In today’s increasingly mobile world, it’s not uncommon for individuals to live in one state while earning income in another. This situation can lead to a potentially frustrating scenario: being taxed on the same income by two different states. Fortunately, the U.S. tax system provides a solution known as the Credit for Taxes Paid to Another State.
This credit is designed to help residents avoid double taxation on the same income. But to benefit from it, you need to understand the rules, eligibility requirements, and proper filing procedures. This blog provides an in-depth look at how this credit works, who qualifies, and how to claim it correctly on your state return.
1. What Is the Credit for Taxes Paid to Another State?
This credit allows residents of a state to offset their income tax liability when they’ve also paid income taxes to another state on the same income. It’s typically claimed on the resident state’s tax return, and it ensures that taxpayers are not taxed twice on the same earnings.
For example, if you live in New Jersey but work in New York, both states may tax your wages. New Jersey allows you to claim a credit for the taxes you paid to New York, reducing your New Jersey liability accordingly.
2. Who Qualifies for the Credit?
You may qualify for the credit if:
- You are a full-year resident of one state (your home state)
- You earned income in another state (nonresident state)
- You paid income taxes to that other state on the same income
Keep in mind, each state has its own rules regarding eligibility. Some states may not offer the credit or may have restrictions based on income type or the other state’s tax system.
3. Common Situations Where the Credit Applies
- Remote work: Living in one state while working remotely for a company based in another
- Commuters: Living near a state border and working in a neighboring state
- Investment income: Receiving income (e.g., rental, business, or dividends) from sources in another state
- Pass-through entities: Earning income through an S-Corporation, LLC, or partnership that does business in another state
4. Income Types That May Be Taxed by Multiple States
Not all income is eligible for the credit. Generally, it must be income that both states consider taxable. Examples include:
- Wages and salaries
- Self-employment income
- Rental income
- Business income
- Capital gains from property in another state
Some states do not tax certain types of income, such as interest or dividends, which may affect whether a credit is applicable.
5. How to Calculate the Credit
The credit is usually the lesser of:
- The actual tax paid to the other state, or
- The amount of your resident state’s tax liability on that same income
For example, if you paid $2,000 to State B on income also taxed by State A, and State A calculates a $1,500 tax on that same income, your credit will be limited to $1,500.
Most state tax software or tax professionals can assist with this calculation by completing specific worksheets required by the resident state.
6. How to Claim the Credit on Your State Return
The credit is claimed on your resident state income tax return. Each state has a specific line, form, or schedule for this credit. Common examples include:
- California: Form 540 Schedule S
- New York: Form IT-112-R
- New Jersey: Form NJ-COJ
- Illinois: Schedule CR
You will typically need to include:
- Copy of the nonresident tax return you filed in the other state
- Proof of tax paid (e.g., withholding or estimated payments)
- Worksheets or schedules showing how the credit was calculated
7. What About Reciprocal Agreements?
Some neighboring states have reciprocal tax agreements that simplify taxation for commuters. Under these agreements, residents pay income tax only in their home state, even if they work in a neighboring state. For example:
- Illinois and Iowa
- Pennsylvania and New Jersey
- Maryland and Virginia
If a reciprocal agreement is in place, the credit may not be necessary because the nonresident state does not tax your income in the first place. Instead, you may need to submit a form to your employer to stop withholding in the work state.
8. Common Mistakes to Avoid
- Not filing a nonresident return: You must first file a nonresident return in the state where you earned the income to qualify for the credit in your home state.
- Incorrect income allocation: Be sure to allocate only the income earned in the nonresident state to that state’s return.
- Missing documentation: Always attach copies of the nonresident return and any relevant W-2s or 1099s.
- Double-dipping: You cannot claim a credit on the same income in more than one state.
9. How Multistate Residency Affects the Credit
If you moved during the year and were a resident of more than one state, you must carefully allocate income by residency period. You may not be eligible for the credit if you were a part-year resident in both states, as each may consider only a portion of the income taxable.
Tip: Check if your resident and nonresident states allow part-year resident tax credits or exemptions for income earned before or after residency.
10. IRS and Federal Tax Return Implications
The credit for taxes paid to another state does not apply on your federal tax return. However, you should still report all income, including multistate income, on your Form 1040. State credits are claimed only at the state level.
Also, state income taxes paid may be included as an itemized deduction on your federal return, subject to the $10,000 SALT (State and Local Tax) deduction limit.
Conclusion: Avoid Double Taxation by Knowing Your Rights
If you live and work in different states—or earn income across state lines—the Credit for Taxes Paid to Another State can prevent double taxation and save you money. But to take full advantage of it, you must file all required state returns, understand each state’s rules, and provide adequate documentation.
Because multistate tax issues can be complex, it’s often helpful to use professional tax software or consult with a qualified tax advisor—especially if your situation involves multiple income types or pass-through businesses. With the right preparation, you can ensure accurate filings and avoid paying more tax than necessary.
