If you live in one state but earn income in another, you may face a situation where both states want to tax the same earnings. This creates a risk of double taxation. Fortunately, many states offer a tax credit that allows you to claim a credit on your resident state return for taxes paid to another state. This credit helps ensure that you don’t pay tax twice on the same income. In this detailed blog, we will explain how the credit works, who qualifies, and how to properly claim it on your state tax return.
Understanding the Credit for Taxes Paid to Another State
This credit is designed to prevent double taxation of income earned across state lines. It generally applies when you are:
- A resident of one state (your home state)
- Earning income in another state (the nonresident or source state)
- Required to file tax returns in both states
Rather than forcing you to pay full tax in both states, your home state may allow a credit for the income tax you paid to the other state. You still must report the income on both returns, but you won’t pay the full amount twice.
Common Scenarios That Trigger the Credit
- Commuters: Living in one state but working in another (e.g., living in New Jersey and working in New York)
- Remote workers: Working for an out-of-state company while living elsewhere
- Rental or business income: Earning income from real estate or operations located outside your resident state
- Investment income: Owning passthrough entities (like an S corporation or partnership) that do business in multiple states
Each state has its own rules for residency, filing requirements, and how the credit is calculated. Always check both states’ tax laws before claiming the credit.
Basic Rules for Claiming the Credit
Although specifics vary, here are some general rules that apply in most states:
- You must be a full-year resident of the state in which you’re claiming the credit.
- You must have actually paid income taxes to another state on the same income.
- You must attach a copy of the nonresident return (and proof of tax payment) to your resident state return.
- The credit is usually limited to the amount of tax your home state would have imposed on the same income.
- Credits are only available for individual income taxes—not for sales tax, property tax, or business franchise tax.
The credit is usually nonrefundable, which means it can reduce your resident state tax liability to zero, but it won’t result in a refund by itself.
Example: New Jersey Resident Working in New York
Let’s say John lives in New Jersey and works in New York City. He earns $90,000 in wages that are taxed by New York. He also must report the same $90,000 to New Jersey because he is a full-year NJ resident.
New Jersey will allow John to claim a credit on his NJ return for taxes paid to New York. This prevents John from being taxed twice on the same income. He needs to include:
- His full-year New York return (IT-203)
- His full-year New Jersey return (NJ-1040)
- Schedule A (NJ), the form used to calculate the credit for taxes paid to another jurisdiction
John’s NJ tax liability will be reduced by the amount of tax he paid to NY, up to the NJ tax owed on that income.
Steps to Claim the Credit for Taxes Paid to Another State
1. Determine Whether You Need to File in Both States
Check your income source and state residency rules. If you earned income in another state (and that state requires a nonresident return), you’ll likely have to file there.
2. Prepare the Nonresident Return First
Always prepare the return for the state where the income was earned (nonresident state) before completing your resident state return. This is because you’ll need to know exactly how much tax you paid to claim the credit.
3. Prepare Your Resident State Return
On your resident state return, include all income (even that earned out of state). Then complete the appropriate schedule or worksheet for the credit. For example:
- California: Schedule S (Other State Tax Credit)
- Massachusetts: Schedule OSC
- New York: Form IT-112-R (for residents) or IT-112-C (for composite partners)
- Illinois: Schedule CR
- New Jersey: NJ Schedule A
You will typically enter the name of the other state, type of income, amount earned, and the tax paid. The credit is calculated using formulas specific to your state.
4. Attach Required Documentation
To validate the credit, you must attach copies of:
- The nonresident state return
- Schedules or statements showing how much tax was paid
- W-2s or 1099s indicating out-of-state income, if applicable
- Proof of payment (e.g., canceled checks, confirmation from the state)
If filing electronically, follow your software’s guidance to upload or mail supporting documents.
5. Retain Copies for Your Records
Even if you’re not required to submit every document, keep full copies of all returns and payment proofs. This is helpful if the state audits or questions your claim.
Limitations and Special Rules
- Credit limits: You can’t claim more than the amount of your resident state’s tax on the same income.
- Double credits: You cannot claim the same tax twice—for example, on both the resident and nonresident returns.
- Reciprocal agreements: Some states have agreements that exempt residents from paying income tax to the other state. In such cases, you may not need to file a nonresident return or claim a credit.
- Non-income taxes: The credit does not apply to property tax, excise taxes, or business entity fees.
States with Reciprocal Agreements
Some neighboring states have signed reciprocal agreements to prevent double taxation for wage earners. If such an agreement exists, you may not need to claim a credit—instead, you’ll pay income tax only to your home state.
Examples of state pairs with reciprocity:
- Illinois and Iowa, Kentucky, Michigan, and Wisconsin
- Indiana and Kentucky, Michigan, Ohio, Pennsylvania, and Wisconsin
- New Jersey and Pennsylvania
Even in these cases, you must file a form with your employer to exempt yourself from withholding in the work state (e.g., PA residents working in NJ must file Form NJ-165).
What If You Paid More Tax to the Other State?
If the nonresident state has a higher tax rate than your home state, you may end up receiving only a partial credit. For example:
• You paid $1,000 in taxes to State A (nonresident)
• Your home state, State B, would tax the same income at only $600
• You may only claim a credit of $600—the rest is not refunded or credited
However, if your resident state has a higher rate, you may still owe some tax even after the credit is applied.
Can You Claim a Credit for Local Taxes Paid?
Most states do not allow a credit for taxes paid to a city or municipality. For example, New York City income tax paid by a New Jersey resident is typically not eligible for a NJ credit. Some exceptions apply if your state allows local-level tax credits—check your state’s specific rules.
Conclusion: Avoid Double Taxation With a Smart Filing Strategy
If you earn income across state lines, the credit for taxes paid to another state is your best tool for avoiding double taxation. It requires careful preparation, accurate documentation, and sometimes multiple filings—but it can save you hundreds or even thousands of dollars.
Always prepare the nonresident return first, use the appropriate forms and schedules for your resident state, and maintain copies of all supporting documents. If your situation involves multiple states, self-employment income, or passthrough business income, consider consulting a tax professional to ensure accurate and optimized filing.
Claiming the credit correctly ensures compliance with both states’ tax laws while protecting your income from unnecessary taxation.
