As real estate professionals expand their portfolios across state lines, understanding state and local tax compliance becomes increasingly critical. In a comprehensive discussion with Rich Hedley, our state and local tax expert with 26 years of public accounting experience, we explored the essential concepts every real estate investor needs to understand to maintain compliance while optimizing their tax position.
Rich Hedley serves as the state and local tax leader for Brown Edwards, bringing extensive expertise to complex multi-state tax situations. With his six-year anniversary at Brown Edwards approaching and 26 years in public accounting, Rich has guided countless real estate professionals through the intricacies of state tax compliance.
Beyond his professional expertise, Rich is a Tampa Bay Buccaneers fan who believes they'll win the NFC South again this year, despite competition from Atlanta. He also weighs in on NFL rule changes, supporting the current system where division winners maintain home-field advantage regardless of record—a principle that didn't change when the recent playoff seeding proposal failed to pass the owners' meeting.
The cornerstone of state tax compliance is understanding nexus—the connection between a taxpayer and a taxing jurisdiction that's sufficient for the state to impose tax. While nexus can seem nebulous due to varying state laws, the principle is straightforward for real estate professionals.
Key Takeaway: Physical presence always creates nexus. For rental real estate, this means the state where your property is located will tax that property, creating income tax filing requirements if the state has an income tax.
The complexity increases for businesses with manufacturing, retail, or other operations that generate sales across state lines without physical presence. However, for real estate investors, the rule remains clear: own property in a state, and you'll likely have filing obligations there.
For businesses operating in multiple states, nexus studies provide valuable analysis to identify where filing is required and, equally important, where it's not necessary. Brown Edwards offers these services, ranging from comprehensive studies to basic nexus analyses.
The goal is ensuring compliance where required while avoiding over-filing in unnecessary jurisdictions—both scenarios can be costly and inefficient.
If you're realizing you might not be in compliance, there's hope. Voluntary Disclosure Agreements (VDAs) offer a structured path to resolve compliance issues with significant benefits.
Critical Insight: If you never file a tax return in a state where you have nexus, there's no statute of limitations. This means states could theoretically assess taxes, penalties, and interest going back 10 or even 20 years.
VDAs provide relief by:
Important Timing: VDAs only work if the state hasn't already contacted you. Physical presence situations (like rental properties) are more likely to be discovered by states, making prompt action crucial.
The Tax Cuts and Jobs Act's $10,000 SALT deduction limitation significantly impacted real estate professionals operating through partnerships and S corporations. Many states, including Virginia (starting in 2021), created workarounds through Pass-Through Entity Tax (PTET) elections.
How It Works: Instead of state taxes flowing through to your individual return (subject to the $10,000 cap), the business deducts state taxes at the entity level, reducing the federal taxable income passed through to owners.
Example: Without PTET, $100,000 passes through to you, and you deduct $10,000 in state taxes on Schedule A. With PTET, the business deducts the $10,000, passing through only $90,000 to you—creating federal tax savings on the $10,000 difference.
Connecticut pioneered this approach in 2018, and the IRS has blessed these arrangements through official notices.
Real estate developers face unique challenges during the months or years between property acquisition and placing properties in service. Property taxes incurred during development phases can typically be deductible, though elections exist to capitalize these costs if more advantageous.
Critical Requirement: The IRS demands meticulous record-keeping, with all activities tracked by individual property. For multi-state operations, this inherently means tracking by state—directly connecting to nexus compliance requirements.
Whether you maintain records yourself, use property management companies, or involve your CPA in the process, proper documentation from day one prevents compliance headaches later.
Depreciation represents one of real estate's most significant tax benefits, but not all states conform to federal depreciation rules. This creates important planning considerations as bonus depreciation currently sits at 40% and potentially could return to 100% under proposed legislation.
Virginia Example:
North Carolina: Even more restrictive, conforming to neither Section 179 nor bonus depreciation, with complex alternative calculations.
All states start with federal taxable income then make adjustments based on their specific laws. Non-conforming states require adding back federal depreciation benefits and taking deductions over prescribed periods instead.
Perhaps the most important concept for real estate professionals to understand: filing in multiple states doesn't necessarily increase your overall tax burden.
The Reality: Resident states provide credits for taxes paid to other states. When property is located in a state with lower tax rates than your home state, you receive full credit for taxes paid, effectively paying the same total amount—just to the correct jurisdictions.
Real Example: A Virginia resident with North Carolina rental property pays North Carolina tax (at a lower rate) and receives full credit on their Virginia return. Total tax burden remains the same, but compliance is achieved.
This resident state credit system prevents double taxation and makes proper multi-state compliance a tool for optimization rather than additional burden.
State and local tax compliance involves numerous nuances that vary significantly by jurisdiction. Working with experienced professionals who understand both the technical requirements and optimization opportunities ensures you maintain compliance while maximizing available benefits.
Whether you're just starting to expand across state lines or managing an established multi-state portfolio, understanding these fundamentals positions you for success in an increasingly complex tax environment.
For additional questions about nexus analysis, voluntary disclosure agreements, or any state and local tax matters, Rich Hedley can be reached at RHedley@BECPAs.com.
The Real Estate Tax Playbook provides timely and precise tax information to real estate professionals building their customized tax planning strategies. For more episodes and resources, visit the Brown Edwards website and subscribe wherever you get your podcasts.