Stephen Williams for MarketWatch writes: Traveling for the winter or permanently moving to warmer climates is a common decision for many retirees, especially when putting into consideration the advantage of southern tourism states with lower income taxes.
Increasing interest in changing domicile — the location of a person's fixed, principal and permanent home — to select the best state for tax purposes is becoming increasingly popular. This trend began to accelerate about 10 years ago with the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001, or EGTRRA, and the real estate bubble that occurred during that time.
When EGTRRA increased the estate tax exemption amount to $1,000,000 and scheduled subsequent increases in estate tax exemption through 2010, the state death tax credit was replaced with a state tax deduction to help pay for that change. As a result, some states saw their state estate tax phased out, while other states saw death taxes continue. This left the U.S. with some states with no state death taxes and others which impose a state estate or inheritance tax.
In the early 2000s, Florida took on heightened domicile interest. In addition to the attraction of moving to a warmer state with rapidly appreciating real estate values, effective Jan. 1, 1995, Florida amended its laws to impose a cap on increases in the assessed value of property that was used as a primary residence. The Florida Save Our Homes property tax amendment imposed a 3% cap on property appreciation assessments. When the real estate bubble caused an annual increase in home property values ranging from 8% to 27%, Florida real estate tax bills for similar properties varied significantly based on whether the 3% cap applied.
Let's take a closer look at domicile, the tax and estate planning consequences of a change in domicile, and recommended steps for making a change following consultation with one's tax, financial and legal advisers.
What is domicile?
Domicile is the location of a person's fixed, principal and permanent home and is the place to which that person intends to return and remain even though currently residing elsewhere. Domicile is different than residency. While a person can have multiple residences, a person can only have one domicile. A person can reside in one state, but still be considered domiciled in another state to which the person intends to return. Once domicile is established in a particular state, it is presumed to continue until a person can show that a change in domicile has occurred.
States, especially the taxing authority of each state, will look at a number of factors to determine domicile. The factors considered will differ state to state and while no one factor is determinative, relevant factors include:
- Physical presence (amount of time spent in the state)
- Residence (whether a person owns or rents a home in the state)
- Employment
- Family location
- Real property ownership
- Voting registration and actual voting
- Driver's license
- Automobile registration and location of most valuable cars
- Bank accounts
- Tax return filings
- Memberships and licenses
- Professional services (doctor, dentist, lawyer, accountant)
- Location of valuables
- Cemetery plots (yes, even those.)
Termination of domicile may involve documenting and communicating the change in domicile to the appropriate taxing authorities. This can sometimes be more difficult to prove than establishment of domicile.
Why is domicile important?
Property ownership rules are governed by domicile. Laws of the state in which you are domiciled will determine a person's right to retain property and the rights of others to make a claim on your property. States may also impose taxes on a person domiciled in their state. From a planning perspective, taxes are probably the most important factor when considering the selection of your domicile. Asset protection and the rights of a spouse in the event of divorce may also be important considerations.
Tax laws apply depending on your place of domicile. The impact of the law will change depending on a person's amount of income, type of income, size of estate and value of the person's home. The following four tax planning points are important to consider when selecting your domicile.
1. Income taxes
Selecting domicile in a state that imposes no income tax can be an effective tax reduction technique. However, a state can tax a nonresident on income that is earned in that state. This includes compensation earned in that particular state (wages, salary, deferred income, Subchapter S income and income from a partnership or LLC) and income earned from a state source (such as rental income or capital gains on real estate located in a particular state). If you continue to work in a particular state, but change your domicile to another state with no state income tax, you won't necessarily save income tax on your earned income.
2. State death taxes
Planning to minimize state death tax is simple. Except for real property that is located in another state, you avoid a state estate or inheritance tax if you change your domicile to a state that doesn't impose a state death tax. States that do impose an estate or inheritance tax will generally impose the tax upon the death of a person domiciled in that state or upon the death of a nonresident who owns real property located within that state.
Most states give their residents a small tax break if a home is used as a principal residence. Typically, the relief is in the form of a reduction in the assessed value of the home or a credit against the property tax amount. If you decide to change your domicile, it will be important to notify your current property tax assessor that you have moved and are no longer eligible for any homeowner tax relief.
Florida offers the most significant property tax relief to persons domiciled in that state. The $50,000 homestead exemption and 3% cap on property appreciation are important tax planning benefits.
4. Fiduciary income taxes
Fiduciary income taxes — taxes imposed on irrevocable trusts — apply in states that impose a state income tax at rates similar to the individual state income-tax rates. Fiduciary income taxes often apply to irrevocable trusts that become irrevocable when the creator of the trust (the "settlor") is domiciled in the state. Frequently, the event that causes the trust to become irrevocable is the death of the settlor. Thus to avoid fiduciary state income taxes, you are advised to change your domicile to a state without fiduciary income taxes before your trust becomes irrevocable. [Note: Some states do impose a fiduciary income tax on irrevocable trusts that are administered in that state.]
Changing Your Domicile
Depending upon the state from which you are moving, the state department of revenue will likely scrutinize your move to the highest degree. Many states are beefing up their department of revenue staff to monitor changes in domicile.
It is recommended to work closely with your tax and financial advisers and legal counsel to consider all ramifications of a change in domicile and, if warranted, take the necessary steps and precautions that will ensure a smooth transition. Remember these considerations:
- Every state employs its own set of factors to establish new domicile or terminate an existing domicile.
- Termination of domicile is often more difficult to prove than establishing a new domicile.
- It falls on the taxpayer to "prove" that domicile has, in fact, changed.
Conclusion
As you can see, changing your domicile is complex, especially if you retain a home in multiple states. There is no magic rule to prove a change in your domicile. However, a change in domicile can significantly benefit your financial and estate plan.
Please consult with your financial adviser, lawyer and tax preparer to determine whether such a move is right for you.
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