For example, if you know you’ll shortly liquidate some investment (cryptocurrency?) that results in very large taxable gains?
Maybe, just maybe, you ought to move. Before the gain gets realized. So, to Alaska, Florida, Nevada, South Dakota, Tennessee, Texas or Wyoming… (That’s the list of states that don’t tax income.)
Note: Washington state used to be a no-income-tax state and an attractive one to move to in some situations. However, Washington state starting on January 1, 2022 levies a 7 percent capital gains tax on the sorts of windfalls that would push someone to move.
Move to a ‘No Tax State’ Strategy in a Nutshell
This strategy? Well, you can already guess how it works. You clearly sever residency with the old state. And you also clearly establish residency in the new state.
You want to check the residency rules for the states you’ll move from and to. Especially the high-tax state. But in most cases, the stuff that determines residency reflects common sense.
Your state of residency probably is the state where you and your family work and live. Where your children, if they’re young, go to school. Where you vote. Where you procure medical or dental or other professional services. Where you bank.
It’s probably the state that issued your driver’s license, issued you any professional licenses, and that registers your vehicles. All of this stuff shows a permanent or indefinite connection to a state. And it suggests residency. Accordingly, to establish residency in some new no-tax state, you move all of this stuff from the old state to the new state. That’s the strategy in a nutshell.
And once you do that? Bingo. You should be able to save on state income taxes. Because you won’t have income earned in the old state.
Possible Tax Savings from Moving to a No Tax State Strategy
The tax savings you get from employing this strategy? Pretty significant in some situations. By moving from a high-tax to a no-tax state, a taxpayer roughly saves an amount equal to the income the original state loses the chance to tax.
Example: Rutherford, a long-time California resident, wants to sell cryptocurrency that will result in a $10 million gain. To avoid state taxes, he relocates from California to Texas, severing all connections to California. He sells his home in San Francisco and buys a new replacement home in Austin. He registers to vote in Texas and gets a Texas driver’s license. And then cancels his California voter registration and driver’s license. And then, after all this, he sells the cryptocurrency. He should in this scenario avoid California’s 13.3% tax on the $10 million.
One obvious thing to keep in mind: Relocation and moving costs add up. The economics sometimes don’t support moving. Even for rather large gains.
Example: Rutherford’s good friend, Grover, is also a long-time Californian. He wants to sell cryptocurrency that will result in a $1 million gain. Though he would love to avoid the large California state tax on the cryptocurrency gains, he holds a great job in California. One where he earns probably $25,000 more a year that he would earn at a similar job in Texas. Further, to sell his California home and buy a replacement Texas home? That would probably cost him $50,000 in commissions. Grover therefore should probably not move for tax avoidance reasons.
Turbocharging the ‘No Tax State’ Strategy
I don’t see any obvious ways to turbocharge the strategy of moving from a high tax state. But a couple of comments. First, tax deductions become less valuable in a no tax state. For this reason, someone moving from a high tax state may want to use deductions when they also save state income taxes. So maybe before they move? And maybe before they file the part-year-resident tax return?
And then one related comment. If someone currently resides in a low-tax or no-tax state and she or he plans to move to a high-tax state, that person may want to intentionally realize taxable income and gains before ending residency in the low- or no-tax state.
Example: Rutherford and Grover have a friend, William, who also sits on large cryptocurrency gains. Roughly $5 million of gains, in fact. He currently lives in Texas but wants to move to California to be closer to family there. He probably should consider realizing his cryptocurrency gains before he moves from his current no-tax state to a high-tax state.
Limits to ‘No Tax State’ Strategy
As a practical matter, timing of residency ending in one state, beginning in another state, and then of realizing some gain may prove tricky. You may not get the sequencing to work.
Also the more time between residency ending in the high-tax state and the point when income or gain is realized, the better.
Keep in mind that if residency ends during a tax year, a taxpayer files a part-year-resident tax return with the high-tax state… And that return? It surely includes the federal income tax for the full year.
Ideally, you would like that federal return to not show the income you’re trying to move out of the high-tax state. That might trigger trouble. Possibly seeing a large income item on the federal tax return for some part-year resident might trigger queries from alert state revenue agents.
Example: Rutherford moved from California on June 30 and files a part-year resident tax return for the year. That return includes the federal return for the year. Rutherford therefore delays selling the cryptocurrency and realizing the $10 million gain until the following year. The following year, he won’t file a part-year-resident California tax return.
Who This Strategy Works Best For
The “Move to a No Tax or Low Tax State” strategy works best for taxpayers who have only loose connections to their current high-tax state of residency and who also have really large taxable income windfalls and gains.
California is probably the most common high-tax folks want to leave. Any Californian who wants to consider establishing residency someplace else wants to carefully read this resource: Publication 1031.
The New York State Society of CPAs published a good discussion of how a taxpayer ends residency in that state worth reading–especially for New Yorkers: A Spotlight on New York State Residency Requirements.
As always, taxpayers want to discuss a strategy like this with their tax advisor. But this plug for our CPA firm: If you don’t have a tax advisor, onboarding info appears here and you can contact us here: Nelson CPA.