Changing State Tax Residency: The Most Powerful (and Common) Response to the TCJA?

2018 has been an amazing year for tax practitioners. Since the passage of the Tax Cuts and Jobs Act, practitioners have been scrambling to understand the implications of the federal tax overhaul and to begin work on implementing new strategies for clients. And though the legislation obviously occurred at the federal level, many SALT practitioners have been dealing with the dramatic fallout at the state level as well, since aspects of the federal tax reform have had complicating and unexpected ramifications for state tax purposes.

But there is one change that may be the most basic—but most dramatic—change, particularly at the personal income tax level: the near-elimination of the state and local tax (“SALT”) deduction. Under the new rules, taxpayers generally can only deduct up to $10,000 of SALT payments as itemized deductions for personal income tax purposes. For individuals in high tax states, this could be the most impactful issue in the entire federal tax reform package. Indeed, historically more than half of the deduction was used up by high-income taxpayers from New York, California, New Jersey, Illinois, Texas, and Pennsylvania, so it goes without saying that the loss of this deduction is extremely meaningful for many taxpayers.

For example, under prior law, if a New York resident paid $50,000 in New York income taxes, he or she would be entitled to deduct that payment from their federal taxes. Thus, assuming the taxpayer was in the highest tax bracket and not otherwise in the AMT, the payment of $50,000 in New York tax would only cost that taxpayer around $30,000, owing to the federal tax benefit of the deduction. Now, however, assuming the taxpayer uses the $10,000 cap for other state taxes such as property tax, he receives no deduction off of federal taxable income. Thus, a $50,000 payment of New York taxes actually costs the taxpayer $50,000. And obviously, when we get to the taxpayers at higher income levels, the negative impact of this change continues to multiply. This is a really, really big deal.

In response to this problem, states such as New York, Connecticut, and New Jersey have proposed (and in some cases, passed) legislation to soften the impact of the lost deduction, including measures that would shift tax payments from individual taxpayers to businesses either through a payroll tax (such as in New York) or an entity-level tax (such as in Connecticut). States like New York, California, and New Jersey have also passed measures designed to essentially allow taxpayers to make charitable deductions in place of tax payments, in effect restoring the lost SALT deduction with increased charitable deductions (which have not been limited under the new federal law). Similar legislation has been proposed in Illinois, Nebraska, Virginia and Washington. But will these changes work? At this point, it’s hard to say. Many of these workarounds are complicated and will be difficult to implement. Plus, the IRS has already advised the taxpaying public that it likely will not acquiesce to these new state laws that are designed to circumvent the loss of SALT deduction through some sort of charitable-contribution scheme. So it doesn’t appear like these workarounds will solve the problem.

In our experience, the most basic and simple response to deal with the loss of the SALT deduction for taxpayers in high-tax states is simple: move from that high tax state! This doesn’t require any complicated income shifting. And it doesn’t require state laws designed to circumvent federal laws. It just requires a taxpayer to pack up their stuff and move to another state! We’ve had direct experience with this recent phenomenon, having received probably more than 100 calls from clients or potential clients looking to explore the possibility of moving from a high tax state like New York to a low tax state like Florida. Those who were once comfortable with paying high state taxes because of the federal benefit are now are unwilling to be so generous with their tax dollars. And while ours obviously is just anecdotal evidence, we expect a significantly increased volume of taxpayers looking to change residency—or attempting to change residency—this year or next. Thus, I also expect a barrage of personal income tax audits in high tax states like New York, Connecticut, New Jersey, and California in the coming years.

This brings up one critical point about such a strategy. If the taxpayer seeks to change residency to a low-tax state to lessen the impact of the lost SALT deduction, there is one critically important thing to keep in mind: they actually have to change their residency! As many former New Yorkers have learned, changing residency from one state to another is not as simple as getting a driver’s license and spending a certain number of days outside a jurisdiction. State residency laws require taxpayers to prove that they “left” their old state with the intention of not returning and “landed” in a new jurisdiction with the intention of residing there at least on an indefinite basis. Proving this is not an easy task. States like New York require that the taxpayer present “clear and convincing evidence” of the change. So any doubt gets resolved in favor of the relevant state tax department.

This, of course, presents an interesting conundrum. While state tax departments like New York are doing everything they can to help their residents deal with the loss of the SALT deduction, it is extremely unlikely that they will look favorably on those whose strategy involves jumping ship. No, to the contrary, we can expect the states to be extra vigilant about making sure that such taxpayers are honestly and legitimately claiming a change of residency, and that they are taking actions in support of such a change.

Despite these concerns, changing residency to deal with the loss of the SALT deduction is absolutely an effective strategy, and will likely prove to be the most effective strategy for dealing with this issue. But we expect it may end up being the one strategy that is also most subject to audit and litigation.

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