For most taxpayers, state taxes are a pretty straightforward component of a tax return. They live and work in the same state and don’t move anywhere else during the year. As a result, they only file and pay the one state.
For those living in one of seven states that do not charge state income taxes, let’s just say it’s even more than straightforward.
Where things get more complicated is when people earn income in multiple states in the same calendar year. This might happen for a variety of reasons, including:
- Changing residency mid-year to a new state
- Work that has you in multiple states (management consulting is the classic example)
- Owning investment property outside of your home state
This article should help clear up some of the common misconceptions around how filing taxes in multiple states.
Determining state residency
Every state has slightly different rules when determining if a person is a resident of their state, but it primarily comes down to answering the question: where is your permanent home? This is also known as your domicile.
For most people, determining your resident state is simple. For those that split time living in multiple states, the decision might be more complicated and you will be at higher risk for a state audit. The state will want proof of your residence by looking at things like where do you live most of the year, where do you own property, where do you have your bank accounts, where do your kids go to school, and where are you registered to vote. Anything that establishes that you live in a state permanently.
Determining your state of residency is a key first step in calculating your state tax obligations, since it will determine in which state you file a resident state tax return.
Non-resident state tax return
When filing your taxes, it is actually most intuitive to first review the state tax liabilities for any non-resident states where you earned income. For these states, you will have to file what is called a non-resident state tax return.
On this form, you will report only the income that was earned in that state. So, if you own an investment property there, it would be the rental income less the associated expenses that would be reported on the tax return. For a consultant working on an out-of-state project, it would be the proportion of his/her salary earned while on that project (meaning a two month project would result in ⅙ of the annual wages being allocated to that state). This income would then be taxed based on that particular state’s income tax brackets.
One important note here is that some states have entered into reciprocal agreements. At a high level, what that means is that a resident of either state can earn income in the other state without having to separately report it to the non-resident state. These are typically common in states that border each other, where a lot of people are likely to live and work in a different state. For example, New Jersey and Pennsylvania have one such agreement. They are important to remember because, if there is an agreement, there is no obligation to file a non-resident state tax return.
Resident state tax return
When you then get to your home state’s tax return, you will report all income earned, including the income earned from other states. That means all of your income from that year will be subject to your home state’s taxes.
When completing the tax return though, you will be given an opportunity to list the taxes owed to the other states. This will be applied as a credit against taxes owed to the resident state, so you are not any worse off by having made a portion of your income out-of-state.
Let’s look at a quick example. Assume a management consultant living in San Francisco,CA, and earning $120,000, works for two months on a project based out of Denver, CO.
- Colorado will claim 2/12 of the income, or $20,000, and subject it to its income tax. Let’s assume the tax obligation to Colorado turns out to be $1,000.
- The taxes owed to California are then calculated based on the full wages of $120,000, and let’s assume the tax obligation comes out to $10,000.
- But since $1,000 is owed to Colorado, that is credited against the CA taxes, meaning only $9,000 is owed to the home state.
- The consultant is not any better or worse off, as total state taxes are still $10,000, it is just that the tax filings got slightly more complex.
All this should sound fairly straightforward, because at a high level, it absolutely is. But things can quickly get messy around two situations.
First, the income reported on your W-2 by state often do not accurately allocate the income correctly, or at all, between the states. In these cases, it can be very easy, especially if you are doing your taxes yourself or with a tax professional who isn’t experienced in those two state tax returns, to accidentally pay state taxes on the same income twice. Earning income out of state should not increase your tax liability, so review your final tax return carefully to make sure there aren’t errors.
Second, there are a few states that flip around the whole process we described above. These “reverse credit” states have us take the tax credit on the non-resident state’s tax liability instead. Examples of states that operate this way are Arizona, Indiana, Oregon, Virginia, and Guam. Although not the norm, you need to be cognizant if earning income in these states to follow their specific instructions for how to allocate income and determine your specific state tax payments.
Part-year resident state tax return
The last state tax return that you should be familiar with is a part-year resident return, relevant for those who have moved states mid-year. By filing a part-year resident return, it allows you to split your income and be treated as a resident in two different states.
The way you divide your income between the states depends on where you were a resident when income was earned. If during one year you made $30,000 while as a resident in New York and $70,000 as a resident in Florida, you would report $30,000 on your New York tax return and $70,000 on your Florida tax return.
If you have moved, make sure to cover your bases, especially if you went from a high tax one to a low tax one, as your chances of an audit are higher. High-tax states hate seeing their money go elsewhere and won’t let you go easily.
You should transfer everything associated with your day-to-day life to the new state. Make sure all mail and bills are mailed to your home in the new state. Take out a driver’s license and bank account in your new state while getting rid of the ones in your old state. Register to vote in your new state. Enroll your children, if you have any, in school in the new state. If you plan to keep owning real estate in your old state, consider at least renting it out so the government won’t say you are planning on moving back.
All of these will help prove that you truly have moved for tax purposes to the lower tax state. If you are concerned, make sure to get professional tax advice to review your specific move and help make sure you are not leaving yourself anymore susceptible to an audit than necessary.
State taxes can take a little more work to navigate, especially if you are filing taxes in multiple states. Too often, we see clients making mistakes on their tax returns that result in an avoidable overpayment. To recap, make sure you follow these steps:
- Determine your resident state – If you have recently moved or live part-time in two states, this can be a gray area and prone to an audit.
- Income allocation – States have different rules for determining how to allocate your earnings when working in multiple states. We cannot always just take the numbers reported on your W-2
- Review your state tax returns carefully – The key is we don’t want you to pay double state tax on the same income.
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