departing residents facing unconventional taxation policies, including exit taxes, at the state level
Leaving a state or setting up a second residence should prompt you to consider how the state you're leaving will react. States that suffer from a net loss of residents use creative and forceful strategies to capture tax income from these departing residents.
A recent innovation is the "exit tax" levied on departing residents. For instance, California is proposing a wealth tax, charging residents and businesses with annual incomes exceeding $30 million ($15 million per married couple) a tax of 0.4% on net wealth exceeding the threshold, with potential liability for up to 10 years after exiting the state.
Threshold amounts for the tax are prone to reduction, so even individuals worth less than $30 million should take notice. Some real estate properties may be exempt from the exit tax, but other real estate property gains face state capital gains taxes at the time of sale.
Exit taxes apply to stocks that appreciate while a person is a California resident but are not sold until they leave the state. In New Jersey, gains on real estate sales become immediately taxable for those leaving the state, even if such gains would be tax-exempt for residents. New Jersey tax is based on the sale's closing.
Some states have managed to tax deferred compensation received by an individual after leaving the state, as well as stock compensation from shares or options that aren't sold until after departure.
In select cases, states request employers to withhold state taxes when deferred compensation is distributed, requiring the recipient to file a tax return to claim potential refunds. So far, there's no known instance of a state successfully taxing 401(k) distributions or pension annuities from former residents.
California has already successfully argued that non-residents owe California state taxes on income earned by their businesses participating in the state, irrespective of location. State tax departments aggressively employ technology to monitor departing residents' claims of relocation.
If someone stops filing income tax returns or switches tax return filing statuses from resident to non-resident (or part-time resident), specific programs are activated. These programs use data from cell phone usage, credit card charges, toll road data, and other sources to determine the departed individual's presence in the state.
Other important databases include driver's licenses, vehicle registrations, real estate ownership, and business and professional licenses and registrations. Once these programs are initiated, the individual can expect a lengthy, probing questionnaire to follow.
To avoid residency audits, it's necessary to demonstrate the severance of most ties with the previous state and the establishment of a new life focus in the new state. Some states use a 'bright line' rule, considering any presence of more than 183 days in a calendar year as full-time residency, taxable on all income.
Other states base residency on an individual's 'domicile,' a place where a person intends to maintain a permanent residence or abode indefinitely. This is a subjective test assessing facts and circumstances indicating the person's intent.
In contrast, states apply the 183-day rule before transitioning to the domicile standard. Few to zero days in the old state can be considered as domicile if circumstances suggest the intention to establish a new home. Reducing contact with the old state makes it increasingly challenging for the state to argue residency.
Although maintaining a business or home in the old state may seem beneficial, it can be a significant connection overriding other factors. When necessary, avoid re-entering those territories, and reduce your stake in existing businesses to passive status.
Update various records, such as driver's licenses, vehicle registrations, and memberships, to imply a more definitive break from the old state. Changing memberships to inactive or non-resident status may not completely free you from taxes, but it lessens the chances.
Severing ties with professional licenses or lodging valuable items in storage away from the old state are essential steps to avoid the leakage of tax revenue. Clear records of personal activities can provide proof of new residency in front of a potential audit.
[2] "Federal and State Tax Issues for U.S. Expatriates," Internal Revenue Service, IRS Publication 4011 (2019)
- Couples considering moving from one state to another should be aware of possible 'state exit taxes' for former residents, as proposed by California with a wealth tax on annual incomes exceeding $30 million ($15 million per married couple), potentially liable for up to 10 years after exiting.
- Establishing residence in a new state requires severing ties with the previous state and avoiding 'tax' liabilities, such as capital gains taxes on real estate property sales in New Jersey that become immediately taxable for departing residents.
- To avoid 'tax audits', couples must demonstrate the severance of most ties with the previous state and establish a new life focus in the new state, using a 'bright line' rule or 'domicile' test to prove their intent for a permanent residence.
- For a 'safest' way to manage taxes on former residents, couples should update various records, such as driver's licenses and vehicle registrations, to imply a more definitive break from the old state and reduce contacts with the old state to minimize tax leakage.
- It's important for couples to be familiar with nonresident tax status and its implications, as the Internal Revenue Service (IRS) outlines in "Federal and State Tax Issues for U.S. Expatriates," IRS Publication 4011 (2019).
