Real estate investments can diversify a portfolio, but the best opportunities may not be in a local market. Washington State residents may be enticed to invest in out-of-state properties, but those investments have tax consequences.
Investments in out-of-state rental properties, whether direct or through a partnership, generate income sourced to the state where the property is located. These properties generate ordinary income or losses from rental activities and gains or losses when they are sold. The sale of an out-of-state vacation home could trigger capital gains, although losses will not be deductible. The income from these properties will require filing non-resident tax returns in the states where the properties are located.
Taxpayers who file state tax returns to report income from out-of-state properties are eligible to claim a credit in their resident states for their nonresident taxes paid. That credit is not available for taxpayers in states with no income tax, so this would reduce the attractiveness of investing in out-of-state properties relative to other investments. The need to file nonresident tax returns is often as discouraging as paying out-of-state taxes.
One way to avoid the burden of filing returns and paying taxes directly on geographically diverse properties is to invest in real estate investment trusts (REITs). REITs can invest in diverse multistate real estate portfolios and do not pass through the state tax characteristics of the portfolios to shareholders. The shareholders recognize dividend and capital gain income from REITs only in their state of residence and not in the state where the properties are located.
Fulcrum Wealth Advisors will help its clients decide whether real estate investing is appropriate for their portfolios, keeping tax efficiency in mind.
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