn $115,900 over five years by investing in a property in a tax-free state. Alternatively, if you invested in a non-tax-free state, you’d only make $109,800.

How Can You Invest from Out-Of-State?

If you are interested in investing in properties in tax-free locations but need to do so from another state, you have a few options for conducting business. These include working with a property management company or investing in a Delaware Statutory Trust (DST) or a Triple Net Lease (NNN) property.

If you work with a property management company, you’ll need to find a company you trust to do business on your behalf. You’ll also have to pay them a monthly fee to manage your out-of-state property.

If you opt for a DST, you may benefit from an investment managed by a real estate Sponsor. This allows you to invest in properties you may not be able to acquire on your own with a pool of other investors. An NNN enables you to invest in a property without maintaining management duties and expenses.

With an NNN or DST investment, you can gain the potential benefits of owning a rental property with fewer direct responsibilities, which is beneficial if you don’t live near the property.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. Programs that depend on tenants for their revenue may suffer adverse consequences as a result of any financial difficulties, bankruptcy or insolvency of their tenants. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. No public market currently exists and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment. There is no guarantee that the investment objectives of any particular program will be achieved. The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time. Diversification does not guarantee a profit or protect against a loss in a declining market.  It is a method used to help manage investment risk. Examples shown are hypothetical and for illustrative purposes only.

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