Mastering the Management of Out-of-State Rental Property Taxes

As a savvy real estate investor, you might be looking to buy rental properties outside of your home state to diversify your portfolio and tap into markets with higher growth potential. Perhaps property prices are more affordable in other areas, or the rental yields are stronger due to better job markets and population growth. Whatever the motivation, owning out-of-state rentals complicates tax-paying.

This article provides a guide on filing taxes on out-of-state rental income. It covers the multi-step process of filing returns for your property owned and how to claim tax credits to avoid double taxation on the same income. We'll also discuss the pros and cons of owning rentals across state lines, from portfolio diversification to the challenges of remote management.

Managing out-of-state rental property taxes may not be the most thrilling topic, but it's something that's essential to master in order to keep the IRS out of your hair and save yourself as much money and stress as possible. With the right guidance and support, the advantages of diversifying your real estate investments across different markets can outweigh the added tax complexities involved, making it worth your while.

Paying taxes on out-of-state rental property

Real estate investors who own rental property in another state must file a non-resident state tax return where their rental property is located. In addition, you'll have to pay that state taxes on your net rental income.

How exactly does this play out? Well, let's say you live in California but have a rental property in Ohio. Come tax time, you'll have to file a non-resident Ohio return. Your resident state, California, will also tax the net rental income and provide a tax credit for taxes paid to the non-resident state to avoid double taxation.

If you own rental properties in multiple states, you'll need to file a tax return for each state.

Filing taxes on rental property located out-of-state

The process for filing returns and paying taxes on your out-of-state property's rental income is as follows:

1. File your federal tax return

Property owners should start with their federal income tax return first. This includes:

• Form 1040: The standard form used by all individuals to file their annual income tax return.
• Schedule E: Real estate investors should use this form to report their rental property income and losses.
• Schedule A: This form allows each real estate investor to claim allowable home mortgage interest, property taxes, and other itemized deductions instead of taking the standard deduction.
• Form 4562: A key tax benefit of real estate investment is depreciation, which reduces your overall tax burden. You'll document your depreciation expense on this form, along with other deductions like property improvements.

2. Submit your resident state income tax return

The next step is to file your resident state income tax returns. You'll gather information from your federal tax return information as well as other documents related to your taxable rental income and expenses. Complete your tax forms and calculate your tax liability, apply relevant deductions and credits, and determine your final tax or refund amount.

3. Complete your out-of-state tax return

Now, you'll file a non-resident tax return in each state where you own real estate and collect rental or other income from that property.

4. Apply for your resident state tax credit

After submitting all your tax returns, you can claim a credit on your resident state return for taxes paid to other states on your out-of-state rental income.

To apply for this credit, first calculate the tax paid in the state where the rental property resides. For example, if you earned $10,000 in rental income and the tax rate in the non-resident state is 5%, you would have paid $500. Then, estimate what you would owe in your resident state. If the rate is 6% on the same income, your tax would be $600.

On your home state tax return, claim a credit for the tax paid to the non-resident state, using the lesser amount of the two calculations — in this case, a $500 credit.

State income tax structures

The tax structures in various states can greatly affect investors who own rental property. Here's an overview of state tax structures for 2024:

States with no income tax

Investing in states without a state income tax can be appealing due to the potential savings on tax liabilities from rental income. However, be aware that these states may balance their budgets by imposing higher property or sales taxes. States with no income tax include:

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

Flat-income tax states

Investing in states with a flat income tax rate can simplify financial planning for property investors. The tax rate on rental income remains constant regardless of your taxable net income amount. This predictability helps budget and assess the potential profitability of rental properties.

Be sure to evaluate the overall impact of a flat tax in the context of other state and local taxes. Here are the states that have a flat income tax rate:

• Arizona
• Colorado
• Georgia
• Idaho
• Illinois
• Indiana
• Kentucky
• Michigan
• Mississippi
• New Hampshire (only for interest and dividend income)
• North Carolina
• Pennsylvania
• Utah
• Washington (only on capital gains)

Graduated income tax states

In these states, the tax rate increases with higher income, which means that the more income you earn, the higher the percentage of tax you may pay.

• Alabama
• Arkansas
• California
• Connecticut
• Delaware
• Hawaii
• Iowa
• Kansas
• Louisiana
• Maine
• Maryland
• Massachusetts
• Minnesota
• Missouri
• Montana
• Nebraska
• New Jersey
• New Mexico
• New York
• North Dakota
• Ohio
• Oklahoma
• Oregon
• Rhode Island
• South Carolina
• Vermont
• Virginia
• West Virginia
• Wisconsin
• Washington D.C.

The pros and cons of owning rental property out-of-state

There are advantages and disadvantages to owning real estate property in other states. Here are major areas to consider:

Potential advantages

• Diversification: Investing in different geographic areas can reduce risk, as your investment properties aren't all subject to the same market conditions. This can help protect you against local economic downturns.
• Higher returns: Some out-of-state markets offer higher rental yields compared to local markets, especially in areas where property prices are lower but rental demand remains high. This can provide better cash flow and overall returns on your investment.
• Access to more opportunities: Different states and cities have unique growth trends and potential. Investing out of state opens up more opportunities to capitalize on markets with strong job growth, population increases, and infrastructure development.
• Lower property prices: In many cases, out-of-state markets may offer lower entry prices than your local market, making it more feasible to purchase properties or get a better value for your money.
• Tax benefits: The location may offer better tax conditions than where the investor resides. These benefits could take the form of lower property taxes or incentives that can improve profit margins.
• Property management: Investing out-of-state often means hiring a property management company. This can make owning property more hands-off, allowing you to grow your portfolio without being bogged down by day-to-day management tasks.

Potential disadvantages

• Distance management challenges: Managing property from a distance can be difficult without the right support. Issues like repairs, tenant management, and regular maintenance require more effort and reliance on local teams.
• Lack of local knowledge: Not being familiar with the local market can lead to poor investment decisions. For success, a property owner needs to understand neighborhood dynamics, the local economy, and tenant demographics.
• Property management expenses: This is an additional expense that can cut into your profits and income. It also requires trust in the property management company you've hired to manage your property effectively.
• Higher operational costs: Traveling to check on your property or to manage tenant turnovers and maintenance issues can add significant costs and logistical complications.
• Legal and regulatory hurdles: Every state and municipality has different laws regarding landlord responsibilities, tenant rights, property taxes, and rental regulations. Managing these can be complex without local expertise.
• Tax complexity: Filing taxes can become more complicated, since you need to complete multiple state tax returns and understand various tax implications in different states.

Managing taxes with out-of-state property

Consider using accounting software like Azibo to manage taxes effectively as an out-of-state rental property owner. A strong system can help you track income and expenses for each property and streamline the tax preparation process. Dedicated software makes sure your financial records are organized and audit-ready come tax season.

Managing rental income from another state

Expanding your real estate portfolio across state lines opens up exciting opportunities but also adds a layer of complexity when it comes to state taxes. Out-of-state properties provide access to stronger markets, higher returns, and portfolio diversification, but they also require diligent record keeping and compliance with tax laws in multiple jurisdictions. For a real estate investor, the potential rewards make tackling these challenges worthwhile.

Following the best practices outlined in this guide can help you pursue promising rental investments, wherever they may be. Seeking professional guidance from a real estate CPA experienced in out-of-state real estate can provide peace of mind and maximize your benefits.

With the right approach, owning property out-of-state can be a great wealth-building strategy that mitigates risks and increases your returns over time.

Owning rental property in another state taxes FAQs

How is rental income taxed in the U.S. for non-residents?

Rental income received by non-residents from U.S. real property is taxed at 30% of the gross rental income unless there is a lower tax treaty rate for your resident country.

Do you have to pay capital gains in two states?

No, you pay tax on a capital gain to only one state — either the state where you reside or the state where the investment property is located, not both.

How does the IRS know if I have rental income?

The IRS can learn about your rental income through several sources, including your tax return, data from banks/payment processors, and records audits.