Military Members and Spouses Could Avoid State Income Taxes Thanks to New Law

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A tax return from the IRS

The rules governing where -- and, in many cases, if -- military members and their spouses pay state income taxes are changing thanks to a new law signed early this year.

The Veterans Auto and Education Improvement Act of 2022, which became law Jan. 5, makes amendments to the tax residency rules in the Servicemembers Civil Relief Act, a law that gives financial and legal protections to troops and their families.

Tax experts I consulted agree that how and when the new law is implemented by both states and the IRS is unclear. They even declined to speculate on the record about what the impact of the law might be.

But according to the text of the law itself, one thing is clear: Changes are here, and they could mean thousands of dollars more, or less, in taxes for military families.

The new law opens the door to service members and their spouses to pick the state in which they pay income taxes from three options: the legal residence or domicile of the service member; the legal residence or domicile of the spouse; or the current permanent duty station of the service member. It also expands to spouses a residency protection already offered to service members that allows them to remain tied to a former legal residency, even if they no longer physically live there.

The change could effectively mean that if the service member and spouse are ever stationed in a state that has low income tax rates or no state income tax they can continue to claim that state as their legal residency after moving away, so long as they met legal residency requirements while living there.

An important caveat: Always consult with a tax professional or tax attorney before deciding how and where to file your taxes.

What the New Law Says About State Taxes and Military

Section 18 of that new law includes:

"A spouse of a servicemember shall neither lose nor acquire a residence or domicile for purposes of taxation with respect to the person, personal property, or income of the spouse by reason of being absent or present in any tax jurisdiction of the United States solely to be with the servicemember in compliance with the servicemember's military orders."

And:

"For any taxable year of the marriage, a servicemember and the spouse of such servicemember may elect to use for purposes of taxation, regardless of the date on which the marriage of the servicemember and the spouse occurred, any of the following:

(A) The residence or domicile of the servicemember.

(B) The residence or domicile of the spouse.

(C) The permanent duty station of the servicemember."

What Makes a Place a Legal "Residence or Domicile?"

To understand the implications of this law, it's important to first understand how a location becomes a legal "residence or domicile." According to tax attorney and military spouse Candice McPhillips, "domicile" is where you've established official connections to a place, through actions like owning property, registering your car, holding a driver's license and registering to vote. A residency, on the other hand, is where you physically live. Different states have different rules as to what actions prove domicile.

What the Previous Law Said About Military Residency and Income Taxes

In the past, service members paid income taxes on their military pay to their state of legal residence. If that state had no income taxes, the service member didn't pay any.

Under those rules, military spouses could pay income taxes in the state where they physically resided, or choose to "borrow" the service member's state of legal residence for taxes.

But those rules created a lot of confusion, since a variety of different state and federal laws dictated when a military spouse could retain a previous state of legal residency after relocating on military orders. For example, a previous version of the law said that for a military spouse to keep their old state of legal residence "for purposes of taxation" when they moved, that state of residency being retained by the spouse had to be the same state of residency as the active-duty service member.

Yet just what actions constitute "legal residence" is a state issue, and the old federal law only offered minimal guidance and protection. For example, some states require that the spouse claim residence in the same state as the service member, while others don't have that restriction. The result was confusion, inconsistency and a lot of unintentional rule-breaking.

What the New Law Says About Military Residency and Income Taxes

While tax professionals are still waiting for more official clarification on how the new law will work, it seems to do two sweeping things.

First, it says that both service members and spouses "shall neither lose nor acquire a residence or domicile for purposes of taxation." That means that if you are a legal resident of a state, you can keep your legal residence "for purposes of taxation," if you move to a new state due to military orders. That rule previously only existed for service members.

The change means that, for example, a spouse who establishes residency in Washington state -- through registering to vote, voting in an election, holding a driver's license or owning property -- can keep that Washington state residency for tax purposes even after moving elsewhere as part of a PCS.

But the second change is more sweeping. Under the new law, both the service member and the spouse can elect to pay taxes in either the service member's state of legal residence, the military spouse's state of legal residence, or the place where the service member is located on PCS orders.

This opens all kinds of options. For example, both the spouse and the service member could easily choose to retain their residency in an income tax-free or low income tax state. A spouse who PCSes to a higher income tax state could instead choose from either their previous legal residency or their spouse's previous legal residency and file there.

But there are a variety of questions floating around this new change that have yet to be clarified.

For example, the law does not indicate the tax year for which the change is effective. Can service members and their spouses use these new options for their 2022 tax returns? What if they've been deployed and haven't filed 2021 yet?

The law also seems to create the possibility that the military spouse and service member can elect to file their income taxes in different locations. Will the military spouse and the service member be required to file their taxes in the same state, or can they pick and choose as suits them? And will taxpayers be able to switch the states in which they file year to year?

Issues that Weren't Addressed in the Change but Maybe Should Have Been

As long as Congress was going to the effort of improving this section of the Servicemembers Civil Relief Act (SCRA), I wish they'd cleaned it up a bit more. Here are a few issues that remain unresolved:

The SCRA says that military members can use their state of legal residence for taxation of their "military income," but spouses may use their state of legal residence for taxation of all their income. That means that a military spouse who drives for Uber Eats at their duty station can attribute that income to their state of legal residence. But if a military member drives for Uber Eats at their duty station, they need to attribute that income to the state where they are stationed and doing the driving for Uber Eats. That creates a situation where the service member needs to file in two states, but the military spouse is only filing in one.

Because the law clearly states that the spouse residency protections are tied to them being physically with the service member "in compliance with the servicemember's military orders," a military spouse who is geographically separated from their active-duty service member loses the residency protections of the law. This means a spouse will lose their legal residence protection if, for example, they want to stay in Maryland for a kid to finish high school while their service member moves ahead to Texas.

It remains difficult to show a state that you are a legal resident. Driver's licenses, vehicle registration and other actions typically show that you mean to make a state your legal residence -- but none of these proof methods are protected by federal laws. That's problematic when a state asks you to prove you're a resident elsewhere, but doesn't necessarily accept the other state's standard as acceptable. In fact, the new change will likely make this even more problematic.

That brings me to my last point of advice.

Be Consistent About Your State of Legal Residence

Wherever you maintain your state of legal residence, one thing remains constant: You need to be clear and consistent in your actions. To the greatest extent possible, maintain all your legal ties and documentation in that one state.

While there is no single indicator of intent, many actions contribute to proving that you're a legal resident. But one of the biggest indicators of state of legal residence is where you file taxes. If you're jumping to different states from year to year, you could make it even more unclear.

For example, don't get a local driver's license because it's easier than renewing in your home state. But do get a local driver's license if state law requires it. Don't sign an affidavit that you are a local area resident, because it saves you a few hundred bucks on your property taxes. Strive to stick to your one state in all your actions, whenever possible.

If you change your legal residency to a state with simpler or no state income tax filing, change everything -- and work to keep it that way. That way, when State X says, "Prove you're a resident of State Y," you can show them your driver's license, vehicle registration, wills, tax returns and voter registration card.

And, again, always consult with a tax professional or attorney before making major decisions that could have a long-term impact.

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