Could a Virginia resident claim credit for North Carolina tax on gain from investment land, and did the special border-state rule apply?

Subject

North Carolina income at issue was not reported on a Schedule C, the border state credit would not apply.

Plain-English summary

Virginia allowed the resident to claim an out-of-state tax credit for North Carolina tax paid on the gain from selling unimproved investment land. The land was a capital asset under IRC § 1221, so its gain fell within the income categories eligible for Virginia's credit.

The credit remained subject to the ordinary limitation: the lesser of the tax actually paid to North Carolina or the Virginia tax imposed on that North Carolina income.

The more generous rule for a single state bordering Virginia did not apply. That rule required the outside income to be earned income or Schedule C business income, and this investment-land gain was neither and was not reported on Schedule C.

What this means for you

• A capital gain can qualify for Virginia's credit even when it is not earned or business income.
• Confirm that the property is a capital asset and that both states tax the same gain in the same taxable year.
• Calculate the general credit limit using both the other state's tax and Virginia tax on that income.
• Do not use the special contiguous-state rule unless its earned-income or Schedule C requirements are met.

Common questions

Q: Was the North Carolina land gain eligible for a Virginia credit?

A: Yes. The unimproved land was held as an investment and treated as a capital asset.

Q: Was the credit equal to all North Carolina tax paid?

A: Not necessarily. The general rule limited it to the lesser of the North Carolina tax paid or Virginia tax on that income.

Q: Why did the border-state rule not apply?

A: The gain was not earned income or Schedule C business income.

Citations and references

• Va. Code §§ 58.1-301 and 58.1-332(A).
• 23 VAC 10-110-221.
• IRC § 1221.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 15-61

Original ruling text

April 14, 2015

Re: Request for Ruling: Individual Income Tax

Dear *:

This will reply to your letter in which you request a ruling concerning the application of the out-of-state credit to a gain from the sale of unimproved real property located in a another state.

FACTS

The Taxpayer, a Virginia resident, purchased a parcel of unimproved real property in North Carolina in 2004. He sold the property in 2014 for a gain. The Taxpayer has no other North Carolina source income. He paid North Carolina income tax on the gain from the sale. The Taxpayer requests a ruling as to whether he can claim a credit for on his Virginia return for the tax paid to North Carolina.

RULING

Virginia Code § 58.1-332 A allows Virginia residents a credit against their income tax liability when they pay income tax to another state on earned or business income, or on any gain from the sale of a capital asset within the meaning of Internal Revenue Code (IRC) § 1221. The intent of the credit is to grant Virginia residents relief in situations where they are taxed by both Virginia and another state on these types of income during the same taxable year. The credit is claimed on the income tax return for the same taxable year in which the income is subject to taxation by another state, even though the tax is actually paid during the succeeding taxable year when the return is filed. The credit may not be claimed, however, if the other state has a credit that is substantially similar to the one provided by Virginia.

For purposes of the credit, Title 23 of the Virginia Administrative Code (VAC) 10­-110-221 defines both the term "earned income" and the term "business income." The term "earned income" is defined by the regulation as:

wages, salaries, or professional fees and other amounts received as compensation for professional services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered. Earned income does not include interest or dividend income, capital gains, income from investments, or similar types of passive income.

The term "business income" is defined as:

income derived from an activity which constitutes a "business" for federal income tax purposes for which a federal Schedule C, E, or F must be filed. For example a sole proprietorship, provided that if the business incurred a loss such loss would be allowable under federal law.

In this case, the Taxpayer incurred tax liability from the sale of undeveloped land in North Carolina that was purchased as an investment. Under the above definitions, the income derived from that sale would not qualify as earned or business income.

Virginia Code § 58.1-301 provides, with certain exceptions, that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the IRC unless a different meaning is clearly required. For individual income tax purposes, Virginia "conforms" to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI).

Capital assets are not directly defined by IRC § 1221, rather the term is defined by exclusion. All assets are capital assets with the exception of:

1. Stock in trade of other property which would be included in inventory,

2. Property, used in a trade or business, which is subject to depreciation or real property used in a trade of business,

3. A copy right, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by a taxpayer whose personal efforts created such property,

4. Accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of inventory, and

5. A publication of the United States Government.

Gains from the sale of real property do not meet any of the exceptions enumerated in IRC § 1221. Because this type of income is eligible for the out-of-state tax credit, the Taxpayer would be eligible for a credit against income tax paid to North Carolina on his Virginia resident income tax return for the 2014 taxable year.

As a general rule, the credit under Va. Code § 58.1-332 A for income tax paid to another state by a Virginia resident is limited to the lesser of: (1) the amount of tax actually paid to the other state; or (2) the amount of Virginia income tax actually imposed on the taxpayer on the income derived in the other state. In the case of a Virginia resident who pays income tax to a state like North Carolina that borders Virginia, a special rule can apply.

If certain criteria are met, the limitation that restricts the credit to the amount of Virginia income tax actually imposed on the taxpayer on the income derived in the other state is disregarded. The special rule will apply if the income subject to tax in a single state contiguous to Virginia is less than Virginia taxable income and all of the income from sources outside Virginia is earned income or business income reported on federal form Schedule C from that single contiguous state. In such instances, the Virginia resident will be entitled to a credit equal to the lesser of: (1) the amount of income tax actually paid to the contiguous state; or (2) 100% of their Virginia income tax liability. See Va. Code § 58.1-332 A. Because the North Carolina income at issue was not reported on a Schedule C, the border state credit would not apply. Thus, the Taxpayer's out-of-state credit would be subject to the general limitation.

This ruling is based on the facts presented as summarized above. Any change in facts or the introduction of new facts may lead to a different result.

The Code of Virginia sections, regulation, and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's web site. If you have any questions regarding this ruling, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns
Tax Commissioner

AR/1-5905408909.B