By Vincenzo Villamena, CPA
You would think that moving away from the United States lets you off the hook from filing US state taxes. But unfortunately, some US states require that expats pay state taxes.
It is a common misconception that you only file state taxes if you live there. This inaccurate belief can have costly repercussions.
With some planning, however, you can avoid state taxes when living abroad. (We recently published an article on Forbes about how location-independent entrepreneurs can save taxes by changing their state.)
If you are new to expat taxes, please check out our Guide To US Expat Taxes. You can also schedule a consultation with our experts to get advice for your tax situation.
In this guide to state taxes for expats we cover the following:
- Do US citizens living abroad need to file state taxes?
- Best state residency for expats – and worst
- California Safe Harbor Rule
- How expats can avoid paying state tax
- How to change your US state residency
- Filing a state tax return when living abroad
Do US citizens living abroad need to file state taxes?
If Americans abroad must still file a state tax return depends on the state. In some states, US citizens living abroad are required to file and may owe state taxes. In other states, expats neither file nor owe state taxes. We discuss the easy and difficult states further below.
You might think the state doesn’t know or care. In our experience though, some states can be quite aggressive in pursuing their taxpayers, even abroad. And if you don’t file while you are abroad, a big tax bill might await you when you move back to the state.
After a few years abroad, you may end up returning to your old home state and start filing tax returns again. The state will notice the gap and can notify you that you owe back taxes, potentially with penalties and interest.
In addition, some states do not allow the Foreign Earned Income Exclusion, e.g. California. So you may have to pay full state income tax of income earned abroad.l
If you cannot prove that you were resident in another state during that time, they may require you to pay your taxes for those missing years.
And it’s not just that expats pay state income tax in some states. Depending on the state, US citizens abroad may also owe dividend taxes, estate taxes, corporate taxes, and more. Furthermore, if you failed to file and pay state taxes while you were abroad, you may owe penalties or interest. In short, misunderstanding your state’s filing requirements and failing to make other arrangements, can be costly.
You might think that you have no intention of returning to your old state. In that case, and depending on the state, it might be better to move to a different state before moving abroad. More about that later.
The first step for expats when it comes to state tax is to determine how their state handles the taxation.
Best state residency for expats – and worst
Generally, US states fall into three broad categories when it comes to expat state taxes: the easy ones, the somewhat neutral ones, and the difficult or “sticky” ones.
A variety of factors determine how states are categorized. Whether the state has an income tax, how easy it is to leave the state, and the state’s reputation all play a role.
Easy states
The easy states for expats are those that don’t have an individual income tax to begin with. This includes Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
Tennessee and New Hampshire are also fairly easy as they only collect state taxes on interest and dividends but not on ordinary income such as wages and salaries.
Many of these states also have reduced dividend or interest taxes, corporate taxes, property taxes, or inheritance tax. In addition, taxpayers may be able to significantly reduce their costs of living.
In recent years, several high-profile entrepreneurs and business leaders have made headlines by moving to states without an income tax. For example, hedge-fund manager David Tepper relocated from New Jersey to Florida.
Likewise, Larry Ellison, the co-founder of Oracle, bought a property in Nevada. Such moves have become so common that a neighborhood near Lake Tahoe was even nicknamed “Billionaires Row”.
Neutral states
Most states are neither easy nor difficult. Usually, if you have been gone for a while, they will stop considering you a tax resident. In some cases, you may have to prove that you live abroad and submit some paperwork, but you are unlikely to face many hurdles.
Difficult states
Four states are known for making it especially difficult to escape their taxation when moving abroad. They are sometimes called “sticky” states and include Virginia, New Mexico, California, and South Carolina. California especially can be difficult for expats. We explain more about California taxes for expat and the Safe Harbor Rule below.
We have also seen issues with expats from Massachusetts, Maryland, and North Carolina.
Those states won’t let you go easily, even when moving abroad. They assume that you will come back and therefore should remain a tax resident for the entire time spent abroad.
To leave the state and tax residency behind, you must show that you have no intentions to ever come back to that state. Otherwise, you will need to continue to pay state tax on your income.
California Safe Harbor Rule
California is one of the toughest states when it comes to taxes for Americans abroad. Not only do you have to file and pay state tax on your income. California does not allow for the Foreign Earned Income Exclusion (FEIE). Other states do recognize it, it is very fact dependent.
On the brighter side, California has a Safe Harbor Rule, which allows Californians abroad with employment contracts to be classified as non-residents for tax purposes. The employment contract must be uninterrupted for at least 546 consecutive days (1.5 years). In addition, there is a limit on investment income during the year and the number of days you can spend in California.
Californians who are moving overseas need to be especially cautious to ensure no California state tax issues while outside of the US.
How expats can avoid paying state tax
Expats from the “difficult” tax states should consider moving to another state before moving abroad, ideally to one without a state income tax.
Moving from a difficult state to a tax-free state requires more than just changing your address. These difficult states can be really sticky. You must show your intent of leaving for good by cutting ties to the state.
You have to be able to prove to your old state that you moved permanently to the new state. That means if you have any intention of moving back to your state, you may have a hard time proving otherwise. Also, if you plan to keep ties to your old state, that will make it difficult.
The tax authorities will look at your intent to establish a permanent home elsewhere with no intention of returning. While intent is a very subjective notion, you can take the right actions to show your intent.
How to change your US state residency
You should sever as many ties to the state as possible and create new ties in your new state. As you make cut ties and build new ones, keep detailed records. When possible, make these changes in writing for your records. In the case of an audit, records documenting the move can be crucial.
The tax authorities look at ties such as:
- Real estate ownership
- Bank accounts
- Voter registration
- Driver’s license
- Mailing address
- Family members, especially dependents
- Health care providers
- Open a new safety deposit box, bank and brokerage accounts
- Update your address anywhere it is on file
California for example, will even track your cell phone records and look at your credit card statements to see where you spent your money. We know cases where California asked for the purpose of moving to Nevada.
Especially when moving from a high-tax state to a neighboring low/no-income-tax state, you need to build a solid case to prove that you really became a resident there.
Another important step is establishing an emotional connection to the new state. Disputes over tax domicile have been settled based on this. Art, photos, personal mementos, and heirlooms should all be relocated to the new domicile. You should also move your pets to the new home.
You can also show local ties by participating in the local community through clubs, the public library, sports leagues, and temples or churches.
Changing domicile should be done well before moving abroad. We have seen domicile changes after moving overseas but this carries risks when trying to prove the case to your old state. Plan ahead, especially when you expect a major taxable event, for example, selling a business with hefty capital gains.
If you move states before leaving the country, you should plan to spend as much time as possible in the new state. Depending on the state, there may be specific time requirements that are important for residency.
Finally, consider selling your home in the previous state. If you don’t want to sell the property, you should not use it as the primary residence.
Filing a state tax return when living abroad
When moving away from the US, especially from a sticky state, you should file a tax return for the last tax year. It shows you as a part-year resident and that you will not be a resident anymore. You may still need to file a non-resident return in the following years, depending on your state and your specific tax situation.
For example, if you continue to have rental property or some other income source in that state, you would still have to file. If in doubt, it is better to file a state return as non-resident than not filing at all.
As always, when making significant financial or tax decisions, you should speak with an expert. In our experience, states will want to see the appropriate documentation showing that you moved and live abroad.
Each case is unique, and there are no one-size-fits-all solutions. Experts can help ensure that the domicile is correctly changed and reduce the likelihood of an audit.
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