Your Guide to Understanding Tax Residency Rules in the United States

Tax residency is a different type of residency than legal residency. To be determined a legal resident, an individual who has relocated to a foreign country needs to apply for citizenship, a visa, or their country’s version of the Permanent Resident Card, also known as a permanent visa. In the US, the Permanent Resident Card is also called a green card.

In many cases, an individual’s legal residency in a given country also makes them a tax resident—this is mostly true for the United States. However, tax residency can also be applied to individuals who are physically present in a country regardless of their legal residency (or immigration) status.

In many countries, a substantial presence test is one of the main criteria for determining whether or not an individual is considered a tax resident if they are not a citizen or legal permanent resident (although other tests may apply). Indeed, the US imposes tax obligations on any individual who meets the criteria of the IRS substantial presence test, even if they are not a legal resident. If an individual is considered a US tax resident and their income is above a given minimum amount, they must file an income tax return.

US Tax Residency Tests

There are three types of recognized US taxpayers:

• Resident taxpayers
• Nonresident taxpayers
• Dual-status taxpayers

Resident Taxpayers

Resident taxpayers are either a US citizen, a US permanent resident (i.e., a green card holder), or they meet the US substantial presence test. All US citizens and permanent residents are considered US taxpayers at all times, regardless of where they live in any given year.

The US substantial presence test applies to those who are not US citizens nor permanent residents (which are always considered US tax residents regardless of their physical location). The test counts a given number of days in the current calendar year with a formula applying to days of physical presence in the three prior years. To be considered a tax resident, an individual must have been physically present in the US for at least:

• 31 days during the current year, and
• 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting:
• All the days present in the current year, and
• ⅓ of the days present in the first year before the current year, and
• ⅙ of the days present in the second year before the current year

For example, Katy, a non-US citizen, was present in the US for 180 days each in the years 2019, 2020, and 2021. To determine if Katy meets the substantial presence test for 2021, she would count the full 180 days she was present in the US in 2021, 60 days in 2020 (⅓ of 180), and 30 days in 2019 (⅙ of 180). This would mean she was physically present in the US for a total of 270 days in the past three years, making her a resident alien for tax purposes in 2021.

Nonresident Taxpayers

Nonresident taxpayers are individuals who are considered nonresident aliens but who derive income from US-based sources. For example, they may own property in the US or have shareholder interests in US corporations.

Any nonresident alien who derives income from sources “within the United States connected with the conduct of that trade or business is considered to be Effectively Connected Income (ECI).” ECI earned during the tax year is taxed at the graduated rates that apply to US citizens and permanent residents (after any allowable deductions).

Dual-Status Taxpayers

Dual-status taxpayers are non-citizen, non-permanent resident individuals who live in the US for only part of the tax year. For example, an individual who owns a rental property in the US but lived in the US for only part of the year on a visa might be considered a Dual Status Alien. If considered a Dual Status Alien, an individual must file two part-year tax returns to the US: one as a partial-year resident alien and one as a partial-year nonresident alien if they have US-sourced income.

Aside from US source income (e.g., rental income, closely-held business income, etc), only income earned during the portion of the year in which they were physically present in the US is subject to US taxes. During the period they satisfy the US tax residency test, all worldwide income is taxable.

The official start and end dates of residency are important for the individual to include on their tax return, but the rules for determining start and end dates are different depending on the method of residency test used (i.e., the green card test or the substantial presence test). The rules for each are outlined by the IRS, which can be found here.

State Rules on Tax Residency for US Citizens

US citizens and legal permanent residents must also consider their state tax obligations depending on the state they lived in if they are considering moving overseas. In the US, there are domicile states, such as California, and physical presence states, such as New York and Minnesota. Physical presence states only require income taxes to be paid if an individual physically works or lives in that state.

Domicile states such as California, however, require residents to pay state income taxes even if they do not physically reside in the state for a given period of time. For example, Emily is a California resident who is relocating to Australia for a work assignment that will last two years or more. Even though she will not live or work in California for two years, she may have to continue paying state income taxes on all her worldwide income. This is especially pernicious as California is not likely to grant a foreign tax credit for Australian federal taxes paid.

For residents relocating away from domicile states like California, they may want to strategize how to cut ties with that state unless they plan to eventually return. In Emily’s case, she may want to sell her California property before moving to Australia instead of keeping it as an investment property. If she were to keep her home as an investment property, California may be able to consider Emily a domiciliary of California.

Any US citizen who is relocating to another country for a substantial period of time should familiarize themselves with their state’s tax residency laws and whether they apply a domicile or physical presence type test. If they live in a domicile state, they will need to incorporate the tax consequences into their financial plan or make arrangements that will allow them to sever ties with that state.

Learn More about Arete Wealth Strategists

High-net-worth individuals who are relocating to or leaving the United States have much to consider in terms of their tax consequences. At Arete Wealth Strategists, we support and serve cross-border citizens. We educate on tax implications for their relocation decisions, as well as how to optimize tax mitigation strategies for clients who need them.

We specialize in providing financial advice to globally mobile individuals and families who need us, and it’s never too late to seek advice. To learn more about Arete Wealth and how we can support you, visit www.arete-wa.com or simply click here to visit our get started page.