Beware of the Tax Traps Sprung On Those Who Move in Retirement

The migration from high-tax states to lower-tax states accelerated during the pandemic and continues today. The high-tax states never took the population shift lightly, but now they take it very seriously. A number of high-tax states have aggressive pro- grams in which they identify people who moved out of their borders and seek to continue imposing income and estate taxes on them. Most people believe whether or not they’ve moved and where they’re living now are obvious. Those still working also think it’s obvious where they’re working and should be taxed. But the law isn’t that simple.

Specific actions are needed to prove to the satisfaction of the tax authorities that you changed your residence or domicile. Otherwise, two or more states could claim you owe them taxes. When you’re working, the state that can tax the earned income isn’t always obvious. Most states impose their income taxes on any income earned while working in their borders, even by residents of another state who are present temporarily.

States that share borders often have agreements that prevent double taxation on people who live in one state but commute to the neighboring state. But several states claim they can tax the earned income of people who used to commute into their states but now are working remotely from other states. Others claim they can tax the income of employees of companies headquartered in their states, even if the workers never step foot in the state. Eventually, Congress or the Supreme Court will have to settle the disputes.

Until then, some remote workers are in limbo about their tax obligations. A person, whether retired or working, generally is taxed by his or her state of residence or domicile on all income received during the year. That’s why aggressive high-tax states claim that people who think they’ve moved to another state haven’t changed their residence or domicile for tax purposes. The old states claim the people still are subject to income, estate, and even sales taxes.

Tax departments of high-tax states regularly begin with a residency audit. Tax and estate planners say they’ve seen an increase in residency audits in recent years. When the state sees that someone who used to file an income tax return as a full-time resident now files as a part-time resident or doesn’t file at all, the state takes a close look.

A residency audit might consist of sending the person a questionnaire asking about their residence, lifestyle, and property owned. Aggressive states also search property records and other public records for evidence of continuing contacts with the state. Some have been known to review social media sites. You have to plan a lot of things when moving. Among them, especially if you’re an upper-middle class taxpayer, is how to prove that you legally established residence or domicile in the new state.

It is best to prepare for a residency audit early, even before starting the move, when possible. If you receive a letter from a state tax authority raising questions about your residence status, you should assume the state already conducted a lot of research into your situation.

The letter might be accompanied by a questionnaire or a request for an interview, or both. Plan your move and accumulate your documentation with a potential residency audit in mind.

Don’t go into a residency audit unprepared or without professional help. Your defense is to show that you severed all or most ties with the old state and made major changes in your lifestyle, centering your life around the new state.

First, learn the old state’s rule for taxing people. Some states have a bright line rule. If you’re in the state for more than 183 days in the calendar year, then you’re a full-time resident and taxed on all income. Spend fewer than 183 days in the state and you’ll be taxed only on income earned while working in the state. Be careful about getting close to the 183-day threshold. States have different rules for counting travel days and other days when you’re in the state only part of the day.

You would be considered present in a state for a day when you were there only a few hours. If you travel back to your old state from time to time or maintain property there, you should maintain logs or calendars that list where you were each day of the year. Also, keep receipts and other records that back up what’s in the logs or calendars. Be aware of how technology tracks you. The aggressive states often review cell phone records and other technology trails.

Instead of the 183-day rule, other states impose taxes based on a person’s domicile. A domicile is the place where a person intended to maintain a permanent residence or abode indefinitely. It is a subjective test in which the state looks at the facts and circumstances to determine your intention.

The domicile review begins with the 183-day rule. But under the domicile standard, you can spend only a few (or even zero) days in a state and still be considered domiciled there when other facts don’t show you intended to leave permanently. The key to showing that you changed domicile is to reduce or eliminate contacts with the old state.

Continuing to own a home or business in the old state is considered a significant contact and can override other facts. Sometimes it’s acceptable to downsize and maintain a smaller home in the old state, but it’s risky. The safest route is to not own or even rent a home you can return to in the old state. Also, don’t be more than a passive investor in a business located in the state.

As much as you can, sever all other contacts with the old state. The more contacts you maintain, the greater the likelihood that you’ll be viewed as a domicile. Your driver’s license, auto registrations, voter registration and church and club memberships all should be changed.

Many states won’t consider the move permanent if memberships are switched to inactive, nonresident, or associate status instead of being resigned or transferred. They’ll argue the change is temporary and you easily can switch back to full or resident membership. Some states also expect you to give up professional licenses in their states or at least obtain new ones in the new state. It also is not a good idea to leave valuable property such as jewelry, furs and art in the old state. Many states consider leaving valuable items, even in storage, a significant contact that triggers taxation. A common mistake is to keep a boat or vehicle registered in the old state be- cause the property taxes or registration fees are lower. Another mistake is to tell the state you’re a passive investor in a business but assert active investor status on the federal income tax return, where it can result in big tax savings.

Another bad ploy: Tell an insurance company you are resident in one state because premiums are lower for its residents, but tell the state you are resident elsewhere. In other words, be sure all your actions are consistent with each other and with the idea that you made a permanent move. An aggressive state will look at these and other actions and pounce on inconsistencies.

Inconsistent actions could trigger fraud penalties in addition to a tax bill. Since states have different rules and interests, it is possible for two or even three states to argue that an individual or estate is fully taxable by each.

Record-keeping is important because a state can spring this trap on your estate after you have passed. For some states, the big payoff is from their estate or inheritance taxes. When you no longer are around to testify and help gather evidence, the states can swoop in and assert their claims against your estate. States might not be your only concern. Cities and counties with income taxes use the same tactics to retain tax dollars. To help make your plan, there’s a checklist of factors used by most states in the Members’ Extras section of our website.