Dinesen Tax Greatest Hits: Filing Separately on Your Iowa Return? Don’t Forget to Allocate Deductions

One last “greatest hits” post before regular, “new” posts resume next week!

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Originally published March 7, 2012

Married couples in Iowa who both have income will usually find that one of the “separate” filing statuses is the best to use on their Iowa taxes, rather than filing a joint Iowa return. The reason is, Iowa has just one tax bracket regardless of filing status, so two people filing a joint return will be taxed on their combined incomes at a high point in Iowa’s highly progressive tax bracket. Filing separate returns allows each spouse to be taxed at a lower point in the tax bracket.

Iowa offers two “separate” filing statuses — married filing separately on a combined return, and married filing separately on separate returns. A more thorough discussion of the differences between the two statuses is for another blog post on another day. The main point I want to make today is: under either of the separate filing statuses, you must allocate itemized deductions based on income.

Allocating Deductions

When a married couple files separately on their Iowa returns — either on a combined return or on a completely separate return — the couple MUST share itemized deductions based on income. This is true even if one spouse made 100% of the payments from their own separate funds.

Example

John and Jane are married in Iowa and file their Iowa taxes as married filing separately. John’s income is $50,000. Jane’s income is $25,000. On the Iowa return, John must claim 2/3 of the itemized deductions ($50,000 income/$75,000 total income of the couple) and Jane must claim 1/3 of the itemized deductions, regardless of who actually made the payments or whether the payments relate to separately held property.

This is a different concept from the married filing separately filing status on federal taxes. On a “separate” federal 1040, the itemized deductions generally go to whoever actually made the payment.

Image: renjith krishnan / FreeDigitalPhotos.net

Capital Losses and Tax Planning

The following question came up recently: ID-100167245

An investor has a $10,000 capital loss carryforward from prior years. They have $5,000 of capital gains from stock sold this year. How does the loss carryforward work this year?

Background

Tax law places limits on how much a taxpayer can deduct in capital losses each year. The limit is $3,000 of losses per year. Any unused losses beyond $3,000 are carried forward to be used, $3,000-at-a-time, in future years.

For more on stock losses and taxes, see this recent blog post.

Answer

Here’s the answer to the question posed at the start of this post.

The taxpayer has $10,000 of unused losses from prior years. These losses off-set all of their current-year capital gains. Plus, the taxpayer can take an additional deduction of $3,000 so that they get to their limit of a maximum of a $3,000 loss deduction for the year year.

So the end result is that their tax return would show a $3,000 capital loss deduction, with $2,000 of unused losses to carry forward to next year.

The $2,000 is arrived at as: $10,000 beginning loss, minus the $5,000 of current-year gains that are essentially “neutralized,” minus the additional $3,000 of capital loss the taxpayer is allowed to take = $2,000 loss remaining to be used in the future.

Image courtesy of David Castillo Dominici / freedigitalphotos.net

Death Master File Changes Coming — Finally!

Congress has finally taken action to stem the tide of tax-related identity theft by limiting access to the Death Master File. From Bloomberg.com:

A provision in the budget measure passed 64-36 by the U.S. Senate (December 18) would limit access to information in the Social Security Administration’s Death Master File to certified entities, such as life insurers and pension funds that use the data to combat fraud and administer benefits. The limits would apply for three years after an individual’s death.

The file contains the names, Social Security Numbers and dates of birth of anyone who has died. As you can imagine, it’s a treasure trove for identity thieves. It’s almost certainly how Brian Boka’s identity got stolen. Someone filed a fraudulent tax return in Brian’s name after he died, leaving his widow and me to battle with the IRS for more than 2 years before the issue was finally resolved.

The legislation requires the Commerce Department to set up a process to verify legitimate users of the file while otherwise exempting the file from the Freedom of Information Act for three years after a person dies.

All I can say is — thank you Congress (how often do we say that anymore?), and it’s about time.

(Hat tip to Joe Kristan at The Tax Update Blog for first alerting me to this story.)

Philosophical Question About Section 108, Principal Residences and Cancelled Debt

Maybe I’m overthinking this, but here’s something that’s bothered me for a long time: what is the definition of “principal residence” for purposes of determining if cancelled debt is taxable?

Background

The general rule for canceled debt is that the debt cancellation results in taxable income. For example, if the credit card company forgives $5,000 of credit card debt, you have $5,000 of taxable income. A similar concept would apply to foreclosures of homes.

There are a number of exceptions to the general rule. For example, if you’re insolvent, cancelled debt is not taxable. There’s also an exclusion that says cancelled debt isn’t taxable if it’s related to your principal residence. This is where my “overthinking” comes into play.

What if the Person Has Moved Out?

My question is. what if the homeowner moves out before the foreclosure process is complete? This happens a lot.

Section 108, which governs taxation of canceled debt, says that the Section 121 definition of “principal residence” is to be used, but that doesn’t help much because Section 121 simply says that a “principal residence” is determined based on “all the facts and circumstances.”

So what would the “facts and circumstances” be for a person going through a foreclosure who moves out of the house prior to the completion of the foreclosure and now lives in an apartment? The foreclosure isn’t complete so the debt hasn’t been cancelled yet. Is the apartment the new principal residence?

I asked this question during a seminar I attended about debt cancellation. The presenter was a tax attorney with more than 30 years of experience. His response was that his firm has grappled with this question and that there’s not a good answer.

I have found no IRS guidance. Everything just says, essentially, if it’s your principal residence you can exclude the cancelled debt.

I have always employed the common sense test. If a person was living in an apartment or a rental and the foreclosure is completed in a reasonable time frame after the move, I would argue that the person still could call their foreclosed home their principal residence. But if the person moves to, say, a new state or somehow manages to buy a new home while going through foreclosure (yes, I have encountered this!), I would say they couldn’t call their foreclosed home their principal residence.

So tax pros — am I overthinking this? Am I missing something?

Stock Losses and Taxes

Are there tax advantages to be gained when stock that you own decreases in value?  The answer is yes, at least to some extent.

Here are some planning considerations:

  • Losses can only be deducted when you sell the stock at a loss.  The reduction in value on stock that you continue to hold is not deductible.  So if your stocks go in the tank but you do not sell them, you don’t get a deduction.

  • If you sold stock at a gain earlier in the year, you can sell other stock at a loss later in the year to eat up the gain.  On your tax return, stock sold at a gain is netted against stock sold for a loss, to arrive at your net gain or loss for the year.

  • The tax code is not overly generous when it comes to deducting losses on investments.  The loss deduction is limited to $3,000 of the net loss per year.  Losses in excess of $3,000 can be carried forward to future years.

  • Beware of “wash sales.”  A wash sale occurs when you sell stock at a loss and then buy the same stock within 30 days before or after the sale.  (Example:  you sell Stock A at a loss on August 1 and then re-purchase Stock A on August 15.  This is a wash sale and the August 1 loss is not currently deductible but instead adjusts the basis of the stock you purchased on August 15.)

  • It is important to know your basis in the stock.  For stock you purchased, your basis is your purchase price.  The basis of inherited stock is generally the stock’s fair-market value on the date of death of the person you inherited the stock from.  If you receive stock as a gift, you generally take on the basis of the person who gave you the stock.

Here is an example of the above concepts:

You bought stock several years ago for $750.  Earlier this year, the value of the stock rose to $1,000.  Then the market crashed and the stock dropped to $500, at which time you sold it.  Your deductible loss is $250 ($500 sale price minus $750 basis).

In the above example, note that the fact that the stock rose in value to $1,000 at one time is irrelevant for tax purposes.  The only thing that matters for tax purposes is your basis and the sale price.