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Don't take the "state" out of estate planning

When it comes to your wealth plan, state of residence can play an important role.

Key takeaways

  • Remember to consider your state of residency when reviewing and updating your wealth plan.
  • When choosing where to live or whether to move, determining if a state is tax-friendly—based on income, estate, inheritance, gift, and other types of taxation—should be one consideration.
  • If you live in a state with an estate tax, it is important to have properly drafted documents that are flexible enough to take advantage of both federal and your state's exemption amounts.
  

When thinking about wealth planning, the primary focus for many is often federal income tax and federal estate tax considerations. However, your state of residency can have a significant impact on your financial plan and shouldn't be ignored. There are 4 key issues regarding your home state that you should consider when reviewing and updating your plan:

  1. Establishing domicile and residency when relocating to a new state
  2. Income, estate, inheritance, and gift tax issues
  3. Portability of estate tax exemption and state qualified terminable interest property (QTIPS)
  4. Community versus common law property jurisdictions

This article will explore each of these issues and how they can influence various aspects of the wealth planning process.1

1. Establishing domicile and residency when relocating to a new state

Relocating to a new state means changing your domicile and residency, which can have a hefty impact on a wealth plan from a state income and state estate-tax standpoint. In determining domicile and residency, it is important to note that the definition of each can vary depending on the issue at hand. For example, these definitions in the context of individual income or estate taxes can differ from those related to the taxation of a trust. In all instances, however, the concept of "nexus" is considered. Nexus is the level of contact that must exist between an individual and a state before the state has the jurisdiction to assess taxes on the individual.

The concept of domicile, in most cases, is an individual's permanent home and the place they intend to return to following an absence.2 Some of the factors that may be considered when determining or proving domicile are the location of items with sentimental value; the proximity of hired professionals, such as attorneys and accountants; memberships to social clubs and religious organizations; income tax filings; executed estate documents referencing a state of residence or employment; and business or family relationships tied to a specific state.

While items such as a driver's license, voter registration, and the location of important documents may also be considered, they may be easily controllable and may not substantiate domicile in certain situations. Domicile plays a critical role in determining if and where an individual’s estate may be subject to state estate tax at their passing. It is important to keep in mind that an individual can have only one domicile at any given time.

The issue of residency often arises when individuals move out-of-state for most of the year, but still maintain a home in their original state. This can have an impact on the state or states to which an individual may be liable for income taxes. Although the definition of residency varies by state, in general, residency is determined by the amount of time spent in a particular state and whether a "permanent place of abode" has been maintained there.

A permanent place of abode is typically considered a property that can be lived in year-round and has been maintained for a substantial portion of a tax year. The New York State Court of Appeals has determined, for example, that substantially all of the tax year is 11 months or more.3 As with the overall definition of residency, this amount of time also varies by state. Both Massachusetts and Delaware use 183 aggregate days in a taxable year as the threshold, whereas Illinois uses an aggregate of more than 9 months.4 Given the varying rules state by state, it is possible for an individual to be considered a resident of more than one state in a given tax year, and, as a result, be subject to multiple states’ income tax requirements in that year.

It's important to note, however, that although an individual may not meet a specific state's definition of resident, they may be treated as a part-year resident, requiring them to report and pay taxes on income sourced to that state. Part-time residency is an important factor to take into consideration if an individual plans to relocate during the tax year, as portions of income may be taxable to different states. Many states have been auditing high-income earners to ensure income has been properly sourced to the state. For example, professional athletes often pay income taxes in every state they play in, because the income earned at each game is sourced to each state. Additionally, states may also review the tax reporting of income-producing property in that state.

For example, a Florida resident who owns an interest in rental real estate in New York should review the New York income tax reporting requirements because, although the income was paid to a Florida resident, it would be considered income sourced to New York. It is important to keep your tax advisor apprised if you are earning income in more than one state or receiving income that could be sourced to a non-resident state, to be sure the associated rules are properly analyzed.

2. Income, estate, inheritance, and gift tax issues

Although tax laws are subject to change, a state's key tax attributes should be one of the factors to consider when deciding where to live.

Income tax Because more states have an income tax than do not, it is simpler to list the states that are most tax-friendly by this definition. Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming all currently do not have an income tax.5 In addition, only one state assesses an income tax on investment income: New Hampshire.6 If income tax is a primary concern, it may make sense to relocate to one of these states to limit tax exposure at the state level.7 However, it's important to understand that a number of states partially or completely exempt retirement income from their state income tax, and as a result, states that levy a heavy income tax burden, in general, are actually quite income tax-friendly to retirees. The rules are complex— in some cases, only income from public pensions is excluded, while in others, income from qualified plans is also exempt—so it may be useful to consult with a state tax expert when making decisions about a domicile for retirement.

Estate tax Most states do not have estate taxes. There are currently 12 states and the District of Columbia with an estate tax: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington.

Rates and estate tax exemptions vary from state to state. For example, New York has a top state estate tax rate of 16% and state estate tax exemption of $6.94 million, as of January 1, 2024.8 It's important to note that there are some nuances related to New York's estate tax calculation and taxable estates that may be close to the exemption amount, which should be reviewed carefully. Due to these nuances, it is possible that the net taxable estate may not qualify for an exemption at all, which is often referred to as the "estate tax cliff."

Inheritance tax Even if a state does not have an estate tax, heirs may still be subject to an inheritance tax. There are currently 6 states with an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. So, for example, in Maryland, both an estate tax and an inheritance tax could be assessed.

Gift tax Connecticut is the only state that has a state gift tax. Connecticut's system works much like the federal estate tax system, with both a gift tax and an estate tax. In Connecticut, gifts made during your lifetime above the annual exclusion amount ($18,000 per person in 2024) will utilize some or all of your $13.61 million state lifetime exemption.9 For example, if Sally makes a $1 million gift to her daughter, Molly, in 2024, $18,000 will be considered an annual exclusion gift and $982,000 will be considered part of Sally's Connecticut lifetime exemption. Therefore, should Sally's taxable estate exceed $13.61 million dollars at her passing, she will only have $12,628,000 of her Connecticut estate tax exemption to offset her Connecticut taxable estate.10

There is one additional factor to consider and discuss with your tax advisor when making gifts during your lifetime: the dreaded state "clawback"— essentially, the concept that although gifts may have been completed during one's lifetime, it is possible that a state can add these gifts back to one's taxable estate at death. There are currently 3 states that have a clawback for estate tax purposes: New York, Maine, and Minnesota.11 The amount that may be clawed back is determined based on the time lapsed from the date of the gift and the date of death. States vary in their clawback periods and in the types of gifts to which a clawback can apply. For example, Minnesota federally taxable gifts made within 3 years of the date of death can be clawed back. However, in Maine the time frame is just 1 year. In states without a gift tax or a clawback (e.g., Massachusetts), gifting is often an effective late step available to reduce state estate tax, though filing requirements may remain even if the gross estate is under the normal filing threshold. Given the complexities mentioned above, it is important to consult with your tax advisor when contemplating gifting during your life and how your state may treat those gifts.

3. Portability of estate tax exemption and state QTIPs

The key to prudent estate planning is to have properly drafted documents that are flexible enough to take advantage of the federal exemption amount, and if you live in a state with an estate tax, your state's exemption amount as well. In addition, the concept of portability of the estate tax exemption was introduced in 2010 to help alleviate some estate planning complexities.12

So what does portability of the estate tax exemption mean? The portability provision affords the transfer of a deceased spouse’s unused lifetime exemption to the surviving spouse. This election is available to US citizens or permanent US residents who are married on the date of death of the first spouse. The federal lifetime exclusion available to all taxpayers in 2024 is $13.61 million. If a married individual were to pass away in 2024, without having used any portion of the $13.61 million exclusion, a decision can be made to elect portability. By making this election, the unused exemption at the death of the first spouse would then be added to the exclusion available to the surviving spouse. The portability election must be made by the executor or personal representative of an estate on a timely filed Form 706, "United States Estate (and Generation-Skipping Transfer) Tax Return."13

When portability was initially enacted, lawmakers praised the bill for simplifying estate planning, stating that sophisticated credit shelter trusts (CSTs) (which have been traditionally used to help married couples take full advantage of federal and state estate tax exemptions) were no longer needed. Now, by simply electing portability, a surviving spouse would be able to utilize the deceased spouse’s estate tax exemption. Additionally, by electing portability, an asset included in the marital deduction calculation will receive a step-up in basis at the first spouse's death as well as with the death of the second spouse. However, there are still a number of benefits to creating CSTs (see "Why credit shelter trusts may still be valuable tools," below).

State and federal exemption amounts often are different It is possible to trigger a state estate tax by fully funding a CST because many state estate tax exemption amounts are lower than the federal exemption amount. A state estate tax could be due on the difference between the 2. Certain planning techniques are required to help prevent this. Some states permit individuals to make a qualified terminable interest property (QTIP) election, which could allow a CST to be fully funded without incurring state estate tax.14 As always, consult with your tax advisor if you live in a state that has a state estate tax to determine whether your state and your personal estate planning documents allow for a state QTIP election.

Why credit shelter trusts may still be valuable tools Even though portability has simplified some aspects of the estate planning process, there are some potential drawbacks to electing portability in lieu of traditional credit shelter trusts (CSTs).

  • First, a credit shelter trust will allow assets placed in the trust at the time of the first spouse's passing to grow estate tax-free and not be taxed at the surviving spouse's passing. So, a spouse electing portability runs the risk of trapping any appreciation on the ported assets in the estate. For example, if a surviving husband elects portability for his wife who had $13.61 million (the lifetime exclusion amount in 2024) in her own name and survives for 20 years thereafter, all the growth on the $13.61 million will be trapped in his estate. However, if the husband disclaims assets to form a credit shelter trust at the time of his wife's passing and fully funds the trust with the $13.61 million then upon his passing any appreciation on the $13.61 million will pass estate tax-free.
  • Second, the generation-skipping transfer tax (GSTT) exemption is not portable, so if your intention is to elect portability you will be wasting the first spouse’s remaining GSTT exemption at death. The GSTT exemption can be used to protect assets from the generation-skipping transfer tax when assets are transferred to grandchildren, grandnieces, or grandnephews (or unrelated persons more than 37½ years younger than the donor).
  • Third, as of 2024, there are 2 states, Hawaii and Maryland, that allow portability at the state level. So if you live in a state with an estate tax that does not offer portability and you decide to elect portability at the federal level, you will effectively be wasting all of the deceased spouse's lifetime state estate tax exemption. Thus, electing portability can cost you significant state estate tax dollars and loss of the first spouse to die's GSTT exemption. Therefore, it is critical to ensure that any estate tax planning done on the federal level coincides with that done on the state level. And with proper planning, it is possible to ensure consistency at both the federal and state levels to achieve optimal results when electing portability.
  

4. Community versus common law property jurisdictions

Community property is a state-specific marital-property regime that enables powerful tax savings at death with proper planning. There are currently 14 jurisdictions in the US that have community property: Alaska,15 Arizona, California, Florida, Idaho, Kentucky, Louisiana, Nevada, New Mexico, South Dakota, Tennessee, Texas, Washington, and Wisconsin.16 Puerto Rico is also a community property jurisdiction.

Community property denotes property in which each spouse has a presently vested, equal, individual interest, regardless of how title is held. Community property applies to assets acquired during the marriage, excluding any gifts or inheritance.

Community property differs fundamentally from common law property. Most states are common law states. With common law property, most legal rights are controlled by how the property is owned or titled. For example, New York, New Jersey, and Massachusetts are common law property states. Because property law rights generally are defined solely by state law, community property is not relevant for federal purposes, with one significant exception. Community property is offered a full step-up in basis on certain assets at a decedent's death on the federal level. The step-up enables the surviving spouse to adjust the cost basis of certain assets to the fair market value at the date of death of the decedent, thus, wiping out all built-in gains on the assets. Assets eligible for the step-up may include land, rental property, and marketable securities. Both the decedent's interest in the community property and the surviving spouse's interest receive the step-up. Common law property, on the other hand, is only offered a half step-up in basis on jointly owned property. For this reason, community property status is a powerful tax planning tool, and makes the tracing and maintenance of community property important from a tax planning perspective. It is important to consult with your attorney and tax advisor to understand how community property or common law property would be handled in circumstances such as divorce and death.

Individuals who are considering moving from a community property state to a common law state should consider the potential impact of commingling community property with common law property. This mostly applies to individuals who still have state-sourced earned income.

For example, a couple that decides to relocate from Texas to New York for business purposes should work with their tax advisor to ensure their investment accounts preserve their community property nature. Further, income sourced from a common law state generally should not be deposited into a community property account. Without proper recordkeeping, it could be difficult to determine which piece of the account will receive the full step-up in basis at the death of the first spouse.

Susan and John

Let's consider a hypothetical example to illustrate the potential benefits of community property over common law property.

Susan and John are married and jointly own a rental property valued at $1,000,000, with a cost basis of $500,000.

What would happen if Susan and John lived in Texas, a community property state, and John were to pass away this year? At John's death, there would be a full step-up in basis of the rental property. Susan's new cost basis would be $1 million and the $500,000 of unrealized gains would be wiped out, resulting in zero capital gains tax should Susan decide to sell the rental property immediately (before it further appreciates in value).

What would happen in the same scenario if Susan and John lived in a common law state, such as New York? At John's death, only one-half of the rental property would receive a step-up. Susan's basis would be $750,000 (Susan's basis of $250,000 plus John's stepped-up basis of $500,000). This would leave Susan with $250,000 of unrealized gains. Should Susan decide to sell the property, she would incur a capital gains tax of $50,000 (assuming she is in the highest tax bracket and is subject to a 20% capital gains tax rate).

Conclusion

Estate planning involves a multitude of complex issues, and state residency is just one of them. The intent of this article is to provide an educational foundation on 4 key estate planning issues that stem from your state of residency. You don't have to be an expert, but a basic understanding of some of these topics may help you identify any potential stumbling blocks so that you can bring them to the attention of your tax advisor and estate planning attorney. Contact your Wealth Management Advisor to discuss how these matters may influence your overall wealth plan.

1. This article is based on current tax law as of the date of publication. 2. Typically, absent the intent to establish a new domicile, the last established domicile will control. 3. New York State Department of Taxation and Finance, Publication 36: General Information for Senior Citizens and Retired Persons, as of Mar. 31, 2015. 4. The Bureau of National Affairs, as of Dec. 12, 2022. 5. Exclusive of possible city/county income tax. https://taxfoundation.org/publications/state-individual-income-tax-rates-and-brackets. Effective 1/1/22 Washington state passed a 7% long-term capital gains tax on gains of $250k or more generated in the state or earned by a resident. There are exemptions for sales of real estate & other specified assets. 6. Tax on interest and dividends in New Hampshire is gradually being phased out through 2026. https://www.revenue.nh.gov/faq/interest-dividend.htm 7. Of course, there are other forms of taxation that should be considered—such as sales and property tax. 8. "Estate tax," New York State Department of Taxation and Finance. As of 12/18/23. https://www.tax.ny.gov/pit/estate/etidx.htm. 9. State of Connecticut Department of Revenue Services publication: See CT Law Ch 217, Section 12-391(g)(9) as of Dec 6, 2023 10. Connecticut General Statute § 12-642(a)(5), as of Dec. 12, 2024. 11. Minnesota statute § 291.016; Maine statute § 4102; and New York statute § 954(a) (as amended by 2014 N.Y. A.B. 8559/S.B. 6359 and as amended by 2015 N.Y. A.B. 3009/S.B. 2009), as of Dec. 12, 2022. 12. Portability was a component of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA for short). TRUIRJCA introduced for the first time the concept of "portability" of the federal estate tax exemption between married couples for the 2011 and 2012 tax years. Then, on January 2, 2013, President Obama signed the American Taxpayer Relief Act (ATRA for short) into law. Under the provisions of ATRA, portability of the estate tax exemption between married couples has been made permanent for 2013 and future years. See Internal Revenue Code §2010(c) (2) for more detail on the portability provision. 13. If the surviving spouse has more than one predeceased spouse, certain limitations apply. 14. Qualified terminable interest property is a mechanism used to enable the transfer of a lifetime income interest in property from one spouse to the other (typically through a trust), with the remainder left to beneficiaries, to qualify for the estate- and gift-tax marital deduction. 15. Alaska, Florida, Kentucky, South Dakota, and Tennessee have adopted a community property system, but it is optional. Spouses may create community property by entering into a community-property agreement or by creating a community-property trust. 16. See IRS Publication 555 (rev March 2020)

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

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