The Multi-State Tax Myth: Why More States Doesn't Always Mean More Tax

One of the most common misconceptions I encounter when discussing state tax compliance with real estate professionals is the fear that filing in multiple states automatically means paying more tax. During my conversation with Rich Hedley, our state and local tax expert, he addressed this myth head-on, and I think it's crucial for our listeners to understand why this fear is often misplaced.

The Common Fear 

I regularly hear from clients and prospective clients who say something like: "Why would I want to do a nexus study that might require me to file in more states than just Virginia? I don't want to pay more tax." 

This reaction is completely understandable. On the surface, it seems logical that more state filings would equal more tax liability. However, this assumption overlooks a critical component of the tax system: resident state tax credits. 

How Resident State Credits Work 

Here's the key concept that changes everything: Filing in more states does not necessarily mean paying more overall tax. Instead, proper multi-state compliance ensures you're paying your taxes to the correct states, and your home state provides credits for taxes paid elsewhere. 

Let me explain how this works: 

The Credit System: Your resident state (let's say Virginia) will allow a tax credit for taxes paid to other states where you have nexus and filing requirements. 

Not Always Dollar-for-Dollar: The credit might not be exactly one-for-one, particularly if another state has a higher tax rate than your home state. 

Full Credit for Lower Rates: If the other state has a lower tax rate than your home state, you'll typically receive a full credit for taxes paid to that state. 

A Real-World Example 

Let's use a practical example that many of our listeners can relate to: 

The Situation: You're a Virginia resident with rental properties in both Virginia and North Carolina. 

The Tax Rates: North Carolina's tax rate is lower than Virginia's tax rate. 

The Result: When you properly file in North Carolina and pay tax on your North Carolina rental income, you'll receive a full credit for those North Carolina taxes on your Virginia return. 

The Outcome: You're not paying more in total taxes—you're just paying the right amount to the right states. 

This is exactly the situation I recently worked through with one of my clients. They had nexus in North Carolina due to rental property there, and we successfully claimed the Virginia credit for taxes paid to North Carolina. The client wasn't paying additional tax; they were simply ensuring compliance while optimizing their overall tax position. 

Our Job as Tax Professionals 

As Rich emphasized during our discussion, our job is to help ensure businesses are paying their overall taxes to the correct states. This isn't about creating additional tax burden—it's about proper compliance and optimization. 

Think of it like this: if you owe $10,000 in total state taxes, the question isn't whether you'll pay $10,000. The question is which states will receive that $10,000, and resident state credits help ensure you're not double-taxed in the process. 

When You Might Pay More 

There are scenarios where multi-state filing could result in higher overall taxes: 

Higher Rate States: If you have nexus in a state with significantly higher tax rates than your home state, you might not receive full credit for those taxes. 

Credit Limitations: Some states have limitations on the amount of credit they'll allow, though this is less common. 

Non-Resident vs. Resident Treatment: Different states may treat the same income differently, potentially creating some additional tax burden. 

However, these situations are the exception rather than the rule, and proper planning can often minimize these impacts. 

The Risk of Non-Compliance 

What many people don't consider is the risk of not filing where required: 

Discovery Risk: States are becoming increasingly sophisticated at identifying taxpayers who should be filing but aren't. 

Penalties and Interest: When states discover non-compliance, the penalties and interest can far exceed any tax that would have been owed. 

No Statute of Limitations: As we discussed in our VDA conversation, failing to file where required means there's no statute of limitations on assessments. 

The Value of Proper Analysis 

This is why nexus studies and proper multi-state tax analysis are so valuable. The goal isn't to create additional tax burden—it's to: 

• Ensure compliance where required 

• Avoid compliance where not required 

• Optimize the overall tax position across all states 

• Minimize risk of future assessments and penalties 

Beyond the Tax Amount 

Even in situations where multi-state compliance might result in slightly higher overall taxes, consider the other benefits: 

Peace of Mind: Knowing you're fully compliant eliminates the stress of potential discovery and assessment. 

Professional Credibility: Proper compliance demonstrates professionalism and attention to detail. 

Investment Planning: Understanding your true multi-state tax obligations allows for better investment decision-making. 

The Bottom Line 

The fear that multi-state compliance automatically means higher taxes is largely unfounded. In most cases, proper compliance results in paying the same amount of tax, just to the correct jurisdictions. The resident state credit system is specifically designed to prevent double taxation. 

Rather than avoiding proper analysis due to fear of additional taxes, embrace the opportunity to understand your true obligations and optimize your position. Work with experienced professionals who can help you navigate the multi-state landscape efficiently. 

Remember, the goal isn't to minimize the number of states where you file—it's to ensure you're filing in the right states while paying the appropriate amount of tax overall. When you understand how resident state credits work, multi-state compliance becomes a tool for optimization rather than a source of additional tax burden. 

Don't let fear of imaginary additional taxes prevent you from achieving proper compliance and peace of mind.