On September 16, 2021, Sand Hill CIO Brenda Vingiello, CFA joined the CNBC Halftime Report panel once again and discussed what positive catalysts investors canread more
Trading Places — Changing Residency from a High Tax State
Welcome to California, such a lovely place … you can check out any time you like, but you can never leave. Despite its natural beauty, mild climate, and other attractive attributes, some people — who once made California their home — eventually choose to leave it. Many others try to avoid establishing California residency in the first place even though they routinely visit the place. Typically, such folks are mainly trying to escape the state’s notoriously high tax rates on personal income, and this objective may become more common given the new Federal tax law that now dramatically limits deductibility of state and local income taxes (the so-called SALT deductions). However, contrary to the paraphrased lyrics above of the classic Eagles song, people can, and do, leave. And yet, it takes some effort to make sure that the move is proper and complete in the eyes of the Franchise Tax Board (FTB), especially if some sort of ongoing presence is still desired in the Golden State.
Nation’s Highest State Income Tax Rate
California has the nation’s highest marginal personal income tax rate at 13.3% of taxable income, and this same rate applies to realized capital gains, too. This revenue supports about 70% of the state’s general fund, and it is estimated that about half of this amount is provided by the top 1% of taxpayers, the equivalent of only a few hundred thousand taxpayers out of a state of almost 40 million residents. Hence, there is some growing concern — even amongst policy-makers themselves — that there could eventually be a tipping point that causes a damaging exodus of wealthy taxpayers. Besides, even if the ultra-wealthy stay put, many modestly affluent Californians might also be feeling the pinch and have less cushion against potentially higher net taxes in addition to already high cost-of-living conditions. Indeed, in a revenue sense, upper-middle-class taxpayers may be the real source of vulnerability for California. This is on top of the fact that some people move anyway for job-related reasons, or to be near family out-of-state; plus, the ongoing housing affordability crunch in California is surely putting its own strain on things and feeding the possible desire to look elsewhere.
Reduction in SALT Benefits Might Further Influence Decisions
Prior to this year, Californians could deduct the full amount of their state and local (i.e. property) taxes from their Federal tax calculation. Beginning this year, though, that deductibility is capped at a rather low $10,000 for state and local/property taxes combined. However, providing some relief, the new law also increases the standard deduction for married couples to $24,000. In addition, many of these same impacted high-income earners often fell into Alternative Minimum Tax (AMT) anyway, which limits many regular income tax preference items and disallows the deductibility of state and local taxes. So, these taxpayers may not be too worse off now than they previously were due to the ultimate effect of AMT. Coincidentally, the new tax law also modified and improved the underlying conditions for AMT, and thus fewer taxpayers will be caught by it.
California Residents are Taxed on All Income
Residency is significant because it determines what income is taxed by California. Residents of California are taxed on ALL income, including income from sources outside California. On the other hand, nonresidents of California are taxed only on income from California sources. Importantly, when it comes to housing-related considerations, keep in mind that if an existing home in California is being sold, the gain or loss from the sale of real estate has a source where the property is located. So, if you sell your California real estate and move out of state, the gain is still taxable by California. Moreover, the gain is taxable by California even if the real estate is sold when you are a nonresident.
According to the FTB publication on the Guidelines for Determining Resident Status, “It is important for California income tax purposes that you make an accurate determination of your residency status. Residency is primarily a question of fact determined by examining all the circumstances of your particular situation.” Additionally, it asks whether you are a resident of California and whether your income is taxable by California. Specifically, are you
- present in California for other than a temporary or transitory purpose?
- domiciled in California, but outside California for a temporary or transitory purpose? (The term “domicile” is examined further below.)
Separately, a part-year resident is any individual who is a California resident for part of the year and a nonresident for part of the year.
Underlying Theory of Residency – and Factors to Consider
The underlying theory of residency is that you are a resident of the place where you have the closest connections. This same publication goes on to list some of the primary facts that must be addressed, and it highlights “factors you can use to help determine your residency status. Since your residence is usually the place where you have the closest ties, you should compare your ties to California with your ties elsewhere. In using these factors, it is the strength of your ties, not just the number of ties, that determines your residency. This is only a partial list of the factors to consider. No one factor is determinative. Consider all the facts of your particular situation to determine your residency status.”
Specifically, factors to consider include the following:
- Amount of time you spend in California versus amount of time you spend outside California
- Location of your spouse (or registered domestic partner-RDP) and children
- Location of your principal residence
- State that issued your driver’s license
- State where your vehicle(s) is/are registered
- State where you maintain your professional licenses
- State where you are registered to vote
- Location of the banks where you maintain accounts
- The origination point of your financial transactions
- Location of your medical professionals and other healthcare providers (doctors, dentists etc.), accountants, and attorneys
- Location of your social ties such as your place of worship, professional associations, or social and country clubs of which you are a member
- Location of your real property and investments
- Permanence of your work assignments in California
The term “domicile” has a special legal definition that is not the same as residence. While many states consider domicile and residence to be the same, California makes a distinction and views them as two separate concepts, even though they may often overlap. For instance, you may be domiciled in California but not be a California resident, or you may be domiciled in another state but be a California resident for income tax purposes.
Domicile is defined for tax purposes as the “place where you voluntarily establish yourself and family, not merely for a special or limited purpose, but with a present intention of making it your true, fixed, permanent home and principal establishment. It is the place where, whenever you are absent, you intend to return. The maintenance of a marital abode in California is a significant factor in establishing domicile in California.”
You can have only one domicile at a time. Once you acquire a domicile, you retain that domicile until you acquire another. A change of domicile requires all of the following:
- Abandonment of your prior domicile
- Physically moving to and residing in the new locality
- Intent to remain in the new locality permanently or indefinitely as demonstrated by your actions
Generally, your state of residence is where you have your closest connections. If you leave your state of residence, it is important to determine if your presence elsewhere is for a “temporary or transitory” purpose. Indeed, this is a common phrase in residency examination. When coming to California for temporary or transitory purposes, you are a nonresident of California. However, when you are in California for other than a temporary or transitory purpose, then you are a California resident. This can include situations such as when an employer assigns you to California for a long and indefinite period; or when you are retired and come to California with no specific plans to leave; or when you are ill and come to the state for an indefinite recuperation. In the reverse, any individual who is a resident of California continues to be a resident when absent from the state for a temporary or transitory purpose. Some more defined absences such as for employment-related reasons could be considered as absences for other than temporary or transitory purposes … and thus you could be deemed a nonresident for that period of time during this type of absence.
Facts and Circumstances – and Potential Audits
When it comes to triggering residency status, there is a popular perception of a “six-month” rule of thumb … over or under. And yet, while it is best to generally spend less time in California — if worried about this issue — spending more than six months does not necessarily make one a resident. Again, no one thing decides it. Plus, the purpose of a visit to California determines how it affects your residency status, not the time per se. However, according to the FTB, “you will be presumed to be a California resident for any taxable year in which you spend more than nine months in the state.” This can be contested — and other factors may apply that support a claim against legal residency despite an extended stay — but it is sensible not to push it too far … and to also plan carefully and consider the many other listed factors that might lead to an audit and an unfavorable residency determination.
The FTB is rather vigilant about all of this, and conducts “fact and circumstances” analysis. It considers all the facts in context, and not just one in isolation. Plus, it not only requires a taxpayer to provide financial information — like any typical audit — but also detailed information about how you spend your time, how you socialize, who you hire and do business with, and much more. Essentially, it is quite invasive and gets deep into your entire lifestyle.
Interestingly, one of the main causes of residency audits is using a vacation house address for receipt of important financial or tax-related documents such as brokerage account 1099s, pension distribution 1098s, and partnership K-1s. It is therefore critical to avoid having such information sent to a “true” vacation home address. For many, the vacation home was once their primary residence — prior to moving elsewhere — and thus they might simply forget, or just not bother, to properly change address information. Don’t be lazy or neglectful. Make the effort to fully establish residency out-of-state (by having all such mail go there), and then treat the vacation house as, well, a true vacation destination. Also, be mindful of the number of days spent at the vacation home, because it is hard to justify spending more time on so-called vacation in California than in one’s home state.
Qualitative Decisions Matter Too
Because of the requirements involved, changing California residency is not simple … especially for those who want to maintain some connection to the state. Besides, it is not always convenient for many individual taxpayers — even if retired and ready to make a change — because a spouse might still be employed. Furthermore, if children are still living at home and in school, this obviously complicates things and compounds the costs (both real and emotional) of possibly moving to a lower-tax state. Indeed, single people understandably tend to migrate more than married people, and yet most millionaires are married (many with children still living with them); so, this likely limits the potential revenue-generating exodus that is causing some growing concern.
For those wishing to leave California and deliberately give up residency, clearly many quantitative factors must be considered; but ultimately, qualitative decisions need to be made too — especially, do you really want to live in the new location? Again, many people move for “proactive” reasons like job-related commitments or family-related desires, and this dictates the outcome; but for those motivated more by “reactive” reasons like avoiding California’s high tax rates, the alternate destination is important. In other words, don’t simply let the proverbial “tax tail wag the investment dog.” Besides, not every other place offers compelling financial relief, and there are also trade-offs in different types of taxation as well as many other financial considerations (including various weather-related risks and costs) plus other subjective considerations. Indeed, some people choose to think of California’s high cost of living as an effective “culture and weather tax” that simply comes with the territory.
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