Digital Nomad Tax Guide Part III - Issues Regarding State Tax Residency

An Introduction

Thus, Part I and Part II of this series have focused on federal taxes. Thinking back to our high school civics classes, we have all at some point learned about federalism in the U.S. We have a layered legal system of federal and state laws. Tax is no different. Each state has its own tax laws. The tax codes vary greatly by state.

In my masters of tax law program, the professors always said that working with the IRS was a breeze in comparison to the Franchise Tax Board, the California taxing authority. Some states, like California, have very strict rules.

Residency Rules

Some states apply a basic rule, like the IRS, where they will tax residents all income regardless of where it was earned. However, each state defines “resident” a little differently.

California considers a person a resident if the person is “present in California for other than a temporary or transitory purpose,” or if the person is “domiciled in California, but located outside California for a temporary or transitory purpose.” Determining a person’s domicile is tricky because it’s an issue of intent. The state looks to whether a person who is absent has an intent to return. This is important because California is likely to consider any nomads who were in CA before they began traveling to be domiciled and therefore residents of CA; thereby taxing all of their income.

New York’s rules are very similar to CA, but NY does provide a carve out for individuals who spent less than 30 days in NY for the tax year and maintained a “permanent place of abode” outside of NY. There are some other, more complex exceptions as well.

Washington state is more lax and provides that a person is a resident if she “maintains a residence in Washington for personal use.”

As you can see, the residency rules vary widely. They’re also very important. If a taxpayers is earning it’s income abroad, most states are only going to tax that income if the taxpayer is a resident of that state. In short, the yes/no answer to the residency question determines which state or states can tax you. It could be possible, for state tax purposes, to not be a resident of any state. If you want to dig into specific state rules more deeply start with a Google search of “_____ [insert state] residency tax rules.” Try to find the information on the state’s official taxing authority website.

Source Rules

California’s tax laws provide that residents are taxed on all income. Nonresidents are only taxed on income from California sources. This is where sourcing rules come into play. Wages are sourced to where the services are performed. If you perform services for an employer while in Brazil, CA would consider those wages to be Brazilian sourced income. You would only be taxed on those wages if you were a CA resident. Similarly business/freelance income, is sourced to where the business carried on. Items like real estate are based on location. This makes sense, right? If you sell a house in CA, it’s CA source.

New York, again, applies very similar rules. Nonresidents are only taxed on New York sourced income, and the sourcing rules are nearing identical to CA.

Other Taxes

Income tax, of course, is not the only issue regarding state tax. Most states also have sales tax and property tax. As a nomad, you likely need not concern yourself with sales tax, as it won’t be applicable if you’re not buying goods in the state. Property tax, however, could be a major consideration if you own or plan to own property. The highest property tax states are:

• New Jersey – 2.38%
• Illinois – 2.32%
• New Hampshire – 2.15%
• Connecticut – 1.98%

Surprisingly (at least to me), Hawaii is the lowest at 0.28% (I guess not that surprising because tourism).

I’m not going to dive into this too much. The point here is to consider and balance income tax with property tax. New Hampshire has no income tax on business income, but is a high property tax state. If you don’t own property, New Hampshire would be a great place to be domiciled.

Local Tax

Some states also have local income taxes. Those states include: Alabama; Colorado; Delaware; Indiana; Kentucky; Maryland; Michigan; Missouri; New Jersey; New York; Ohio; Oregon; Pennsylvania; and West Virginia. Note that the District of Columbia is considered a local tax, but the rate is higher than most cities as it’s effectively a state tax and in keeping with state tax rates (4%-8.5% based on income).

In most states, only the larger cities impose local taxes. Here is a sampling of cities and their rates.

• Philadelphia: 3.9%
• New York City: 2.9-3.6%
• Portland: 0.6%

Note that California has the highest income tax, but has no local income taxes. New York City and Philadelphia have high local income taxes. When added the their state tax rates, those cities rival California has some of the highest taxed places to live. Similarly, Illinois has relatively high state tax and property tax, but no local tax.

Planning Considerations

At this point, you might be thinking “I’m so overwhelmed – what the hell am I supposed to do with this information.” Let’s assume that you are from Vermont, the state with the 6th highest income tax state. Maybe it would be worth taxing steps to change your tax residency before traveling the world. Moving a couple hours over to New Hampshire, who only taxes interest and dividends, could mean 7+% more money in your pocket come tax time.

As noted earlier, some states make it more difficult to transfer residency. California typically presumes an individual who was a resident still is a resident unless that individual affirmatively proves their non-residency. Here are some proactive steps individuals can take to show an intent of changing residency:

• Get a new driver’s license in new state;
• Transfer bank accounts;
• Get a new library card;
• Change voter registration;
• If you own a home in the state from which you are trying to move, renting it on a longer-term lease will help show that you no longer intend to live there.

Also, be sure not to have any facts that would help a revenue agent from the former state argue that you never gave up your residency. For example, if you have a kid receiving in-state tuition in New York, that may be a problem if you are now claiming to be a resident of Pennsylvania after having moved from New York.

You may be asking how all this information comes into play. Let’s use an example. Assume a taxpayer has been living in California for five years. He has family in Washington state. He wants to become a digital nomad but still plans to come back to California a couple times a year to visit friends. The taxpayer leaves California at the end of January. Travels most the year, but goes back to California a twice for 10 days each. When he goes back, he stays in a home that he owns. The rest of the year, he rents it out on AirBnB. The following April, he files his tax return. He states that he is a resident of Washington because he moved most of his belongings into his parent’s garage. Sometime thereafter, the California Franchise Tax Board (FTB) send this taxpayer a letter saying that he owes $10,000 on his foreign earned income because he was still a resident of California while traveling. The taxpayer hires me to deal with the FTB on his behalf. 

As taxpayer’s lawyer, I am going to use whatever facts I have to help show that taxpayer is no longer a resident of CA. If taxpayer only moved his belongings to his parents, and took no other steps listed above, I am likely going to be unsuccessful. The FTB will likely counter that since taxpayer merely rented his home on AirBnB, he clearly has an intent to move back in once he stops traveling. Remember the rule in CA is that a person is domiciled in CA if they are transitory but have an intent to return. If taxpayer instead, sold his home, got a new state ID in Washington, switched banks, and changed his voter registration, I am going to have a much better time arguing with the FTB.

Quick Links to Each Part of this Blog Series

Part I

Part II

Part III 

Part IV 

Part V