Regarding income taxes, many U.S. states offer tax credits to residents for taxes they have already paid to other states. However, a handful of states take a different approach. 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 such as Arizona, California, Oregon, and Virginia offer this type of credit. However, these credits are typically limited to residents of states that also offer reverse credits, and there are specific rules regarding when and how they can be claimed.
How Does a Reverse Income Tax Credit Work?
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 reside in a state that has a reciprocal arrangement with the nonresident state offering the reverse credit.
Claiming the Credit: When you file taxes in the nonresident state, you’ll calculate your tax liability based on the income earned there. You can then apply a credit for the income taxes already paid to your resident state on the same income, reducing your nonresident state tax liability.
The Key Twist: The credit typically matches the amount of income tax paid to your resident state. However, if the tax rate in your resident state is lower than the nonresident state’s rate, you may still owe taxes. In such cases, the credit may not fully offset your liability in the state where you earned income, requiring you to pay the difference.
Why Is This Important?
Understanding reverse income tax credits is crucial because they can result in unexpected tax liabilities. If your home state has a lower tax rate than the state where you earned income, you may still owe additional taxes.
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 have already paid taxes to Arizona on the income you earned. Virginia grants you a reverse credit for taxes paid in Arizona. However, because Virginia’s tax rate is higher, the credit will not fully cover your tax liability, and you’ll owe the difference to Virginia.
Navigating Reverse Income Tax Credits
The potential for residual tax liability is the key factor to consider when claiming a reverse income tax credit. If your home state has a lower tax rate than the state where you earned income, you may still owe taxes. This detail is often overlooked by taxpayers unfamiliar with reverse credits.
Conclusion
Reverse income tax credits allow nonresidents to offset tax liabilities when earning income in states such as Virginia, California, Oregon, and Arizona, provided they have already paid taxes in their home state. However, because these credits do not always eliminate tax liability, it’s essential to understand how they work and carefully calculate your obligations. Before filing, consulting a tax professional with expertise in reverse income tax credits is highly recommended to avoid any surprises.
Cedar Bauer, Esq.
Tax Research Associate