State Treatment of Moving Expense Deductions
and Gains from Sales of Primary Residences

This 1997 compendium of state rules on moving expenses and capital gains on residence sales is fraught with more uncertainty than usual, due to the newly enacted federal repeal of the rules deferring capital gain on home sales and their replacement by an exclusion available every two years. As in 1993, when the federal moving expense rules were altered substantially, the states have not had a chance to react to the new federal law on residence sales.

Therefore, while the state rules concerning moving expenses have undergone almost no change in the past year, the rules concerning treatment of gain on home sales are in the midst of significant change. The explanation and chart on page 24 are based on telephone inquiries to tax officials in each state, analysis of currently available state forms or publications, and "best guesses" as to state reaction to the new federal law.

Moving Expenses
As noted above, there is little remaining uncertainty as to moving expenses. As of September 1996, California finally conformed its law to the 1993 federal changes. At this point, all states that permit a deduction essentially follow the post-1993 federal rules. Most states begin their calculations with federal adjusted gross income (AGI), often with some variation, but most do not follow the federal itemized deduction rules. As a result, under pre-1994 federal law, there was substantial disparity between the state treatments of moving expenses. Since the new federal rules took effect in 1994, most of these states' rules have changed to the benefit of taxpayers.

For all expenses incurred since December 31, 1993, the federal moving expense deduction is not an itemized deduction. Rather, if unreimbursed, it is an "above the line" deduction, that is, deducted when computing federal AGI. If reimbursed, the reimbursement is excluded from income entirely, and no corresponding deduction is claimed, either above the line or as an itemized deduction. As noted, most states have conformed to this treatment. Only three states with an income tax-Massachusetts, New Jersey, and Pennsylvania-do not allow a moving expense deduction. Other issues arise in some states. In Alabama and New York, the new job must be in-state for the deduction to be allowed. In Georgia, Illinois, Michigan, North Dakota, South Carolina, Virginia, and Wisconsin, the new residence must be in-state. In other states, the deduction is allowed only on moves into the state. This rule applies in Iowa, Nebraska, Oklahoma, Oregon, Rhode Island, and Vermont. Generally, the result is the same in all three of these categories, whether the limitation is stated in terms of the new job, the new residence, or the direction of the move. That is, the expenses of outbound moves are deductible, if at all, only in the new state.

Gain on Residence Sale
Prior to May 7, 1997, federal tax law allowed an individual to defer or "roll over" a gain realized on the sale of his or her principal residence if a replacement residence was acquired within two years of the sale at a price that at least equaled the basis of the original residence. The mechanics of the transaction worked something like this: an employee sold Residence A with a basis of $100,000 (purchase price plus qualifying improvements) at a gain of $25,000 (sales price less basis). Within two years, the employee purchased Residence B having a basis of $150,000. Instead of Residence B having a basis of $150,000, however, the $150,000 basis was reduced by the $25,000 gain from Residence A, which was not currently taxed. Tax on the $25,000 gain from Residence A was deferred until the new residence was sold and not replaced with another home at an equal or greater price. Frequently, homeowners "rolled over" gains from home to home without paying capital gains tax until the new home cost less than the old home. Using this approach, individuals generally did not face substantial taxable gain until retirement, when their desire for a smaller house or easier lifestyle may have led them to purchase a less expensive home. The federal rules also gave these taxpayers a break: at age 55 and older, on a one-time basis, taxpayers could exclude up to $125,000 of the gain on the sale of their principal residence, even if no replacement home was purchased.

Most state rules regarding rollover varied only slightly from their federal counterpart. Since most states began their tax computation with federal AGI and the rollover gain already was excluded at that point, the gain also usually was excluded from state income. Alabama, Arkansas, and Hawaii, however, required that the replacement residence be in-state to qualify for exclusion. In New Jersey, the old residence must have been owned and occupied for three of the five years preceding its sale for any resulting gain to qualify for rollover. Pennsylvania does not allow any rollover of gains but does provide for a one-time exemption of any gain resulting from the sale of a principal residence by a person age 55 or older.

A fundamental change took place in federal law, effective May 7, 1997. The new law repeals the old rollover and age-55 exclusion rules, and replaces them with a new exclusion available once every two years to any taxpayer. The new rule provides that taxpayers of any age can exclude up to $250,000 of gain ($500,000 on a joint return), if the taxpayer has owned and used the home as his or her principal residence for at least two of the five years prior to the sale. Generally, this exclusion (which is permanent, unlike the old rollover rule, which merely deferred taxation) can be used on one sale every two years. Thus, it eventually should shield virtually all home sale gains from tax.

For transferees who do not meet one or the other of the "two-year" rules above, the law provides relief under some circumstances. First, as a transition rule, the law provides that sales or exchanges prior to May 7, 1997, are not taken into account for purposes of the "once every two years" rule. For example, if a transferee sold a home and moved on June 30, 1995, and then sold the new home on June 1, 1997, the new law could exclude all gain up to $250,000 (or $500,000 on a joint return) even though the once every two-years rule was not met, provided the "two out of five" rule was met.

Second, the law provides that if failure to meet either of the two-year rules is "by reason of a change in place of employment," then the two-year rules will not apply. Instead, the taxpayer is given a reduced exclusion based on the ratio that the period of actual ownership and use as a personal residence bears to two years. For example, if a married transferee moved again in 18 months, the maximum gain exclusion would be 18/24 x $500,000 = $375,000. Obviously, this reduced exclusion should be ample to cover any gain accrued during that short period. For those with gains in excess of the new amounts, an election to use the rollover rule is available up until the date of enactment (August 5, 1997), including those with binding contracts on that date or those who had purchased replacement residences. For homeowners who are not eligible for the exclusion and must pay tax on the gain, the rate still will be reduced to 20 percent.

How will this affect the states? In some states, the answer is clear, but, in others, it depends on whether and how fast the state legislature or tax authorities act.

Generally, states fall into three categories in terms of the relationship of their tax laws to federal law. First, a few states simply do not follow federal law (e.g., Pennsylvania), and clearly will remain unaffected by the new exclusion rules unless they decide to adopt them.

Second, many states follow federal law, and begin their calculation of state tax with federal AGI, but do not automatically conform to new federal code amendments. That is, they have adopted the federal tax code as of some discrete point in time and must act affirmatively to incorporate new federal law. Most such states likely will adopt the new 1997 federal laws, but until they do so, the old federal rollover rules will continue to apply. These states often conform retroactively, however, when they get around to doing so.

A third category of states has adopted so-called "continuous conformity" statutes, under which their tax law is automatically conformed to federal changes in the absence of specific state action to modify the changes. In such states, the new exclusion automatically will apply.

Because of this disparity, the chart on page 24 retains entries describing state rollover laws in those states that do not have continuous conformity. Companies will need to monitor the situation as due dates for 1997 tax returns approach to determine how many noncontinuous conformity states have moved to conform. In many cases, the result will be the same. Under either the old or new federal law, AGI will not include the home sale gain. But that result will depend on meeting different sets of rules-the rollover rules for nonconforming states, and the new rules for conforming states. Even for the latter, sales before May 7, 1997, will be subject to the old rules.

Finally, attention should be given to the tax impact of what appears to be a growing trend among states, namely, withholding on sales of real property by nonresident taxpayers. Depending on the circumstances surrounding the sale, such rules could adversely affect either the nonresident employee or the company facilitating the relocation.

General Issues
Calculating the tax consequences of an employee's move can be especially complicated when the move involves interstate travel. Generally, the employee's deductions (the moving expense) and income (the reimbursement for those expenses) must be allocated or apportioned between the periods of residence in each state, and there is no guarantee that both states will apply the same or similar rules. Under the 1993 law, the problem is further complicated by the effect of the federal "exclusion" of reimbursed deductible expenses. Most states include taxable reimbursements as income in the new state, regardless of when they were received. However, some states do not follow this rule and may try to tax a portion of the reimbursement if it is paid to the employee before he or she leaves the old state. Generally, the effects of any "double taxation" of the reimbursement are offset by tax credits available in one state for the taxes paid in the other state. Nevertheless, bear in mind that not all states provide credits for taxes paid to other states and, even in some cases where credits are allowed, the actual blend of state tax rates and income and expense calculations may not be advantageous to the employee. As a general rule, it is safer to defer reimbursement (when possible) until the employee is safely settled in the new state.

Although some states allow the deduction or exclusion only of expenses related to the individual's employment in the state, some states will prorate or allocate the expenses based on one of the following factors:

• the period of residence in the state;
• the actual moving expenses incurred in the state; or
• the amount of reimbursements included as income in the state.

In light of the various state tax treatments, a thorough analysis of each relocation plan is important to ensure that the potential for double taxation of the reimbursement is minimized while the ability of the employee to deduct or exclude his or her moving expenses is maximized. For example, if the state to which the employee is moving allocates all or part of the deduction to the state from which the employee moved, and the state from which the employee moved allows the deduction only to the extent of reimbursement, a problem is created unless the employer matches the reimbursement with the deduction. Similar problems can arise when one of the states has no income tax.

The 1993 federal changes to the moving expense deduction make the foregoing analysis less complicated in some states. Because federal (and most state) laws now exclude reimbursements of deductible moving expenses from income, there is no necessity for the employee to take a corresponding deduction in the state. Issues relating to matching the reimbursement with the deduction should be minimal; however, as noted above, some states do not follow federal law, and issues also will arise as to the timing of taxable reimbursements. While in many cases it may be easier and more beneficial to reimburse employees after their move, remember there will be situations that necessitate an alternative treatment in order to limit double taxation of reimbursements and maximize the benefit of moving expense deductions. Because different tax treatments may apply from state to state, it is important to look at each interstate move individually.

The following chart is excerpted from the November 1997 issue of Mobility magazine, published by the Council. Other tax and legal information is published in Relocation Law. This publication is a guide to the application of federal and state laws on tax and legal issues. Topics covered include moving expense deductions, homesale programs, employer-provided loans, environmental regulations, and many more.