LOS ANGELES – It all started because Auntie Weezer didn't want her new husband to lose his refund just because she had tax debt. "What about married filing separately?" she asked.
There are the usual culprits when it comes to "married filing separately," but in states with community property laws, married filing separately has even more dimensions of misery. First, let's take a look at those usual culprits:
If you're married filing separately and there's a child (or children), you can't file head of household. Each person must file using the Married, Separate status. When you're older, if you're collecting Social Security, you completely lose the right not to tax your Social Security income when your income is under $25,000 ($30,000 if married filing jointly), even if you would have qualified to exclude the Social Security income had you filed jointly. You lose the Earned Income Tax Credit that lower income families rely on each year. For education costs, you can't use the Hope Credit or the Lifetime Learning Credit.
Filing separately in a community property state
Let's look at what happens when someone in a community property state files separately. Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington State and Wisconsin.
You don't get to file separate tax returns that reflect just his income and her income. Since everything you own is his and vice versa, you must split all the household income and expenses on each return.
This is a big concern when you don't trust your spouse's accounting practices or business ethics. This is a special concern when you suspect your spouse of tax evasion, and that's the main reason you're filing separately. In cases like that, you do have an out.
You don't need to include your spouse's income on your tax return - if your spouse never tells you his/her income. This is what IRS says about including community income in your separate tax return:
Certain community income. Community property laws may not apply to an item of community income. You are responsible for reporting all of it if:
You treat the item as if only you are entitled to the income, and You do not notify your spouse of the nature and amount of the income by the due date for filing the return (including extensions).
The IRS also says this:
Relief from separate return liability for community income. You are not responsible for reporting an item of community income if all the following conditions exist.
You file a separate return for the tax year. You do not include an item of community income in gross income on your separate return. You establish that you did not know of, and had no reason to know of, that community income. Under all facts and circumstances, it would not be fair to include the item of community income in your gross income.
Another idea the IRS doesn't mention is to enter into an agreement, preferably a written one, to keep your incomes separated for a number of years, or even forever.
Let's look at hypothetical case where they don't have a written agreement to keep their incomes separated.
Suppose Auntie Weezer's husband has $80,000 in income, with IRS withholding of $16,000 and state withholding of $4,000. And Auntie Weezer has $20,000 in income and zero withholding. They want to file separately so she doesn't visit her tax debt upon her husband, remember?
They would each have to file a tax return showing $50,000 worth of income, with IRS withholding of $8,000 each and state withholding of $2,000 each.
Not only would her husband lose his refund, but they would each be responsible for additional taxes. They would each have to pay more than $900, and related penalties, even though he'd had adequate withholding.
If this had not been a community property state, Mr. Weezer could have filed a tax return reflecting only his income - and he'd have had a refund of more than $1,200.
And Auntie would have owed more than $1,350.
Total household cost in a community property state would be $1,800 ($900 x 2) plus penalties and interest.
Total cost in a non-community state would be $150 ($1,350 due minus $1,200 refund), plus the penalties and interest on $1,350.
That $1,650 is a huge difference when you're struggling to build a life together and pay off old tax debt.
When it comes to expenses, bills paid out of community funds are split 50-50. But anything paid from separate funds are only deductible to the person who paid them.
Suppose Auntie came into the marriage with money, and now only works part-time, earning $5,000. She pays the mortgage from her funds, while he's the breadwinner and pays all the other bills. He can't deduct the mortgage interest on a separate return. And while she can deduct the interest, she doesn't have enough income to itemize. The mortgage expense goes to waste.
Or suppose she does have income, but he pays the mortgage and property tax. She doesn't pay anything that would let her itemize. However, since he has itemized on his tax return, she is forced to itemize on hers. She loses her $5,150 standard deduction.
It gets more complex as real life comes into play. IRS's publication about community property does not really address the issues clearly for couples who are living together. Although, there's a good example of how to split income for those couples who haven't agreed to keep their income separated.
Be sure to test the computation both ways, by filing jointly and separately, if you don't distrust your spouse's data.
When your main reason for filing separately is to protect a refund, consider using the Innocent Spouse Form - Form 8857. Better yet, get a loan to pay off the tax, leave IRS out of the equation altogether, and file jointly.
If you're living in a community property state and need to file separately for whatever reason, follow this cautionary advice: Be sure you have agreements in place to allow you to report only your own income and relate expenses.
Copyright (c) 2006 MarketWatch, Inc.