California taxes on out-of-state property captial gains

Right. If you are a resident of CA, you have to pay CA tax on your worldwide income. However, you get a credit for taxes paid to AZ on the AZ source income. So there's no double tax, just higher tax in most cases :).

If you used the home as your primary residence in 2 of the last 5 years then you can claim the housing exclusion. CA allows this exclusion as well; I don't know about AZ. There are restrictions on the exemption when a personal residence is converted to a rental, or the other way, I can't remember which.

California has no special tax rate for capital gains, it is all ordinary income.

The AZ "other state tax credit" for a California resident is not claimed on the CA Schedule S; for AZ (and a handful of other states), you claim the "other state tax credit" on the other state non-resident return.

Except for grand-fathered periods of use before 2009, the "restriction" (pro-rated exclusion) applies when a rental is converted to a primary residence. You can still convert a primary residence to a rental for up to three years and get the full 2-out-of-5 exclusion amount.

-Mark Bole

True, but the original post did not ask about this.

I'm confused. Suppose the original poster is a CA resident. Suppose the CA marginal tax rate is 10% and AZ is 2.5%. Suppose the profit is

10k. There are 2 ways.

(1) Since this is AZ real property, AZ gets 2.5% of 10k or $250. In fact, they might impose witholding on the sale of the property -- at least CA does this for nonresidents. CA taxes 10% of 10k or $1000 minus the credit paid to AZ, so net to CA is $750.

(2) Since the person is a CA resident, CA first gets their $1000. AZ tax is $250 but minus the $1000 paid to CA, the net AZ tax is $0.

In both cases the person pays $1000, but each method pays to different states. I'm sure the states have a rule they follow. From what you wrote above it seems like you're saying it is method (2). Where is this in the rules?

"State Capital Gains Taxes" [from OP]. The OP didn't ask about a Section 121 exclusion on his primary residence either, but you included that in your reply. In fact, you frequently toss in extra info in your replies in this newsgroup, but I'm not complaining -- it's part of what the newsgroup is about, exchanging ideas and information.

If this were most other states, CA Schedule S for residents has you calculate the CA tax on the double-taxed income, the other state tax on the double-taxed income, and then you get a credit for the smaller of those two amounts.

The tax computation is not based on marginal rate, but is each state's total tax liability multiplied by the ratio of double-taxed income to AGI for each state. In other words, if the double-taxed income was 50% of your total AGI for a given state, then the amount used on Schedule S is 50% of your total tax liability for that state.

I don't see what withholding has to do with it, but see comment above.

See the instructions for CA Schedule S ("No credit is allowed if the other state allows residents a credit for net income taxes paid to California") and AZ Form 309.

-Mark Bole

A little further explanation:

In general, states tax their residents on all income, regardless of its source. States also tax nonresidents on income from sources within the state. As a result, if you are a resident of State A and have income from a source in State B, both State A and State B will tax that income. (Of course there are exceptions; some states have no individual income taxes, and a few states exempt a resident's business income from out-of-state sources.)

The resulting double taxation may be mitigated by a credit granted by one state for the tax paid to the other, or by a reciprocal agreement between two states. Reciprocal agreements generally apply only to income from employment (wages), so that a resident of one state working in the other pays tax on his or her earnings only to the state of residence. Thus the source state cedes the tax to the residence state. California has no reciprocal agreement with any other state.

Credits for taxes paid to other states generally are allowed to residents of the state granting the credit. As a rule the credit is limited to the lesser of (a) the tax actually paid to the source state or (b) the proportion of the resident state tax liability that relates to the "double taxed" income. As a result the taxpayer's total net state income tax on that income is at the higher of the two states' average rates for that taxpayer's filing status, income level, number of dependents, etc. When the residence state grants the credit it is in effect cediing the tax to the source state -- the source state keeps the money.

A few states stand in a reverse credit relationship whereby the source state grants a credit for the tax paid to the state of residence. Arizona, Indiana, Virginia, Oregon, and California have such a reverse credit relationship with one another. Thus a resident of one of those states with income sourced in another of them looks to the source state for a credit for the tax paid to the residence state. In this case the source state is ceding the tax to the residence state. Again, the credit is limited to the lesser of (a) the actual tax liability to the source state or (b) the proportion of the residence state tax liability that relates to that income, and the net state tax on the "double taxed" income is at the higher of the two states' average rates applicable to that taxpayer.

The OP in this thread must pay California tax on the gain on the sale of his Arizona property, and file an amended return with Arizona to claim credit for the California tax (assuming the statute of limitations on the AZ return is still open).

Note that the credit and reciprocal agreement mechanisms that mitigate (but do not always eliminate) the double taxation of income appear to be a matter of legislative grace. They are not required by any constitutional or federal statutory provision. Sometimes credits are not allowed. For example, many states allow credit for tax paid to another state only if the tax was paid in the same year; if an item of income was taxed in one year by State A and in a different year by State B, no credit may be allowed. Also, many states limit the credit to taxes paid to the other state on income FROM SOURCES WITHIN THAT STATE -- and states differ in their definitions of source income. For example, if you are a California resident and sell real property in Massachusetts on an installment basis, Massachusetts will tax both the gain element and the interest income that you receive on the installment note, because both are considered Massachusetts source income. California will give you credit for the tax you pay to Massachusetts on the gain element, because that is Massachusetts source income by California's lights; but California will not allow credit for the tax paid to Massachusetts on the interest, because by California's lights that is income from an intangible (the note) and is sourced at your residence -- California.

Katie in San Diego

So if the rental property was in another state like HI, then HI would tax the capital gain, and CA give a credit for tax paid to HI? But as the property is in AZ, AZ gives a credit for tax paid to CA.

How did such an agreement come about? It seems to favor states with high tax rates. If an AZ resident sells their CA home, they get a credit on their CA tax return for taxes paid to AZ, but as CA tax rates are higher, CA still gets a good bit of money on the sale. In this case, AZ will get $0.

The statute of limitations to file an amended state return is 4 years, not 3, so maybe the original poster will still be lucky. However, I've read on this newsgroup that many states are not paying interest on refunds.

Thanks for all the detailed information.

Reciprocal agreements with regard to wages earned by nonresidents are negotiated between the states involved. Illinois once had such an agreement with Indiana, but Illinois decided it was getting the short end of that stick (i.e., there were more Indiana residents working in Illinois than vice versa) and asked Indiana to pay an annual amount to equalize the effect. Indiana declined to do that, so the agreement was terminated.

As far as I know, however, there's no particular interstate negotiation involved in the reverse credit arrangements. Instead the reverse credit is simply a matter of the statutory law of the state granting the credit to a nonresident. Most states allow credit for taxes paid to other states only to their own residents, but the states on the reverse credit list also allow the credit to a nonresident if the state of the taxpayer's residence would allow credit to a resident of the granting state.

California law allows a credit to a nonresident if the state of the taxpayer's residence either does not tax California residents on income sourced in that state, or allows California residents credit for the California tax paid on such income. Cal Rev & Tax. Code Sec.

18002. Arizona law contains a similar provision: Ariz. Rev. Stats. Ann. 43-1096. Since California would allow an AZ resident credit for the AZ tax paid on California source income, AZ will allow a CA resident credit for the CA tax paid on AZ source income.

Yes, the state with the higher average rates gets to keep the difference. On the other hand, AZ gets to keep the tax on its residents' income from California sources, and CA gets to keep only the excess, if any, over the AZ tax. Presumably it all comes out in the wash. A state that felt that, on the whole, it was getting the short end of the reverse credit relationship would no doubt repeal the statute that allows credit to nonresidents. In fact, Maryland did just that a few years ago. Coincidentally, Oregon adopted its nonresident credit provision at about the same time. So Maryland dropped off the reverse credit list and Oregon joined it.

Katie in San Diego