Property is an enticing investment option for many people, be it residential, commercial, investment or multi-family. Historically, it’s one of the most reliable investment mediums, and it only becomes more valuable as time goes on. But unlike investment in stocks and other securities, property investment happens in a much more diverse way. For example, real estate takes on a new meaning when you consider investing in out-of-state properties.
The Advantages to Out-of-State Investing
We all know property prices differ by state. Generally speaking, for example, you’ll get more bang for your buck in Mississippi than in California. But there’s more to lower costs than the sale price.
Appreciation should play a role in your decision to invest in out-of-state property. According to Airbnb’s data, for instance, the best place to check is Lansing, Michigan—which has an expected real estate appreciation rate of 6.3% for the next year.
Cash return will also be a major driver behind your decision. Being able to generate cash flow from rental income means establishing an immediate value stream for your personal wealth. There could also be an up-and-coming market in another state that presents an opportunity too good to pass up. If you can buy in such an area before property values rise, your ROI will increase.
Additionally, spreading your real estate investment in out-of-state properties diversifies your risk. If a city or region in which you’ve invested sees economic downturn or other disaster, your property value can plummet. If you’ve put all your real estate eggs in one basket, it could spell disaster for your portfolio.
Done right, investing in out-of-state properties can be a lucrative opportunity. But these benefits and more are only accessible to investors who take steps to protect themselves. Rushing into these investments could result in a quagmire of problems—not least of which is a high tax burden that could eat into your profits.
Be Aware of Out-of-State Investment Challenges
Property as an investment vehicle takes considerable effort up front. The burden of buying, preparing and managing a property only increases for out-of-state investors. Many new property owners aren’t adequately prepared.
If you’re considering an investment in out-of-state properties, be sure to avoid common investing pitfalls. Here are a few tips to remember:
- Get familiar not only with the property, but the local markets and economy as well. Local trends often have a much bigger impact on housing markets than national trends.
- Find and hire a property management company with reasonable fees. These costs will recoup themselves in peace of mind. Work with a licensed, bonded property management firm to reduce your liability and potential exposure to fraud.
- Be mindful of when and how you’ll visit out-of-state properties. Never buy sight unseen, and make routine visits to gauge the condition or be present for things like improvements. Remember, travel is a deductible expense for property investors but does have a negative impact on your ROI.
- Find a trustworthy lender with a presence in the local market. Out-of-state buyers could potentially face higher mortgage interest and down payment requirements because lenders considering them riskier borrows.
- Planning on listing your property on Airbnb or VRBO? Check with local statutes before investing. Some areas don’t allow these short-term rentals and may more require special homeowners insurance.
- Beware of states that have rent control laws. (California, New York and New Jersey are a few such states.) Do you your homework and understand the local laws. They could have a negative effect on your cash flow and ROI.
Beyond these tips, pay close attention to state and local housing laws and the financial challenges that come with them. You should always know state laws pertaining to subsidized rent terms and eviction process, for example.
Understand the Tax Consequences
Investors who do everything right when buying and managing out-of-state properties still need to be aware of the tax implications. Failing to account for them could become troublesome during tax season, disrupting cash flow or creating unexpected expenses.
For starters, investors may need to pay state income tax due to rental income or capital gains at the state’s ordinary rates. Many states do not have different rates for capital gain vs ordinary income, but tax all income the same. Figuring out these numbers ahead of time allows investors to factor them into cash flow figures or ROI estimates.
Another concern to worry about is double taxation. This can occur if you live in a state that has income tax and requires you to report in your home state. This tax is in addition to tax in the state where your investments reside. To offset this, you may be able to take a credit for state income tax paid in another state. However, the Tax Cuts and Jobs Act limits the deduction of state taxes to $10,000 on your federal income tax return.
Planning on investing through a business entity? Make sure your LLC is recognized by the state and doesn’t owe its own taxes. For example, some states treat LLCs as taxable entities or assess a tax on an LLC’s gross revenue. And be cognizant of your yearly franchise or net worth and the tax burden it incurs.
You’ll also need to consider any mandatory state withholdings stemming from the sale of out-of-state properties. The withholding is usually based on a percentage of the gross sale price, not net profit. Most states do not refund withholding until a tax return is filed. This could delay expected cash being received for up to one year, depending on when the sale occurred.
Underwater on your investment? When deciding on selling a property that will not turn around, many property owners take a loss to offset other income. The loss may qualify as an operating loss or capital loss carryover deductions of up to $3,000 per year. The state treatment of these losses could differ significantly or be restricted or lost depending on the state rules.
Finally, keep in mind the additional cost for compliance or filing in states. You may not be required to file a tax return if your income is below a certain threshold. However, if you have losses on out-of-state properties, you may need to file to establish those losses with the state. Unfortunately, there is a cost associated with preparing and filing the state tax returns. This cost should be included in your ROI calculation.
Consult With a Real Estate CPA
If you’re planning on buying out-of-state properties and want to do it right, contact an experienced real estate CPA. He or she will advise you on how to best approach the sale and help protect against tax complications.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.