How Your State Taxes Affect Your Federal Taxes: What to Know Before April 15th

Every US taxpayer must file a federal tax return with the IRS while living abroad — but what about state taxes? The answer to this question is highly variable and can be straightforward or relatively complicated. This depends on which state you moved abroad from. After all, there are 50 states, each with different laws. As the April 15th deadline approaches, let’s look at some things you should know about how your state taxes might affect your federal taxes.

Defining State Residency

When it comes to how state residency might affect your tax obligations, there are two distinct legal concepts you should know about: domicile and residency. Here’s a quick comparison between the two:

• A domicile is your true, fixed, and permanent home — the place you left from and will return to after your time abroad. In the eyes of the law, your domicile is the state where you have a driver’s license or state ID. You are also registered to vote, hold financial accounts, own property, and have close family ties there, and so on.
• Residency, on the other hand, is more flexible — it is defined as your temporary place of residence. It is also a place where you live based on the amount of time you spend there. Most states will consider you a resident if you spend over 183 days (six months) of the year there. This may then trigger certain tax obligations.

Some states have stricter residency rules than others. In general, states that do not have income tax obligations (e.g., Florida, Texas, Washington) do not require expats to file a state return. However, expats domiciled in states such as California or New York, for example, must continue to file state returns. They might even potentially owe income tax each year they are living abroad.

You can have multiple residencies but only one domicile. It is important that you establish a single domicile, as doing so will determine if you need to file a state return at the end of the year. Not only that, but failure to cut ties with one state could leave you in a position where two states can claim you as a tax resident. At that point, you could end up being double taxed on one worldwide income.

How State Taxes Can Affect Your Federal Tax Return

Impact on Tax Deductions

If you itemize your deductions (versus taking the standard deduction), you may be able to deduct state, local, and foreign income taxes paid on Schedule A of your federal return. However, if you receive a state refund as a result, the IRS may tax the refund as federal income the following year. By taking the standard deduction, your state refund is not taxable at a federal level in the next tax year.

Impact on Expat Tax Benefits

Two of the most beneficial tax benefits every expat should know about are the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC). The FEIE and the FTC help expats offset US tax liability for income already paid to a foreign country.

The FEIE allows you to exclude up to $126,500 in foreign-earned income — but some states, such as California and Pennsylvania, do not recognize the FEIE. In this case, your domicile state could still tax your full worldwide income, even if your salary is excluded from your federal return.

As for the FTC, the IRS states that only foreign income taxes qualify for this benefit, so it does not apply to state taxes. This may leave you on the hook for taxes owed when filing your state return.

Tips for Reducing State Tax Burden

There are a few ways you can reduce or fully eliminate your state tax burden while abroad. If you live in a high-tax state such as California or New York and plan to live overseas long term, consider changing your domicile to a no-tax or low-tax state. To do this, you would need to legally terminate residency in your former state and establish residency in a new state.

Some ways you can do this include:

• Selling any property you own in that state
• Closing financial accounts you have open in that state
• Removing any local mailing addresses
• Selling vehicles you own or moving your auto registration
• Moving any investments and retirement accounts
• Moving your driver’s license or state ID and voter registration

Also, be aware of the states that have the 183-day rule we mentioned above. If you spend more than 183 days out of the year in these states, they may consider you a full-year resident for tax purposes, so limit your time there to avoid this.

Please note that you do not have to do the above to end state ties, but they can certainly help. For many states, it would be enough to simply move and start working abroad. In this case, you would just file a Part-Year State Return and Non-Resident State Return the following year to create a “paper trail” of moving abroad.

Conclusion

Navigating federal taxes as an expat can seem pretty daunting at first glance. This is especially true when you’re dealing with 50 individual states that each have their way of doing things. Understanding how your state tax obligations affect your federal taxes will help you avoid any surprises once April 15th rolls around.

If you need help, sign up for a free MyExpatTaxes account. Simply answer a few questions, and based on your responses, we’ll determine if you must file a state return along with your federal return. Should you need any additional help, our Tax Professionals are on hand to answer any questions you may have.