Investors beware: Tax-free doesn't always mean tax-free

For private investors, there is a certain allure, and an apparent financial benefit, to investing in properties located in tax-free states. If the property happens to be a net-leased asset, the benefit clearly would seem to magnify. But peeking behind the curtain of assets advertised as tax-free can reveal a very different scenario.

There are nine states that are tax-free, specifically: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington State and Wyoming. The two Sunbelt states in that list pack the extra allure of climate and are, for that reason and others, in serious growth mode. As a result, many of the properties there are priced at a premium.

But tax-free does not always mean tax-free. In fact, if you reside in one of the remaining 41 states, “tax-free” simply does not apply. Let’s break this all down:

In general, you are taxed on your worldwide income in your state of residence. You’ll get a credit for taxes paid to any other states, but if there was no tax there, you get no credit. As a result, you will always have an effective tax rate that is either your home state’s tax rate or that of the state from which you are receiving income, whichever is greater. For example, if you live in California with a 10 percent-plus tax rate and you invest in a Florida property, you will pay California 10 percent of the income generated.

Now, there are three important points to bring out here. First, you should always consult your accountant or tax counsel on such matters early on in the process when considering a particular purchase. Second, out-of-state investors will get the tax benefit if they reside in another tax-free state. (Again, we say, make sure your tax counsel is close at hand.)

Finally, and most important, determine the total value of the property to you, both the financial value and the emotional one. We are not suggesting anyone walk away from a potentially attractive investment simply because of an asterisk to the tax situation. To do so would be a case of the tail wagging the dog. Real estate investment is, when considered wisely, always accretive to your personal bottom line. It is the merits of that asset, whatever you define them to be, that ultimately should drive the decision.

Ultimately, the operative word there is wisdom. A few conversations with trusted advisors, a little soul searching and a clear goal in mind are the recipe for investment success.

Jonathan Hipp is head of Avison Young’s US  Net Lease Group.