11 Apr Say Goodbye to State Tax Returns

I flew from my current home in Mexico to my childhood home in New Jersey recently to visit my Dad. As we sat talking, with the late afternoon sun streaming through the window into the living room, we heard a distant train whistle. 

“That’s something I don’t miss,” my dad said.

I knew exactly what he meant. For thirty years, my father commuted to New York City for work.  To get there required him to wake before dawn to catch a train to Hoboken, where he caught another train to Manhattan, where he had to walk a few city blocks to the office. When it was time to punch out, he did the trip in reverse. It didn’t matter if it was raining, cold, snowing, or hot, he had to get to the office to do the work. There was no such thing as work-from-home. Even though his job required him to be on the phone all day, which is actually something that he could have easily done from home, he had to burn two hours or more of each day to get to an office. Darn, he even had to go to the office to get paid. There were no direct deposits to his bank account. He was handed a paper check.

Things slowly began to change during my 20-year career as an attorney with the IRS. Before I retired in 2018, employees in my office were allowed to work from home several days per month. Then COVID hit and everyone had to work from home, all the time. People began to realize that they could do the work just as effectively from their bed, or, if they were ambitious, from their couch. And as the world opened again to travel, people who thought outside the box realized they didn’t even need to be in the United States to do the work and started taking advantage of “digital nomad” visas being offered by countries across the globe. These visas allow for temporary stays in the country, generally ranging from one to three years, and are suited to persons who work online. Some people don’t even bother applying for the visa, and just go overseas to live and work without proper documentation. During the pandemic I met one guy who didn’t tell his employer that he had left the US and was working from San Miguel de Allende, Mexico! 

If you live overseas you still pay US taxes

As a tax attorney, I knew that even though I lived and worked in Mexico, I was going to have to pay US taxes. It always surprises me that people don’t know that. It’s important to know, so let me plug that fact right here. United States citizens who live and work overseas are still required to file a US tax return to pay tax on their income. 

What also surprised me, though, was that many of the people who lived abroad and did file their US tax returns, also continued to file a state tax return. When I told them they might not have to do that anymore, they were confused. 

“But such and such state was the last place I lived.” But if you don’t live there now, you probably don’t have to file a tax return with the state.

“Really?” Yes, really.

“But I have a drivers’ license from the state.” That doesn’t mean you have to file a tax return with the state.

“Really?” Yes, really.

“But I want to vote in the state.” You don’t have to file a state tax return to vote in that state.

“Really?” Yes, really.

The takeaway from this exchange is that even though many of us have strong ties to the state where we may have lived for many years, moving overseas could not only land you in a place that is more affordable and life-affirming than the US, and just as modern and safe, but it could also greatly reduce or eliminate your state income tax bill. 

Move overseas to reduce or eliminate state taxes

Only eight US states do not have an income tax. Those states are Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. So,unless you live or lived in one of those states, tax time includes filing a state income tax return.

States generally tax state residents on all of their income, no matter where it is earned. If you live in California, that tax could be as high as 13%. Hawaii has big waves, but it also has one of the highest state income tax rates at 11%. In New York, your income could be hit with an 8% tax, while on the other side of the country, in Oregon, the highest rate is over 9%. The other states tax income at lower rates, but any rate is too high if you aren’t obligated to pay it.

So who has to pay state income tax? The simple answer is, state residents. And who is considered a state resident?  The most common way to be a state resident is to live in the state. But, for tax purposes, residency goes beyond physical presence. 

For example, New Jersey determines residency by looking at whether you have a domicile in the state. New Jersey defines domicile as the place you consider your permanent home, that is, the place you intend to return to after a period of absence, such as a vacation, temporary work assignment, or for educational leave like time spent at college. Wisconsin defines domicile similarly; as your true, fixed, and permanent home from which, whenever absent, you intend to return. I’m not going to break down every state’s definition, but rest assured that the majority of them view domicile similarly. Thus, based on the standard that you can be physically present in one place and still have a domicile in another, your intent becomes muy importante. 

So, when can I stop paying state taxes if I live overseas?

One of my first clients after I moved to Mexico was still filing North Carolina state tax returns even though she had not lived in the state, in fact, had not lived in the US, for the previous five years. When I asked her if she intended to go back to North Carolina to live, she said, “No way!”

When I filed amended state tax returns for her as a nonresident, and she was refunded nearly $700, she thought I was the smartest person in the world. I’m not, but it was nice that she thought so.

But what if you aren’t as certain as she was that you don’t intend to move back to the US? For example, what if you have a digital nomad visa that expires after a year? Or, what if there is a little voice in the back of your head that keeps saying, “New Jersey is your home.” Does that mean your intent isn’t clear and you still have to file a New Jersey income tax return even though you’ve lived in Virginia for 20 years? 

I look at it this way, it isn’t rocket science, it’s tax law. In tax, you can take positions based on reasonable facts and circumstances that you wouldn’t take if you were building a spaceship. Therefore, it’s my view that if (1) you intend to abandon your old domicile in a state and take actions consistent with that intent, such as actually moving out of that state, and (2) you intend to acquire a new domicile and take actions consistent with that intent, such as renting a house in Mexico, and (3) you are physically present in your new house in Mexico, then you have changed your domicile and are no longer a resident of the US state that you left.

Let’s use my situation as an example. My wife and I lived and worked in Virginia for twenty years. During that time we filed a state income tax return as residents and paid income tax to Virginia on our wages, investment income, and bank account interest. 

In 2018, we left our jobs and moved to Mexico. We didn’t intend to move back to the US, but there was an element of uncertainty. In case things didn’t work out, we decided not to sell our house or our bread machine. Instead, we rented the house and stored the bread machine in my in-laws’ attic. We left Virginia, rented a house in Mexico and moved there full-time, only traveling back to the US for family visits. We put our kids in school in Mexico. We ran a business from our foreign address. These were all, in my opinion, indicators of our intent to establish a new domicile outside of Virginia. 

When tax time came around, I determined that we were no longer residents of Virginia. 

Generally, if you are not a resident of a state, you only have to pay state tax on income earned from sources within that state. This means that only income earned from a job or business performed in the state, or from rental property located in the state, is taxed by the state. Since the business income we earned was not sourced in the state, we weren’t required to report this income as Virginia source income. Additionally, our investment income and interest were not sourced in Virginia. However, because we owned a house in Virginia that we rented to tenants, we were required to file a nonresident income tax return to report the rental income. 

What if we only planned to be overseas for as long as it took for our kids to graduate high school and then planned to move back? Given the same facts, I would have taken the same position regarding our state residency. So long as we weren’t using our VIrginia house as our home, in other words, going back and forth there during the year, and we lived and worked out of Virgina, we had given up our residency.

What if we were only overseas for one year on a digital nomad visa? This is a little trickier, as the time period is shorter and it could be viewed as a temporary absence. But if the same facts were present, and we had moved out of our Virginia home for the entire year and established ourselves out of the country, my opinion is that it would be reasonable to consider us as having established a new domicile for the year. My advice to anyone in this situation is talk with your tax professional about your specific facts and circumstances. 

State issued driver’s licenses and the right to vote

There are a couple of reasons I hear from people who don’t live in a state about why they continue to file state income tax returns. First, they have a drivers’ license from the state. There are good reasons to hang onto your state-issued license when you move, but having a state driver’s license doesn’t mean you have to file a state income tax return. There is no correlation between the two. States don’t require that you turn in your license when you move to another state (although, your new state may prefer you get a license issued by it within a reasonable amount of time) and states don’t require that you turn in your license if you move overseas (although your new country of residence may prefer that you get a license issued by it within a reasonable amount of time.) 

Another reason given by expats for continuing to file state tax returns even though they don’t live in the state is that they want to continue to vote in US and state elections. However, under the “Uniformed and Overseas Citizens Absentee Voting Act” (UOCAVA), if you were eligible to vote when you were a resident in the US, you are eligible to vote if you live outside the US. There is no requirement to maintain residency or own property in the US in order to vote in Federal elections (President, Vice President, US Senator, and US Representative). 

You may also continue to vote for state and local offices (such as Governor, State Legislator, County Clerk, Mayor, etc.) There is no correlation between state residence for tax purposes and the right to vote. For voting purposes, your “voting residence address” would continue to be the last home where you actually resided in the US. Many states even allow US citizens who have never lived in the US to register to vote based on their parents’ last US voting residence address. 

For nonpartisan information pertaining to each US state’s requirements, visit www.overseasvotefoundation.org. The Federal Voting Assistance Program (www.FVAP.gov) website has information about how you can register with local election officials in your state of voting residence AND request an absentee ballot.

There may be one benefit to maintaining state residency even if you live overseas. When it came time for my daughter to apply to college, I had been filing Virginia nonresident tax returns for years. I couldn’t in good conscience have her apply to Virginia state schools as a “resident.” Also, we had to provide Virginia tax returns for this purpose, so we would have been busted. In my haste to avoid paying more in state taxes than necessary, I blew a chance to take advantage of in-state tuition rates. Fortunately, my daughter didn’t want to go to any of the Virginia schools, but my failure to consider that she might is evidence that I am NOT the smartest man in the world. In case you were wondering.