At tax time, residency does not equal domicile
People are more mobile than ever. But while individuals may be quick to change locations, the states they leave behind are sometimes not as eager to let them go.
Consequently, knowing clients’ state of residency is crucial. Any state in which the individual may reside has the right to tax that individual on all income worldwide. This means if residency is triggered in multiple states at once, worldwide income may be subject to income tax in any or all of those states.
Individuals — particularly those in northern states who travel south during winter — are often surprised by the complexity of residency rules. All too commonly, they believe that a 184-plus-day stint Down South gets them both warm weather and a lower tax bill. That’s often not the case.
Given the potential tax and legal implications, determining domicile and state(s) of residency requires not just careful consideration of which state(s) the individual wants to reside in, but the exact rules that each state uses to determine domicile and/or statutory residency. What follows is a look at actions that can help clients successfully establish domicile in a new state, and a few not-so-obvious factors that can hinder that effort.
The precise definition of what constitutes domicile varies slightly from state to state, but states generally agree on two key concepts: that a domicile is a person’s fixed, permanent and principal home that they reside in and that they intend to return to and/or remain in; and that while a person can have multiple residences, they can only have one domicile.
This distinction is important, because an individual may be living in a certain residence for a certain period of time — even an extended one — but if it’s not the place to which they attach themselves and intend to return, it’s not their domicile.
Determining domicile is based heavily on the deemed intent of the individual. When someone only has one home, this is pretty easy to determine. However, if an individual has two homes in different states — e.g., houses, apartments, condos and/or other places to live — that they reside in for alternating periods of time, they still may only have one true domicile, i.e., the primary location in which they live.
Most people would assume that the best way to establish a client’s domicile is by posing a question such as, “In which state did I spend the most amount of time?” While that may determine statutory residency, it misses the key motivating factor.
Indeed, the only person who can truly know a client’s intent is the client. While you may find this hard to believe, some people — hold on to your hats — would lie about their intent in order to claim a more favorable domicile state that might lower their taxes or provide other benefits tied to having their domicile located in that state.
The determination of a person’s intent, therefore, is necessarily left to an outside individual such as a revenue agent or judge, which introduces subjectivity into the determination process. To further complicate matters, there is generally a presumption that no change of domicile has taken place unless it can clearly be proven otherwise.
So the best advice is often to treat a former domicile like a bad ex: Just cut ties and leave for good. But just as walking away cold turkey from an old flame can be difficult, so too can abandoning ties to a state where one has spent the better part of one’s life.
The fact that a domicile is a primary residence an individual maintains and/or plans to return to means the individual is deemed a resident for tax purposes of the state. However, even if an individual spends excessive time in a second state, that state can also claim the individual as a statutory resident, regardless of the person’s demonstration of intent, and tax him/her accordingly.
Many states, New York and New Jersey among them, consider an individual a statutory resident if they maintain a home in that state for all or most of the year, and they spend at least half the year within the state. Other states may use a threshold of 200 days or some other period of time. If you satisfy those statutory resident guidelines — and you lack a special exemption such as those provided to certain members of the military and their spouses under the Servicemembers Civil Relief Act and Military Spouse Residency Relief Act, respectively — you are a resident of that state. Full stop.
Other states forego a days-in-state measure of residency. Illinois has no precise statutory resident rules and will consider someone a resident if it deems them to be in the state for other than temporary and transitory purposes. Similarly, in California there is no statutory resident provision, but if you spend more than nine months there in any one year they will presume you a resident.
These definitions matter because showing domicile in one state isn’t enough to ensure that only that state will tax the household. Instead, domicile merely ensures that the state is a state of residence, while other states may claim the individual is a statutory resident as well, triggering another potential layer of income taxes.
WHY DOMICILE MATTERS
The importance of an individual’s domicile cannot be overstated. It impacts everything from income taxes to creditor protection to matters of family law.
The domicile determination tends to have the greatest impact on individuals’ state income taxes, as the following hypothetical scenario illustrates:
Example: Charles is domiciled in state A, which imposes a 7% tax on all of his income. During the year, Charles is called away on temporary assignment to state B. As a result he doesn’t earn any income in State A but does earn $50,000 in state B. Accordingly, state B taxes his income at 6%. Finally, Charles is the owner of a condo in state C, which generates $10,000 of taxable rental income. The state income tax rate for state C is 8%.
Given the facts outlined above, here’s how Charles would generally be taxed by states A, B and C on his income:
- Charles’ $50,000 of employment income would be taxed by state B at its 6% income tax rate because it was earned there. Thus, Charles would owe state B $3,000 of income tax. Additionally, state A — Charles’ state of domicile — would impose its 7% state income tax on the same $50,000, resulting in a tax bill of $3,500. However, state A will give Charles a credit for the $3,000 paid to state B toward its own tax bill of $3,500.
Thus, Charles will owe $500 of additional tax on the same income to state A. This means in the end that Charles has paid a total of $3,500 of combined state income tax on this income, which is equal to the $50,000 of income he earned times the higher 7% tax rate of his domiciled state. The state tax credit rules simply facilitate splitting the bill between two states, where state B gets first crack at taxing the income because it was earned there.
- Charles’ $10,000 of condo rental income would be taxed by state C at its 8% income tax rate. Thus, Charles would owe $800 of state income tax to state C. Additionally, state A would impose its 7% state income tax on the same $10,000, resulting in a pre-credit tax bill of $700. Since Charles earned the $10,000 in state C, then again state C gets first crack at taxing that income.
Here, state A will give Charles a tax credit of up to $800, though Charles can only use $700 of it — the amount that his home state A would have taxed in the first place, and enough to completely offset his state A tax liability. The end result is Charles paying $800 in cumulative state income tax, which once again is equal to the income produced ($10,000) times the higher of the two state income tax rates.
The key point is that income across multiple states is often taxed in all those states. But while each can only tax the portion of income that’s actually connected to it, the state of domicile has the right to tax all of that individual’s income — whether it was earned there or not.
Despite all this variability, many states provide real estate benefits to persons domiciled within their state. These benefits can take a number of different forms.
Many offer some sort of property tax break to individuals on their primary residence. Oftentimes this benefit comes in the form of a reduction to the assessed value of an individual’s home, which in turn lowers the homeowner’s property tax bill. Other states cap increases on property taxes to a limited percentage per year. But these benefits only apply to the primary residence and aren’t available for those who simply own non-resident investment real estate in the state.
Another common benefit provided to property-owning individuals domiciled within the state is a homestead exemption. Where they do exist, homestead exemptions generally provide some level of creditor protection for a person’s primary residence. In states such as Florida, Texas and South Dakota, a homestead exemption can shield an unlimited amount of a primary residence’s value from most creditors, while in Nevada ($550,000) and Montana ($250,000), the exemption can protect only a limited amount of a home’s value from the reach of creditors.
ESTABLISHING NEW DOMICILE
It’s impossible for an individual to leave their old domicile until they have established and arrived in their new one. This is sometimes referred to as the “leave and land” rule.
This necessitates having a residence that can reasonably be viewed as an individual’s fixed home. From there it’s imperative to take steps to establish one’s intent to make that home a permanent base.
Of all the steps an individual can undertake, time spent in state is still one of the most, if not the most, important elements in the process. Thus, tracking time spent in the new environment is critically important.
Personal and business calendars, however, are often given only modest weight since they are produced by the taxpayer themselves. Additional records such as credit card receipts and statements showing dates of purchases of items within the new domicile state; EZ Pass or other toll-road charges; flight records; landline telephone bills; and cell phone records with GPS time/date stamps all help bolster an individual’s claims.
Real estate ownership and properties rented can also be strong indicators of a person’s intent. Generally, if an individual owns one residence and rents another, more weight will be given to the owned home. However, additional factors may also be considered, such as furnishings. The nicer a home is furnished — and the more suitable it is for year-round use — the more likely it will be considered a person’s principal residence.
Artwork, jewelry, safety deposit boxes — they all should be part of the relocation. Two cars? Make sure the nicer one makes the move.
Even pets play a role. In the Matter of the Petition of Gregory Blatt, decided by the State of New York Division of Tax Appeals on February 2, 2017, Blatt’s dog ended up saving him more than $400,000 in New York State income taxes. Blatt had previously undertaken many of the steps necessary to change domiciles, but hearing the case on appeal, the New York State administrative law judge determined that Blatt’s change of domicile was effectively completed when he moved his dog.
TACTICS FOR SEPARATION
Just as establishing as many ties as possible to the new state can be helpful, so too can trying to sever ties to the old one. Indeed, when legal challenges arise they almost always revolve around the old state not willing to give up its status as domicile.
For the cleanest of breaks it’s best to sell any and all real estate owned in the old domicile state. Coupled with the purchase of a new residence in the desired domicile state, this is probably the single best indicator of a person’s intent.
Of course an individual may wish to retain at least some residence in their former state of domicile. In such cases it’s also helpful to spend as little time as possible there, at least for the first few years. Returning and spending a substantial amount of time with family and friends — even in their homes — can complicate matters.
And just as opening accounts and memberships in their new domicile can be effective, so too can canceling or closing them in their old domicile state. They should turn in their driver’s license as soon as possible as well, and if there’s any income in the old domicile state, they should file tax returns as a non-resident whenever possible.
BEWARE JANUARY 1
One way to make a former state suspicious of an individual’s change of domicile is to indicate on state tax returns that the change took place on January 1. Yet this is often the date CPAs and other tax preparers will choose to use to indicate the change in domicile.
Why? Because it makes things easy — at least for income tax purposes.
Making the change on January 1 obviates the need for partial-year resident and non-resident returns, which reduces paperwork as well as the amount of expenses and income that need to be allocated between different states. The problem is that virtually nobody moves on January 1.
Thankfully, the solution to this problem is easy: Report the actual date your client arrived at the new domicile, even if it requires partial-year resident and non-resident returns.
Ultimately, there’s no single bright-line test that can prove a change in domicile because it’s based on a determination of intent. The good news is that advisors, tax accountants and clients themselves have clear dos and don’ts to follow to have the best chance at proving — and in some cases, defending — a bona fide change.