When it comes to paying income taxes, many states in the U.S. offer tax credits to their residents for taxes they have already paid to other states. However, there are a handful of states with a different twist on this structure. A reverse income tax credit allows nonresidents to claim a credit against their tax liability in a state for income taxes paid to their home state on the same income. States like Arizona, California, Oregon, and Virginia offer this type of credit. However, these credits are usually limited to residents of states that also offer reverse credits, and there are specific rules on when and how these credits can be claimed. 

 

How Does a Reverse Income Tax Credit Work? 

1. Eligibility: You must be a nonresident of the state where you’re claiming the credit, but a resident of another state where you’ve already paid income tax on the same income. However, not every state offers reverse credits, so you must be a resident of a state that has an arrangement with the nonresident state offering the reverse credit. 

1. Claiming the Credit: When you file taxes in the nonresident state, you’ll calculate your tax liability based on the income you earned there. Then, you apply a credit for the income taxes you’ve already paid to your resident state on that same income. This credit will reduce your nonresident state tax liability. 

1. The Key Twist: The credit usually matches the amount of income tax already paid to your resident state. However, if the tax rate in your resident state is lower than the nonresident state, you may still have a residual liability. In this case, the credit might not fully offset your tax liability in the state where you earned income, and you’ll need to pay the difference. 

 

Why is This Important? 

Understanding reverse income tax credits is crucial because they can lead to unexpected tax consequences. If your home state has a lower tax rate than the state where you earned income, you may not eliminate your tax liability completely.  

For example: 

• You live in Arizona, where the state income tax rate is 2.5%, and work in Virginia, where income over $17,000 is taxed at 5.75%. You’ve already paid taxes to Arizona on the income you earned. Virginia grants you a reverse credit for taxes paid in Arizona, but if the amount of tax owed to Virginia exceeds what you paid in Arizona, as it likely will due to Virginia’s higher tax rate, you’ll owe the difference to Virginia. 

 

Navigating Reverse Income Tax Credits 

The potential for residual tax liability is the key factor to understand when claiming a reverse income tax credit. If your home state has a lower income tax rate than the state where you earned income, you may still owe taxes. This is an important detail often overlooked by taxpayers unfamiliar with reverse credits. 

 

Conclusion 

Reverse income tax credits allow nonresidents to offset their tax liabilities when earning income in states like Virginia, California, Oregon, and Arizona, provided they’ve already paid taxes in their home state. However, because these credits can leave you with a residual tax liability, it’s essential to understand how they work and calculate your tax obligations carefully. Before filing, it’s highly recommended to consult a tax professional who understands the complexities of reverse income tax credits to avoid any surprises. 

-Cedar Bauer, Esq., Tax Research Associate