The State of Taxes in America

FOR MOST AMERICANS, the primary driver of their tax liability is their tax rate. For others, it is their ZIP code.

Because the Tax Cuts and Jobs Act of 2017 capped the deduction for state and local taxes (SALT), wealthy residents of New York, California and other high-tax states could see their federal income tax bills rise even as their tax rates have dropped. Fortunately, these residency-related tax issues may be addressed by planning strategies that extend beyond calling a moving company.

Congress giveth and taketh away

The new tax law slashed rates on ordinary income, increased the standard deduction and doubled the federal estate and gift tax exemptions, significantly reducing most Americans’ tax liability. However, to help offset the cost of that largesse, Congress capped the SALT deduction, which was open-ended prior to the tax act but is now limited to $10,000 ($5,000 if married, filing separately). This limitation, like most of the tax changes affecting individual taxpayers, expires at the end of 2025.

Taxing Your Income

States with the highest tax rates as of January 1, 2018 

Because they will be able to write off only a portion of their state and local taxes, many upper-income residents of high-tax states could suffer sticker shock in April 2019. In New York, one of the states most affected by the SALT cap, nearly one-third of taxpayers with income in the top 1% could see higher federal income taxes, according to the Tax Policy Center. New York, New Jersey and Connecticut have passed laws to counteract the limited SALT deduction and other states are considering such changes. The Internal Revenue Service has indicated it does not look favorably on efforts to circumvent the new limit on the SALT deduction. Ultimately the courts might be called upon to determine the legitimacy of states’ actions to reduce the impact of the SALT limitation on their residents.

States Most Affected by New Tax Rules

Percentage of taxpayers projected to see tax increases

An easy solution to the SALT limitation — but a big decision — is relocating to a state with no state income tax (or one with a lower tax rate). To successfully relocate for income tax purposes, one typically must reside in the new locale for the majority of the year and spend no more than a specified number of days in the former state. States also consider the location of a transplant’s employer, voting district, and clubs and social organizations to determine whether the person is truly a permanent resident or merely posing as one. Officials who suspect the latter may review credit card transactions, electronic tolling charges and even frequent-flier-mile records to determine the individual’s actual residence.

For those not inclined to  pull up stakes for tax purposes, another strategy — albeit a complicated one — might provide some relief. Because the SALT limit applies to each taxpaying entity, it may be possible to multiply the deduction limit by placing real estate and income-producing assets in non-grantor trusts. If the individual’s annual SALT taxes total, say, $50,000, he might transfer a primary residence or vacation home into several such trusts to generate enough deductions to cover his full SALT liability. Again, this strategy is complex and would require an experienced tax professional to execute.

Minimizing state estate taxes

As important as it is, the cap on the SALT deduction is not the only provision in the tax act that makes location a central part of the tax-planning conversation. The doubling of the federal estate tax exemption to $11.18 million for an individual or $22.36 million for a married couple effectively eliminates federal estate tax liability for the vast majority of Americans. As a result, state estate taxes may loom larger for residents of states that impose them. Indeed, with the dramatic expansion of the federal estate tax exemption, some taxpayers may now owe more state estate tax than federal estate tax, despite the latter’s 40% rate.

Taxing Your Estate

Estate tax rate and exemption by state

A change of residency could potentially eliminate state estate taxes, but relocating presents its own difficulties, one being the lack of an objective determinant of residency. Living in a state for a certain number of days might help establish residency for state income tax purposes, but generally that is not the case with regard to state estate taxes. A transplanted New Yorker might reside in Florida the entire year, but if she retains her Manhattan apartment, New York state tax officials might determine she still is subject to New York estate taxes.

If changing one’s domicile isn’t feasible, the taxpayer could adopt a common strategy to mitigate estate taxes, which is to shrink one’s taxable estate by transferring wealth to individuals or trusts during one’s lifetime. One way to do this is by making lifetime gifts, which are not subject to gift taxes provided they do not exceed the annual gift tax exclusion of $15,000 per recipient ($30,000 for married couples electing to split gifts) or the lifetime gift tax exemption, which is $11.18 million for single taxpayers and $22.36 million for married couples.

For taxpayers who want to maintain control of their assets, it may be possible to mitigate state estate tax liability by changing how their assets are owned. A Florida resident with a second home in another state, for example, might hold the home in a limited liability company (LLC). Rather than owning real property in the other state, the individual would own a 100% interest in the LLC, which could, in some cases, eliminate the other state’s estate tax on the property.

A premium on planning

Strategies to minimize tax liability are complex, and those that work for one taxpayer might not be options for another because of differences in the individuals’ tax situation and the vagaries of state and federal tax rules. Arcane as they might be, these strategies deserve strong consideration, especially by wealthy taxpayers in high-tax jurisdictions, because the recent tax “cuts” could make the high cost of living in those enviable ZIP codes even costlier.