New Mexico Resident Denied Credit for Tax Paid to California on Rental Income

By: Jeff Glickman, SALT Partner

At a glance

• The main takeaway: A recent New Mexico decision illustrates that just because a resident pays income tax to another state, it does not automatically entitle the resident to a tax credit in their home state. 
• Assess the impact: While double taxation is unfortunate, this case is an important reminder that taxpayers should analyze the potential state tax impact of making investments or doing business out of their home states.
• Take the next step: Aprio’s State and Local Tax (SALT) team can navigate you through the complex rules of multistate operations and transactions. When possible, we can offer recommendations to minimize multistate income tax obligations.

Schedule a free consultation today to learn more!

The full story:

As a general rule, in order to mitigate double taxation on income earned by a resident in another state and taxed by that other state, the state of residence will provide a tax credit against the resident’s individual income tax liability. That credit is typically limited to the lesser of (i) the amount of tax paid to the other state or (i) the tax that the state of residence would impose on the same amount of income.¹  However, it is not always the case that the resident state will provide a credit just because a resident pays income tax to another state. This situation is illustrated by a recent New Mexico administrative decision.²

A closer look at the case

The taxpayers are a married couple who file a joint resident New Mexico income tax return. In addition to income from wages, interest, dividends, business, capital assets and royalties, the taxpayers earn rental income from properties located in five states, including California and New Mexico. On the taxpayers’ 2019 federal income tax return,  $10.00 of rental income was reported for all rental properties, and the rental income solely from the New Mexico properties was $12,005.⁴ On its New Mexico return, the taxpayers reported the income from the rental properties as rental income and not as business income.

Under New Mexico law, residents are entitled to a credit against their income tax liability for taxes paid to other states on income sourced to those other states when that income is “required to be either allocated or apportioned to New Mexico.”⁴ Nonbusiness rental income from property located in New Mexico is allocated to New Mexico.⁵

Breaking down the ruling

Based on these rules, the Hearings Officer explained that since the taxpayers did not report the income as business income on their New Mexico return, it is treated as nonbusiness income. As a result, rental income from the California properties is not “required to be allocated or apportioned to New Mexico.”  Accordingly, the taxpayers are not entitled to a credit for taxes paid to California.

Interestingly, the taxpayers conceded that the state’s position is a technically accurate application of the rules. However, they made two additional arguments:

• First, they contended that the application of New Mexico’s rules in this manner resulted in unconstitutional double taxation. In rejecting this position, the decision noted that the existence of double taxation does not mean that the rule is per se unconstitutional. Sometimes the application of different tax laws in two states operate in a way that results in double taxation, but there is nothing inherently unconstitutional about each state’s laws, which are independently valid.
• Second, the taxpayers argued that they were entitled to an equitable remedy because their federal adjusted gross income, which is the base of their New Mexico income tax, already includes the California rental income. The state’s position, which the Hearing Officer found persuasive, was that the taxpayers’ New Mexico income was actually higher than their federal adjusted gross income, so the taxpayers are already in a more favorable position by using federal adjusted gross income. Therefore, the taxpayers’ request for an equitable remedy was declined.

The bottom line

This case is an important reminder that double taxation, while unfortunate, does not always mean that the result is unconstitutional or requires the state to provide a remedy. 

Aprio’s SALT team has experience with individual state tax credits and their complex rules, particularly as they may be applied to significant or nonrecurring transactions. We work with our clients to help them understand the consequences of their multistate operations and transactions. Based on the facts and circumstance of each situation, we will offer recommendations for structuring and reporting those transactions in an alternative manner (when possible) to minimize multistate income tax obligations. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

This article was featured in the October 2023 SALT newsletter.

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¹ This is to account for the differential in tax rates among states.

² In the Matter of the Protest of Daniel & Terezinha McGlynn, AHO Nos. 22.10-047A and 22.10-048R, D&O No. 23-12 (July 21, 2023).

³ As a result, the taxpayers’ federal adjusted gross income was less than their New Mexico income.

⁴ NMSA § 7-2-13.

⁵ NMSA § 7-4-6(A). The statute is silent on the allocation of rents from property located outside New Mexico since New Mexico allocation rules are only concerned with identifying nonbusiness income that is sourced to New Mexico.