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Same-Sex Marriage, Community Property, And Multi-State Income — Part 3

May 17, 2013 in Same-Sex Marriage and Taxes with 1 Comment

This is the third and final part of my series on same-sex couples, community property law and multi-state income.

This part will detail how to handle the state returns. Refer to Part 1 for a basic overview of community property law and to Part 2 for an in-depth analysis of applying community property laws to the actual federal returns that Angie and Alice (the fictional couple being used in this example) filed.

(For people who read Part 2 when it was first published on 5/15 — Part 2 had a few errors and things that needed clarification. You might want to go back and re-read to see the changes. Thanks to an attentive reader named Ray who pointed out the error of my ways regarding dividends, which caused me to make a few other tweaks to parts of the scenario.)

The Mock Federal Return

Same-sex couples must prepare a “mock” federal tax return for use in filing their state returns. The mock return will generally use a filing status of married filing jointly, but a couple couple also use married filing separately. I tell people to use whichever filing status they would have used if they were filing the return with the IRS.

If we refer back to Part 2, if Angie and Alice filed as married filing separately, their taxable income would be exactly the same as in table 1. And their income is such that their tax liability under an MFS filing status is the same as under the single filing status of that table. End result: Angie $8,424 tax liability + Alice $10,774 tax liability + Alice $4,000 early withdrawal penalty = $23,198 total tax liability.

How about married filing jointly? In that case, there’s no community property law to worry about and everything is simply combined onto one tax return. Total taxable income = $108,500. Total tax, including the $4,000 early withdrawal penalty, would be $23,185.

Advantage, by a hair, is married filing jointly on the mock return.

State Returns

Remember, our scenario has Angie and Alice moving from California to Iowa during the year. The first thing they would need to do on the state returns is file their California return. I have prepared California non-resident returns before but am by no means an expert on California taxes. Therefore I’ve decided to leave out a detailed discussion of the California return.

My interest is more in the Iowa return.

In Iowa, most couples with dual income will benefit by filing as married filing separately. I talked about this filing status in more detail here.

Part-year residents of Iowa must first calculate their Iowa taxes as if they were a full-year resident. This means reporting all income from all sources on the Iowa return and calculating their Iowa tax on all income from all sources. Then, they get to take a credit based on the percentage of income earned in the other state vs. earned in Iowa.

So, if a couple files as married filing separately on the Iowa return, does community property law apply in reporting their all-source income on the Iowa return?

The answer is, no. The California income is reported in Iowa 100% by the spouse who earned it. This is true even if Angie and Alice created a mock return with a filing status of married filing separately and applied community property law to their California income on that mock return. Iowa is not a community property state and community property law would never apply to any item on the Iowa tax return. (I should mention that, just to be safe, I did confirm this with the Iowa Department of Revenue before I wrote this blog post!)

Thus concludes this series on multi-state taxation issues of same-sex couples who move from a community property state to a common-law state.

I learned a few things along the way (see the text and the comments section of Part 2 for the things I learned/had to clarify). This is a complex topic but hopefully I helped shed a little light on it.

Same-Sex Marriage, Community Property, And Multi-State Income — Part 2

May 15, 2013 in Potpourri of Tax Topics, Same-Sex Marriage and Taxes with 4 Comments

Here in Part 2, I’ll explore what happens when a same-sex couple in a community property state moves to a non-community property state such as Iowa during the middle of the year.

I have encountered this issue several times in my practice. What follows is a composite of some of these encounters. Please note that “Angie and Alice,” the “client” used in the example below, are fictional characters, not real clients of mine.

The Setup

Angie and Alice are in a same-sex marriage in California. They moved to Iowa in September. Both states recognize their marriage (although I believe that most of this scenario would be the same even if they moved to a state that didn’t recognize their marriage).

I warn you, this is going to get deep. Consider yourself warned!

Here we go:

Wages

Alice earned $56,000 of W-2 income while a resident of California. She had $11,000 of federal taxes and $4,000 of California taxes withheld from this income.

Angie earned $32,000 of W-2 income in Iowa. She had $4,000 of federal taxes and $2,000 of Iowa taxes withheld from this income.

OUTCOME: The California income and withholding must be split 50/50 between Angie and Alice.

Because Iowa is not a community property state, Angie will report 100% of her Iowa wages and associated withholding on her return.

End result: Angie reports $60,000 of income ($28,000 + $32,000) and Alice reports $28,000 of income.

Dividends

Angie earned dividends during the year, on a separate brokerage account in her name only. The statement from the investment company showed $400 of dividends earned while she resided in California, and $200of dividends earned while she resided in Iowa. (For the sake of simplicity, we’ll assume that all dividends are ordinary dividends taxed as ordinary income.)

OUTCOME: In California, dividends, interest and rents from separately held property is NOT community property and is reported 100% by the spouse earning the income. The original version of this story, as published on 5/15, had this wrong. Thanks to reader Ray for catching my mistake (see the Comment section below). So Angie reports all $600 of the dividends on her tax return, including the dividends earned while she resided in California.

Pension Withdrawal

After she moved to Iowa, Alice withdrew $40,000 from a retirement account. $8,000 of federal taxes and $2,000 of Iowa taxes were withheld.

OUTCOME: This is not community property because the withdrawal happened in Iowa. Alice has $40,000 of taxable income to report. She’ll get credit for the full $8,000 of federal taxes withheld and can take an itemized deduction for the $2,000 of Iowa taxes withheld.

Unemployment

Angie was unemployed while living in California. She received $16,000 if unemployment benefits, which ceased upon moving to Iowa. Federal taxes of $1,600 were withheld from these benefits.

OUTCOME: This is community property. Angie and Alice will each report $8,000 of unemployment income and $800 of associated federal withholding on their federal tax returns.

Mortgage

Angie and Alice paid $14,000 on a mortgage for their home when they lived in California. They sold the home at the same time they moved to Iowa. (They sold it at a loss, so no capital gain to worry about.) They paid $4,000 of property taxes on this house. Angie and Alice owned the home jointly.

They also paid $2,000 of interest on their new home in Iowa. Angie and Alice agree that Angie made 100% of this payment. They made no property tax payments in Iowa in 2012.

OUTCOME: The $14,000 of California interest and $4,000 of California property taxes are split 50/50. The $2,000 of Iowa interest is claimed 100% by Angie. So Angie will show a $9,000 mortgage interest deduction, while Alice will show a $7,000 deduction. Note that if the California property was owned entirely by Angie or Alice separately, then only that spouse would claim the deduction.

Charitable Contributions

Angie and Alice made $500 of cash charitable contributions while residing in California. The contributions were made from joint, community funds.

OUTCOME: This is community property. Angie and Alice will each claim a $250 charitable contribution deduction on their federal tax returns.

End Results (using 2012 exemption amounts and tax tables):

Item Angie Alice
Wages $60000 28000
401(k) Withdrawal $0 $40000
Dividends $600 $0
Unemployment $8000 $8000
AGI $68600 $76000
Less: State Withholding $4000 $4000
Less: Property Taxes $2000 $2000
Less: Mortgage Interest $9000 $7000
Less: Charitable Contributions $250 $250
Less: Personal exemption $3800 $3800
TAXABLE INCOME $49550 $58950
TAX (Single Filing Status) $8424 $10774
Early Withdrawal Penalty $0 $4000
NET TAX $8424 $14774
Less: Federal Withholding $10300 $14300
REFUND $1876 $474 OWED

 Total refund; $1,402

Here’s how it would look if they didn’t apply community property rules. Angie and Alice would each claim whatever they were entitled to claim, without having to split anything:

Item Angie Alice
Wages $32000 $56000
401(k) Withdrawal $0 $40000
Dividends $600 $0
Unemployment $16000 0
AGI $48600 $96000
Less: State Withholding $2000 $6000
Less: Property Taxes $2000 $2000*
Less: Mortgage Interest $9000 $7000
Less: Charitable Contribs. $250 $250*
Less: Personal Exemption $3800 $3800
TAXABLE INCOME $31550 $76950
TAX (SINGLE FILING STATUS) $2951 $15274
Early Withdrawal Penalty $0 $4000
NET TAX $4301 $19274
Less: Federal Withholding $5600 $19000
REFUND $1299 $274 OWED

Total refund: $1,025

*-Even though we’re not applying community property laws in this table, the California mortgage interest and property taxes should be split 50/50 barring any agreement to the contrary. The charitable contributions were made jointly out of joint funds and thus should be split 50/50 in all circumstances.

You’re a brave soul if you made it this far!

This is just the federal returns. In Part 3, I’ll explore how to handle the “mock” federal return and the state returns.

 

Same-Sex Marriage, Community Property, And Multi-State Income — Part 1

May 8, 2013 in Same-Sex Marriage and Taxes with 2 Comments

When couples in a same-sex marriage live in a community property state, they must follow community property laws on their federal tax return, even though the federal government doesn’t recognize their marriage.

How does this work when a same-sex couple moves from a community property state to a non-community property state during the middle of the year? It makes for a headache-inducing situation. Indeed, some of the most complicated tax returns I’ve ever prepared have been for same-sex couples that moved from California (a community property state) to Iowa (not a community property state) during the middle of the year.

Background

Most states in the United States follow “common law,” but there are nine states that use “community property” law: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

For tax purposes, community property law treats most income and some (but not all) deductions of married couples as belonging half-and-half to each spouse. When spouses file separate tax returns, each spouse reports half of their own income and half of their spouse’s income.

Note that this only applies when married couples in those states file separate tax returns.

Example:

John and Betty are a married couple in California, which is a community property state. John’s income is $80,000. Betty’s income is $20,000 (so $100,000 of total income as a couple). They decide to file separate federal tax returns. On those separate returns, John and Betty will each report $50,000 of income — 1/2 of their own and 1/2 of their spouse’s income.

How Does This Apply to Couples in a Same-Sex Marriage?

Even though the federal government doesn’t recognize same-sex marriages, the IRS says that couples in same-sex marriages or domestic partnerships (RDPs) in community property states must apply community property laws on their separate federal tax returns. See IRS Letter Ruling 201021048. Couples in same-sex marriages or RDPs in community property states CANNOT file as married, but they MUST apply community property laws.

Example:

Angie and Alice are in a same-sex marriage in California. Because of the Defense of Marriage Act, Angie and Alice cannot file as a married couple on their federal tax returns. They can only file as single or head of household. But they MUST apply community property laws on those federal returns, so they will have to split their income and deductions according to community property laws, same as in the “John and Betty” example above.

Now, let’s muddy the waters and say that Angie and Alice move to a non-community property state, such as Iowa, during the middle of the year. I’ll explore that issue in Part 2.

In a Same-Sex Marriage? Watch Your Federal Tax Withholding

April 24, 2013 in Same-Sex Marriage and Taxes with 3 Comments

Here’s something I encountered more than a few times the last two tax seasons: people in same-sex marriages in Iowa who haven’t had enough federal taxes withheld from their paychecks, so they owe (sometimes $1,000+) when they file their tax return.

What’s going on? Some employers are withholding based on the “married” withholding tables rather than the “single” tables.

Example:

Angie is in a same-sex marriage. She earns $60,000/year, payable twice a month (so $2,500/pay period). She claims 0 withholding exemptions. 

Since the federal government doesn’t recognize her marriage, Angie must file her federal taxes as a single person, so her employer should withhold at the single person tax rates. Using the single person rates, her employer should withhold $432.40 from her wages each pay period ($10,378 over the course of a full year).

Instead, Angie’s employer withholds taxes at the married person rates. This results in withholding of $285.90 from her wages each pay period ($6,862 over the course of a full year).

As you can see, the difference between withholding at the single rates or the married rates can result in a huge difference in how much tax is withheld.

In Angie’s case, if all she has is $60,000 of income, the standard deduction ($5,950) and her personal exemption ($3,800), her taxable income will be $50,250, and her tax owed would be $$8,599.

If her employer properly withholds at the single rate, she’ll get a refund of $1,779 ($10,378 – $8,599). If her employer incorrectly withholds at the married rate, she would owe $1,737 ($6,862 – $8,599).

Caveat

One point I want to make is, Angie is not really “paying more” in taxes if her employer withholds at the married rates instead of the single rates. Her tax liability is $8,599. That’s the amount she’ll truly pay in taxes during the year.

The point on the withholding issue is, will she have to pay in when she files her tax return or will she get a refund? But in the end, her tax liability is $8,599 regardless of how much her employer withholds during the year.

Soon a Moot Point?

Of course, this could all become a moot point in late June or early July, if the U.S. Supreme Court overturns DOMA. But for now, it’s something for people in same-sex marriages to watch.

Same-Sex Marriage, Divorce and Taxes

April 10, 2013 in Same-Sex Marriage and Taxes with 1 Comment

How does tax law treat property settlements when same-sex couples divorce?

Issues

Generally, property settlements in divorce are not taxable. But the federal government doesn’t recognize same-sex marriage — as far as the federal government is concerned, there was no marriage to begin with, so the typical rules regarding divorce and taxes don’t apply. Consequently, divorcing same-sex couples may face both income tax problems (in the form of capital gains) and gift tax problems in property transfers.

Example:

Angie and Alice are in a same-sex marriage in Iowa. They jointly own a house and are both on the mortgage. Angie and Alice get a divorce. The divorce settlement awards the house and the mortgage liability to Angie.

The house’s fair-market value is $160,000. The mortgage balance is $130,000. 

Because their marriage isn’t recognized, it appears that Angie and Alice have a tax problem.

Or do they?

Let’s tackle the gift tax issue first.

Gift Tax

For gift tax purposes, a gift takes place whenever someone gives something to someone for less than full consideration. In this case, it would appear that Alice has given a $15,000 gift to Angie — she’s given Angie a piece of property worth $80,000 (1/2 of the $160,000 value of the home) and received $65,000 of consideration in return (being released of 1/2 of the $130,000 mortgage balance).

$15,000 is above the $14,000 gift tax exemption, so it appears Alice is subject to gift tax on this transfer, right?

Not so fast.

DOMA Can’t Overrule Everything

There is no gift here, because Alice gave up ownership of the house as part of a legal settlement that releases her of her spousal obligations under state law.

The $15,000 difference between the “consideration received” (release of $65,000 mortgage obligation) and Alice’s share of the market value of the home ($80,000) is not a gift. Rather, she is being released of intangible marital obligations under state law. See the 1962 U.S. Supreme Court case of Davis v. United States (the part in parenthesis below is my alteration of a citation within the ruling; the rest is a direct quote):

Any suggestion that the transaction in question was a gift is completely unrealistic. Property transferred pursuant to a negotiated settlement in return for the release of admittedly valuable rights is not a gift in any sense of the term. To intimate that there was a gift to the extent the value of the property exceeded that of the rights released not only invokes the erroneous premise that every exchange not precisely equal involves a gift but merely raises the measurement problem discussed in (a part of the ruling).

Capital Gain

Angie may have a capital gain here, though, depending on what her basis in the property is compared to $80,000. Whether this gain is taxable or not depends on how long Angie owned and lived in the home.

Beware if Truly Unmarried

Angie and Alice are not subject to gift tax because they were married under state law, and the marital obligations were dissolved and property was split in accordance with a court order under state law. This is true even though the federal government doesn’t recognize their marriage.

But if Angie and Alice were truly unmarried, there would be a gift tax issue. This is true regardless of sexual orientation. So this would apply to opposite-sex, boyfriend/girlfriend couples who own property together and then break up and need to split up property.

Let There Be Wine (And Taxes)

January 8, 2013 in Same-Sex Marriage and Taxes with 1 Comment

I’ll be giving a presentation called “Wine and Taxes” on Tuesday, January 15, at 5:30 pm at the offices of One Iowa in Des Moines.

This is an action shot of me giving my same-sex marriage presentation in 2012.

This is an action shot of me giving my same-sex marriage presentation in 2012.

The topic of the presentation is the tax issues of same-sex marriage: the complexities of navigating the differing laws that apply at the federal and state level, and what will happen with taxes if the Defense of Marriage Act is repealed (which could happen as soon as this summer).

Perhaps most importantly — free wine will be served! Wine and light snacks and desserts.

One Iowa’s address is 419 SW 8th Street in Des Moines. The event starts at 5:30 pm and will last about an hour, with plenty of time for questions, answers, and mingling.

Pre-registration is requested but not required. To register, click here or contact me.

And did I mention there will be free wine?

What Couples in Same-Gender Marriages Should Be Doing, Tax-Wise, Before Supreme Court Ruling

December 12, 2012 in Same-Sex Marriage and Taxes with 1 Comment

The U.S. Supreme Court will take up the Defense of Marriage Act in March, and could issue a ruling by the end of June. If the Supreme Court overturns DOMA, couples in same-gender marriages will be treated the same as opposite-gender couples for all federal purposes … including taxes.

So what should couples in same-gender marriages be doing, tax-wise, in preparation for the ruling?

  1. Examine your tax situation for prior years. If you would have benefited from filing a joint return in prior years, you may want to submit an amended, joint tax return to put in a protective claim for refund in the event DOMA is overturned. Note that the IRS will not process your amended return until after the DOMA ruling comes down.
  2. You can go back as far as 2009 to file an amended return. For most people, the amendment window for 2009 closes April 15, 2013.
  3. Make sure to file the proper disclosures with your amended return. Basically, because DOMA is still considered a valid law, you have to include certain language that tells the IRS that you are amending your return based on court challenges to DOMA. You can find much more guidance in this document from GLAD.
  4. For now, DOMA is still the law of the land, and will be until at least June. So, when you file your 2012 tax return, you’ll still have to file as two separate, single people. But after you file those returns, you can always submit an amended, joint tax return. Or….
  5. Put your 2012 return(s) on extension until after the DOMA ruling is released. If DOMA is overturned, you could then file an original 2012 tax return as a married couple and not mess with having to amend. If DOMA is upheld, you would go ahead and file your separate, single returns instead. Note, though, that A) this would mean putting off getting your refund, and B) extensions give you an extension of time to file, but not an extension of time to pay any tax you owe, so if you end up owing on your 2012 tax return, you could be subject to penalties if you don’t pay what you owe by April 15th.

Further Reading

  • Professor Pat Cain at Santa Clara Law School in California maintains a must-read blog about the tax issues of same-gender marriage.
  • GLAD and Lambda Legal are two other good resources on this topic.

IRS Releases FAQ for Same-Sex Married Couples

October 12, 2012 in Same-Sex Marriage and Taxes with 1 Comment

The IRS recently published an FAQ for couples in same-sex marriage. The FAQs cover much of the same ground as has been chronicled on this blog (click here to see the archives for my stories about same-sex marriage and taxes) and on Professor Pat Cain’s blog.

It’s refreshing to see the IRS publish this FAQ. The IRS does a lot of things wrong, but on the topic of same-sex marriage, the IRS has been surprisingly open-minded.

Now if only the Iowa Department of Revenue would publish a similar FAQ — or give us SOMETHING.

Same-sex marriage has been legal in Iowa for 3 1/2 years, but in that time, IDR has only published a brief, 1 1/2-page memo in which the department opines that couples in same-sex marriages may have to perform “special calculations” when preparing their Iowa tax returns.

The only thing said in the yearly instructions to the Iowa Form 1040 about same-sex marriage is to refer people to this memo. Not once has IDR ever released anything about what those “special calculations” referenced in the memo are. It sure would be nice if they would.

Dinesen Tax Greatest Hits — How to Claim Someone as a Medical Dependent

September 7, 2012 in Same-Sex Marriage and Taxes with 0 Comments

Since this is a holiday week, I’m taking the easy way out and re-posting some of my most popular blog posts.

Here’s one from January of this year about a topic that doesn’t get a lot of attention, but that can be critical for people in same-sex relationships: how to claim someone as a medical dependent without claiming that person as a dependent on your tax return.

—–

Originally published January 23, 2012

People in same-sex relationships know that if a same-sex partner is not a dependent, then the value of health benefits provided to that partner are taxable income. Some of my clients in same-sex relationships have upwards of $10,000 of “income” added to their W-2s because they have a partner on their health insurance.

But most people, employers and accountants are mistaken in thinking that this is the way it always has to be.

Definition of “Dependent” Depends

Health insurance provided to a spouse or dependent is not taxable. People in same-sex relationships can never be considered married (and thus the term “spouse” cannot apply) for federal purposes because of the Defense of Marriage Act. But what about saying a same-sex partner is a dependent?

This is where it gets confusing. A person can be your dependent for medical purposes without you claiming that person as a dependent on your tax return. If a person qualifies as a medical dependent, then you should not be taxed on the value of health benefits provided to that person.

Here are the rules for someone to qualify as your medical dependent:

  • The person must live with you all year.
  • You must provide over 1/2 of their support.

Note what is missing: there is no gross income limitation. The gross income limitation only applies for trying to claim a dependency exemption for a person on your tax return. It doesn’t apply for purposes of someone being a medical dependent.

CAUTIONS

Before rushing to say that your spouse or partner is a medical dependent, PLEASE PROCEED WITH CAUTION. IT’S NOT AS EASY AS IT SOUNDS TO SAY SOMEONE IS YOUR MEDICAL DEPENDENT! 

For example, the mere fact that you make more money than your spouse/partner doesn’t necessarily mean that your spouse/partner qualifies as your medical dependent. It is possible to make more money than someone without providing more than 1/2 of that person’s support. It is vital for you to do the following two things:

  • Complete the support worksheet in Publication 501 to document that you really are providing more than 1/2 of your spouse/partner’s support.
  • You must continue to provide more than 1/2 of your spouse/partner’s support going forward in order for them to keep qualifying as your medical dependent.

I will say this one more time for emphasis: it’s not as easy as it sounds. You may want to discuss with a professional who specializes in LGBT tax issues, such as myself.

More to Come

Next week I’ll provide more details about the topic of taxation of health benefits, including code sections and other resources.

Image: Keerati / FreeDigitalPhotos.net

Image: digitalart / FreeDigitalPhotos.net

Same-Sex Marriage, Community Property, and Self-Employment Earnings

July 25, 2012 in Same-Sex Marriage and Taxes with 1 Comment

I have blogged before about how community property laws apply, for federal tax purposes, to couples in same-sex domestic partnerships or same-sex marriage, even though those couples can’t file joint tax returns. There’s a dispute, though, over whether community property laws apply to self-employment earnings.

Self-employment earnings are subject to the income-splitting rules under community property law. But some, such as Professor Pat Cain at Santa Clara Law School, say this does not apply to same-sex couples. Professor Cain’s stance is that self-employment earnings should be reported 100% by the spouse earning it, rather than reported 50/50 by each spouse.

I need to dig into the code and court cases before forming my own opinion on this. For now, you can read Professor Cain’s musings on the topic here.

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