Is the Grass Greener Outside of the Golden State?

Without a doubt, some Californians have chosen to reside in the Golden State for its vast beauty, tremendous employment opportunities, and diverse population and points of view. However, many folks are beginning to question whether these benefits are justified by the high cost of living, particularly when it comes to housing and taxes. Corporations are also subject to high expenses, which has some corporations reassessing their regulatory and tax environment.

What’s the Fuss?

There have been numerous articles discussing company migrations from California following recent high-profile announcements from Elon Musk and Tesla, Larry Ellison and Oracle, Charles Schwab, and Toyota Motor North America, to name a few. Many of these articles pronounce the California dream is over and that the state has overstepped its reach into individuals and corporate pockets. While there may be a hint of truth to some of these claims — California’s population growth is close to stalling — a closer inspection is warranted.

Cost of Living: Housing and Gas Are Major Gripes

According to Zillow, the average home price in California is $617K compared with the national average of $266K while the U.S. Census Bureau reports a median annual California wage of $80K compared with a U.S. median of $66K. As most Californians know, we spend a larger percentage of our earnings and savings on real estate compared with the rest of the nation. While rich home values are a boon to established homeowners, new entrants to the housing market face real challenges coming up with down payments and making monthly mortgage payments. However, from a property tax perspective, California’s Prop 13 provides homeowner protections and should not be discounted. Prop 13 limits property tax to 1% of assessed value at time of purchase and increases a maximum of 2% per year. California’s 1.00% base rate is below the national average of 1.07% and significantly below the 1.69% rate of Texas. Of course, voter-approved ballot measures also contribute to the overall cost of housing but other states are also subject to taxes over and above the basic property tax rate.

Traveling to other regions of the U.S., it is easy to think Californians pay too much for fuel. While we do pay nearly the highest rate per gallon in the country, one needs to consider the vastness of the state and access to toll-free roads. Traveling across New Jersey, for example, one quickly learns that “pay-as-you-go” turnpikes and parkways are in sharp contrast to California’s freeways. Also, California’s focus on environmental issues ultimately works its way into higher gas prices, a small price for a worthy cause.

Income Taxes: Don’t Be Fooled

Pinching personal cash flow even further is California’s progressively steep income and capital gains tax rate. The top rate clocks in at over 13% (which includes the 1% mental health service tax) for couples earning greater than approximately $1.2 million annually. New Jersey is the only other state also in the double-digit income tax club — not necessarily abundant company. However, when we dig a bit deeper, we see that the average Californian is not paying too much more in income taxes than many other states. California’s average annual wage of $80K is subject to a 6.0% marginal rate for a married couple after accounting for the standard deduction, though a majority of that income would be taxed at an average rate of approximately 2.5%. Taking a look at some other states, all income in Utah is taxed at approximately 5.0% while income in Colorado is taxed at about 4.6% and taxpayers in Oregon quickly enter the zone of 8.8%. Yes, it is true that some states such as Nevada, Texas, Washington, and Florida do not levy an income tax, but one could argue the average Californian is not overly burdened relative to most states.

Finally, California does not currently have an estate tax, comparing quite favorably to the 12 states that do. So, while you may move to Washington to save on income taxes, your heirs may regret your shortsighted decision as your estate may owe taxes upon your death. Compounding things further, six states have an inheritance tax that is levied upon certain estate beneficiaries — though California does not.

Weather: Generally Pleasant But…

Unless you appreciate cold, snowy winters, it is hard to argue against California’s weather. The Mediterranean climate — not too hot, not too cold — is conducive for year-round outdoor exercise and entertainment. That said, with climate change has come a more pronounced fire season and risk of drought. Insurers and home buyers are slowly adjusting to this new reality as are local regulators. However, packing up due to weather risk would likely result in taking on another risk — snow/ice storms, hurricanes, tornadoes, and floods, to name a few.

Regulations: Hard to Dispute…

In addition to high corporate taxes, companies located in the Golden State must also face California’s difficult regulatory environment. The Tax Foundation ranks California as 49th in the nation from a corporate tax complexity and rate perspective, ahead of only New Jersey. On the regulatory freedom front, the CATO Institute ranks California 48th in the nation. However, since California is the most populous state in the U.S. and has a tremendous educational system, our workforce is an attractive employee base for world-class corporations. Over time, it is reasonable to expect mature companies to expand or move outside of California, especially those whose employees fall into the upper tax bracket echelons.

What Is Right for You and Your Family?

Should high-earning Californians pack their bags and move out of state? What about folks who have significant net worth tied up in California real estate, should they sell and run? This is, of course, a very personal decision. While certain costs may be elevated relative to other states, one could argue that you get what you pay for and the market (population) ultimately determines the right price. In other words, if the cost of living continues to increase in California and the perceived value of living in California declines, then the state will be forced to react to market forces to entice individuals and corporations to move back and/or stay. Real estate values should also ultimately reflect residents’ desire to live in California and reflect the affordability of such a decision.

Those for whom the math cannot justify the added cost and intend to move out of state, we recommend a solid understanding of the California residency rules in regard to income taxes. This is especially true for those high-income families that retain a home in California or have executive stock compensation related to California employment.

Tax Compliance

At the basic level, a taxpayer is presumed to be a California resident for any taxable year in which they spend more than nine months in the state. It gets more complicated than that, however. California has a track record of challenging residency based on more subjective evidence. According to the 2020 Guidelines for Determining Resident Status, residency is also determined by the location where you have the closest connections. Therefore, even if you move out of state, you need to sever ties with California to ensure you do not maintain close connections, which may be evidenced by:

State that issued your driver’s license
Location of your bank and where you originate transactions
Location of your healthcare providers
State where you are registered to vote
Location of social ties such as church or country club¹

Individuals with stock options and restricted stock grants will experience further residency complications and should pay close attention to the rules. It may be the case that a California nonresident exercises a stock option but may owe California taxes based on the location where services were provided between the option’s grant date and exercise date. The same goes for restricted stock units (RSUs). If an RSU vests for a California nonresident, per tax rules, the income is sourced to the state where the services were performed between the grant date and the vest date. Therefore, if you are trying to avoid California taxes in advance of an option exercise or the vesting of an RSU, we recommend consulting your tax professional to ensure you meet the requirements.

Weighing the Benefits and Costs

The stories of the exodus from California make for good press and drive web traffic. However, the state remains a desirable place to live and work as evidenced by a growing economy and strong real estate values. Yes, it is expensive to live here when compared to states with 0% income tax rates, but one must also consider the benefits of such added costs. If the costs cannot be justified, we recommend a thorough analysis of your financial picture before moving out of state to ensure the anticipated savings – and increased quality of life – are truly reaped.

¹See Franchise Tax Board Publication 1031 for a full list of what might be deemed a close connection.