Living in a high-tax state? Explore the benefits of dual residency

Where you live can affect your retirement and other earnings. Understand your state residency tax requirements.

What’s on your retirement wish list? Sandy beaches? Mountain views? How about a lower tax rate? Knowing whether you can live in one state and claim residency in another is key to minimizing your tax burden. Understanding the concept of tax residency and exploring the best states to live in for retirement can significantly impact your financial future.

Millions of Americans are eligible to retire each year, and most start planning well ahead of their last clock out. Choosing your state of residence is an important step in planning since it has longer-term tax and earning implications.

The following factors can help you determine whether an out-of-state relocation is a smart financial move:

Can you be a resident of two states? Domicile vs. residence

Hardly any of us use the term “domicile” in our day-to-day conversations, but it’s an important term in the tax world. Legally, you can have multiple residences in multiple states, but only one domicile. This raises the question: Can you be a resident of two states?

You must be physically in the same state as your domicile for most of the year and able to prove the domicile is your principal residence, “true home” or “place you return to.” This is often referred to as your permanent home or tax home.

To establish a domicile, you need compelling proof that you live and invest in the state — and tax authorities want more than just a mailing address or driver’s license. You’ll need to track time spent at the domicile compared to your other residence(s). Voting registration is another factor that can help establish your domicile.

As an example, let’s say a long-time Minnesota couple purchased a second home in Florida to use three months out of the year. Since the couple spends most of the year in Minnesota, it's their domicile. They have a residence in Florida. If audited, tax authorities could investigate where the Minnesotans earn income, where their children attend school and where they belong to clubs or religious institutions to help determine their domicile. This process is known as a residency audit.

Establishing a domicile in a new state means you truly want to make a permanent and fulfilling life there.

Tax implications of establishing your state domicile

Relocation is a complicated, personal decision. It can also be costly if you don’t plan for tax implications like income tax and estate tax. Other factors, like tax incentives and sourcing, should weigh into the decision too.

Income tax

The state where you are domiciled can tax your income, regardless of where you earn it. This makes the prospect of moving to a state with a lower tax rate (or to a “no-tax” state) more attractive for potential tax savings.

However, if you become a nonresident, a state can still tax the income you make from sources within the state. This is known as non-resident tax. Income earned from stock options, restricted stock awards or from pass-through business income reported on state K-1s can be “sourced” to a nonresident state.

If you’re thinking about selling a business — plan ahead. You can structure the sale to influence how income is eventually sourced.

Nonresident states generally can’t collect tax on the sale of stock, but they can tax sales of tangible property that’s located within the state, interests in partnerships that operate there or gains from installment sales of either.

To evaluate the state tax impact of moving, you need to understand the sourcing rules that apply to the income you would earn after a domicile change.

Estate tax

Some states have an estate tax exemption that’s lower than the federal allowance. When you pass away, your estate could avoid federal estate tax, but not state tax. If your estate already exceeds the federal exemption, a change in location could mitigate any state estate tax that will be due.

Some states have much lower estate taxes than others, and some don’t have an estate tax. Carefully review estate tax laws before choosing a new domicile.

Tax incentives

Several states have tax incentives to keep residents from moving away. For example, the 2017 Tax Cuts and Jobs Act (TCJA) capped the personal itemized deduction for state and local taxes (SALT) at $10,000. That cap caused many individuals to feel the full burden of their state’s individual income tax rate.

However, TCJA didn’t limit the business deduction for SALT. At least eight states enacted workaround laws so owners of pass-through entities (e.g., S corporations, partnerships and LLCs) can pay tax on the entity’s income instead of passing the income through to and taxing owners. Pass-through entities can fully deduct tax — without a cap — to restore the prior deduction and make it less expensive for owners to live in a “high-tax” state.

Before moving to a new state, owners should investigate whether workaround elections are offered. A tax advisor can help you calculate the potential tax liability and the pros and cons of moving.

Current and future state tax liabilities

If you owe taxes, they don’t disappear when you leave. You could have trailing income from the state you’re exiting, too.

Your home state reserves the right to tax income if it’s related to work you performed or earned there. That includes deferred compensation, stock options, restricted stock units or other income that vests over time. If you sell a business, even in installment sales, the state where it’s located may tax you on the income.

On the other hand, nonresident states cannot tax intangible income, such as dividends, interest, stock sales and retirement income.

To quantify the financial benefit of moving to a new state, you have to understand what income will be sourced to your old state, what won’t and whether it’s worth the cost to you.

Dual state residency: One more note of caution

The rules for residency vary by state, but most define a resident as an individual who is in the state for more than 183 days in a year. This is commonly known as the 183-day rule.

It’s important to keep track of where you spend your time since residency can lead to additional tax liability.

If you’re thinking about testing out a potential domicile — be careful. It’s easy to run afoul of the rules and find yourself in a dual residency situation.

Here’s how easily it can happen. Let’s say a retired couple is close to spending more than 183 days out of their domicile state. They planned to go back home, but now it’s Christmas and they want to spend a few more days with their grandchildren.

They pass the 183-day mark and become “statutory residents" and owe taxes in two states. This situation can lead to double taxation.

Changing your state domicile is a personal decision. You may be able to save thousands of dollars in taxes, but at great personal cost (like being away from family or leaving a community you love). In the end, only you can decide whether it’s worth it.

Are you ready to make a move? A trusted advisor can help you evaluate the costs and the pros and cons of relocation — including key tax and financial implications.

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Wipfli works to help you achieve your business and personal goals. We make sure your tax, estate and business transitions are aligned so you can live the life you want.

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