Avoiding Taxation Troubles

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Millions of Americans own or have owned two homes at the same time, many in two different states. Some might be family getaway cabins, while some are purchased to generate extra income in highly desirable vacation areas. Others might be houses filling the gap when families move from one state to another.

When homeownership falls in two different states, it’s important dual homeowners consult with a tax professional to ensure they don’t set themselves up for income tax troubles in two different states. You can have more than one residence, but only one domicile—the state you consider your permanent place of residence.

A tax strategy that some employ entails homeowners deliberately buying a second home in another state that has no state income tax, while still owning a home in another state that charges state income tax. They file in the tax-free state to avoid paying those dollars.

“So the tax savings issue becomes a state-by-state taxation issue. This can be complex since every state has its own definition of tax domicile. Some states look at not only income source, but driver’s license and real estate and property taxes to determine if you are a legal resident of that state,” noted Ellen Johnston, CPA, MBA. “So just because you own a house in Florida, with no state income taxes, Kansas may consider you a resident if you pay real estate taxes on a residence or business property that is located in Kansas. If you are a legal resident of Florida but own income-producing property in Kansas, you still will be paying Kansas income tax on that income. It is not considered a Florida source just because you live in Florida.”

Ellen adds that even though a state may offer no income taxes as a break to your bottom line, true monetary savings may not be realized. Usually states that have no income tax have higher sales and property taxes. Also, higher ad valorem taxes, which can be charged by state and municipal governments on the assessed value of a product or property, could be a part of your tax bill. Therefore, those state income tax savings might not be an overall total tax savings.

States have the right to tax an individual’s income if they are believed to be a resident and domiciled in that state. This means the full amount of a resident’s earnings from all sources, including portfolio income, can be used to establish taxable income. As budgets tighten, governments are more carefully reviewing residents who change their domicile to another state. Many former citizens are finding themselves in the middle of “residency audits,” which can result in tax claims made by multiple states.

According to the NOLO legal website in an article written by Mary Randolph, J.D., possessing a home in a state, or spending most of your time there, isn’t enough to make it your domicile. The crucial factor is your intent. To protect yourself from the risk of taxation troubles, take every opportunity to demonstrate or affirm that the preferred state is your permanent residence.
For example, it’s important to use your in-state address for your tax returns; insurance records; passport; credit cards; Social Security; bank and brokerage accounts; and membership organizations. Also, according to Randolph, you can further reinforce your “preferred” or new home state by taking certain actions. If the state requires special tax returns, file them. Register to vote, get a driver’s license there and register your vehicle. Open checking and savings accounts and a safe-deposit box in the state; get a library card; join a gym or social group. Consult local professionals such as doctors, dentists, lawyers, tax preparers and accountants. Contribute to or volunteer with local charities. Buy a home and claim it as your homestead for property tax purposes.

When you’re moving, it’s critical you sever all ties with your former state and then establish proper residency or domicile in your new state. Of course, this means keeping lots of paperwork to ensure that if you are audited you can back up your claims. Many times, job transfers, military moves or simply picking up and starting in a new area may be your motivation for bidding adieu. If that’s in your future, it pays to complete careful planning. The hassle of moving can be followed by an even bigger headache of unanticipated tax bills with multiple states claiming your income. Remember, you can have only one domicile, which is the permanent place you call home, but you can have more than one residence.

If you’re considering moving to another state or trying to gain a tax advantage by declaring residency in one state versus another, have the proper planning and paperwork in place. Consult with a tax expert to ensure you don’t fall into the trap of state income taxation troubles. ■