Article Highlights:
- Changing Filing Status
- Liability
- Community Property States
- Social Security Benefits
- Capital Loss Limitations
- Sec 179 Business Expensing Election
- Rental Loss Limitation
- Traditional IRA Contributions
- Roth IRA Contributions
- Education Credits
- Series EE or I Bonds
- Higher Education Interest
- Standard Deduction
- Medicare Premiums
- Allocating Home Mortgage Interest
- Alternative Minimum Tax (AMT)
- 2021 Tax Rate Tables
- Child and Dependent Care Credit
- Child and Dependent Credit
- Earned Income Tax Credit (EITC)
- Adoption Credit
- Estimated Taxes Allocation
- Premium Tax Credit (PTC)
Couples who are married on the last day of the tax year basically have two filing status options when filing their tax returns: either married filing jointly (MFJ) or married filing separately (MFS) returns. Generally, filing MFJ will produce the better tax result. However, other factors – usually personal or financial rather than tax-related – can come into play that cause taxpayers to choose to file MFS returns.
There is one exception to the requirement that married taxpayers file either MFS or MFJ. This is where one spouse lived apart from the other spouse for the last 6 months of the year and (1) pays more than one-half of the cost of maintaining as his or her home a household (2) which is the principal place of abode for more than one-half the year of a child, stepchild or eligible foster child that (3) the taxpayer may claim as a dependent. (A nondependent child qualifies only if the taxpayer gave written consent to allow the dependency to the non-custodial parent.) When these requirements are met, the head of household status can be used. The other spouse would still file as MFS unless that spouse also qualifies for the exception.
Whatever the reason for filing MFS, the consequences encountered when filing separate returns are as follows.
Changing Filing Status – Once a couple files a joint return, the joint filers may not change to filing separate returns after the unextended due date of the tax return. The unextended due date is generally April 15 unless it falls on a weekend or holiday, in which case it will be the next business day.
Liability – When married taxpayers file joint returns, both spouses are responsible for the tax on that return. What this means is that one spouse may be held liable for all the tax due on a return, even if all the income on that return was earned by the other spouse. This also applies to back taxes and back child support. When spouses file MFS, each is liable only for the tax on their own return.
Community Property States – Where taxpayers reside in a community property state, the allocation of income when filing separate returns is governed by state law. If the spouses file separate returns, each spouse, with certain exceptions, must report one-half of the income from community property, and if the couple is estranged or uncooperative, determining the correct amount of income that each should report may be difficult. The IRS can disregard community property laws when a spouse is not informed of community income by the other spouse. However, the IRS’s ability to disregard community property laws only occurs after the fact should the IRS question the allocations.
Taxpayers may be able to disregard community property rules if the spouses have an agreement (commonly referred to as a prenuptial agreement, but agreements can also be created after marriage) that their property is separate property, and thus income from such property is separate income. It is best for an attorney to draft any such agreement.
Following are how some of the most common types of income are treated for federal tax purposes in community property states.
- Wages – Earned income from personal service received by a husband and wife domiciled in a community property state is generally community income during the period the community is in existence. Thus, wages are community income during the period of the community and must be split evenly.
- Example: Bill and Chris are married and live in a community property state. Bill is employed and had wages for the year of $120,000 ($10,000/month), while Chris is not employed. If they file MFS returns, each will report $60,000 of wages as income. Let’s say they separated on July 1 (i.e., the community ended) but were still married on December 31. They file MFS returns – Bill’s return will include $90,000 of wage income ((6 months x $10,000 x 50%) + (6 months x $10,000 x 100%)) and Chris will report $30,000 of wages (50% of Bill’s $60,000 wages for January through June).
- Credit for Tax Withheld on Wages – If a husband and wife domiciled in a community property state file separately for federal tax purposes and each report one-half of the community wages received during the tax year, half the credit for the income tax withheld on the community wages that are reported on separate returns is taken by each spouse.
- FICA Wage Withholding – The FICA (Social Security and Medicare) withholding cannot be allocated. It has already been reported to the Social Security Administration and credited under the Social Security Number (SSN) of the individual who actually earned it.
- Net earnings from self-employment – Where the net self-employed earnings of a taxpayer is community property, and the spouses file MFS returns, then:
- Self-Employment Tax – Is assessed on the taxpayer who actually earned the income. If the spouses jointly operate the trade or business, for SE tax purposes, the gross income and related deductions are allocated between the spouses based on their distributive shares of the gross income and deductions.
- Income Tax – For purposes of income tax, the SE income that is community income is divided 50/50 between the spouses and the SE income that is separate income is allocated 100% to the spouse who owns it.
Example: Where a married couple lives in a community property state and only one spouse is self-employed, that spouse must pay SE tax on his total gross SE income, less total business deductions, despite the fact that half of that income is attributable to the other spouse for income tax purposes.
- Disability and Unemployment Income – Since these are substitutes for current earnings, they are treated as community income.
- Dividend & Interest Income – Interest and dividend income can be either separate or community income. This depends on whether the underlying investment that produced the income was acquired with joint or separate funds and whether the couple’s domicile was in a community or separate property state at the time the investment was acquired.
- IRA & SEP Accounts – Traditional IRAs, Roth IRAs, SIMPLE IRAs, and simplified employee pension (SEP) IRAs are separate property by law; thus:
- Distributions – Are reported by the individual who owns the IRA.
- Contributions – When deductible, the deduction is claimed by the individual who owns the IRA.
- Social Security and Equivalent Railroad Retirement Benefits – Are treated as the income of the spouse who receives the benefits.
- Pension Income – Income from qualified plan distributions can be either community income or separate income based upon the amount of separate and community income used to fund the pension account. One possible proration scenario would be prorating by the respective periods of participation in the pension while married and domiciled in a community property state or in a noncommunity property state during the total period of participation in the pension.
Example: Prorating by Years – Suppose Dave has had a 401(k) plan since January 1 of 2010. He and Shirley get married on January 1, 2017. On January 1 of 2020, Dave retires and begins taking distributions from his 401(k) plan. Dave had the 401(k) plan for 10 years, three of which were during the period of his marriage to Shirley. Thus, prorating by year, Dave’s 401(k) distributions would be 70% separate income and 30% community income. If they filed married but separately, Dave would report 85% of the income (70% plus ½ of 30%) and Shirley would report 15%.
Partnership Income – Income from a partnership is based upon whether:
- Income Is Attributable to the Personal Services of Either Spouse – Where the income from the partnership is attributable to the efforts of either spouse, the partnership income is community property.
- Income Is Not Attributable to Personal Services – In this case, income can be either communal or separate based upon whether the partnership involves community or separate property.
Now, let’s look at some tax-related issues where filing MFS is generally unfavorable:
Social Security Benefits – Social Security (SS) income is not taxable until their modified AGI (MAGI) – which is regular AGI without Social Security income plus 50% of their Social Security income, tax-exempt interest income, and certain other infrequently encountered additions – exceeds a specific threshold. The threshold is $32,000 for MFJ taxpayers. However, for taxpayers filing MFS, the threshold is zero, meaning they lose the benefit of the tax-excludable portion of Social Security benefits enjoyed by others and will have 85% of their Social Security benefits counted as income.
Exception – There is an exception to this MFS penalty if the spouses lived apart for the entire tax year. The Tax Court has held that separate-filing spouses must live in separate residences to qualify as living apart.
Capital Loss Limitations – When a taxpayer’s reportable sales of capital assets, such as stocks, result in a loss for the year, the loss is first used to offset capital gains; then, any excess loss is deducted from ordinary income, but the entire excess loss may not be deductible. Instead, the tax code limits the losses to $3,000, and amounts not allowed are carried over to the subsequent year. For MFS filers, that amount is reduced to $1,500. This will cause an MFS penalty, whereas the losses would all be reported on only one of the MFS returns.
Example: One spouse of a married couple has separate property that generates a $4,000 loss, which is the only capital gain or loss between them for the year. If they file jointly, they would be allowed a $3,000 capital loss deduction. If they file separately, then the spouse whose separate property generated the loss would report the entire transaction on their own separate return and would be limited to a $1,500 loss. The other spouse would not have a loss.
Sec 179 Business Expensing Election – Under Section 179 of the tax code, taxpayers are allowed to expense (write off) rather than capitalize and depreciate personal tangible equipment purchased for business use. For purposes of the Sec 179 election, married taxpayers are treated as one taxpayer for determining the Section 179 limit. Thus, when filing MFS, the limit is divided equally between the taxpayers, unless they elect an unequal split. This will generally not be an issue for most taxpayers, since the Sec 179 expensing limit is $1,050,000 for 2021.
Rental Loss Limitation – Rental property in the early years after acquisition will often show a tax loss. These losses are generally attributable to an accounting deduction for depreciation. The tax code includes some complicated rules related to deducting rental losses, but they are generally limited to $25,000 for taxpayers with an AGI of $100,000 or less and ratably phased out for taxpayers with AGIs between $100,000 and $150,000.
MFS taxpayers are not allowed any loss unless they live apart the entire year. If they lived apart all year, the allowance is reduced to $12,500, and phaseout begins at an income level of $50,000.
Traditional IRA Contributions – Deductible traditional IRA contributions are allowed for taxpayers up to $6,000 ($7,000 if age 50 or over). However, the deductibility now begins to phase out in 2021 for married joint filers if they are active participants in another plan when their AGI reaches $105,000 and is fully phased out when the AGI reaches $125,000. If only one spouse is an active participant in a qualified plan and files jointly, the phase out range is $198,000 – $208,000. If the couple files MFS, the AGI phaseout begins at zero AGI and is fully phased out at $10,000, which essentially eliminates a deductible contribution for either spouse.
Plans That Create “Active Participation”:
- A qualified annuity plan
- A tax-sheltered annuity
- A simplified employee pension (SEP)
- An employer-sponsored qualified pension, profit-sharing or stock bonus plan
- A plan established by a governmental agency for its employees, other than an unfunded deferred compensation plan for employees of state and local governments or exempt organizations (§ 457 plan)
- An employee-only contributory plan exempt from tax
Roth IRA Contributions – Even though contributions up to $6,000 ($7,000 if age 50 or over) are allowed, unlike traditional IRA contributions, Roth IRA contributions are not deductible. Since Roth IRAs enjoy tax-free accumulation contributions, Congress decided contributions should not be available to high-income taxpayers. Thus, for 2021 the contributions now begin to phase out for married taxpayers with AGIs of $198,000 and are fully phased out when the AGI reaches $208,000. However, for MFS taxpayers, the phaseout range is $0 to $10,000, essentially eliminating a contribution for either spouse. This AGI limitation applies regardless of whether the taxpayer is an active participant in a qualified plan.
Education Credits – Tax law includes two tax credits to aid taxpayers who are paying higher education tuition and certain expenses for themselves and their children. The American Opportunity Tax Credit provides a tax credit up to $2,500 per eligible student, of which 40% is refundable. The second credit is the Lifetime Learning Credit, which provides a nonrefundable credit of up to $2,000 per tax return.
Both credits are phased out for higher income taxpayers. However, for those filing MFS, no credit is allowed at all.
Series EE or I Bonds – An individual who pays qualified higher education expenses with redemption proceeds from Series EE or I bonds issued after 1989 can potentially exclude the bonds’ interest from their income. However, no exclusion is available to a taxpayer using the MFS filing status.
Higher Education Interest – An “above-the-line” deduction (i.e., a deduction from AGI) is allowed for interest payments due and paid on any “qualified student loan,” regardless of when a taxpayer first incurred the loan. The maximum deduction per year is $2,500. This is a per-return limit, not a per-student limit. However, MFS filers cannot deduct any amount of higher education interest.
Standard Deduction – Married taxpayers filing jointly benefit from a 2021 standard deduction of $25,100, while the standard deduction for those filing as MFS is $12,550 (half of $25,100). However, if either spouse filing MFS itemizes their deductions, the standard deduction for the other spouse becomes zero, which forces that spouse to also itemize their deductions even if less than $12,550. Exception: Where a married individual qualifies to file as head of household as discussed at the beginning of this article, that spouse can take the standard deduction even if the other spouse itemizes.
Filing Requirements – For years 2018-2025, an individual is required to file a federal return if their gross income exceeds their standard deduction amount. For MFJ couples, the standard deduction for 2021 is $25,100, but taxpayers filing as MFS are required to file a return if their gross income is $5 or more.
Medicare Premiums – For those who qualify for Medicare, the premiums are based upon a taxpayer’s modified adjusted gross income (MAGI) and filing status from the tax return two years prior. As the Medicare chart for 2021 shown below illustrates, the rates for individuals filing MFS are substantially higher than for other Medicare participants.
|
MONTHLY MEDICARE B PREMIUMS |
||
|
Filing Status |
MAGI from 2 Years Prior (2019) |
2021 premium |
|
Married Filing Jointly (MFJ) |
$176,000 or less |
$148.50 |
|
$176,001 – $222,000 |
$207.90 |
|
|
$222,001 – $276,000 |
$297.00 |
|
|
$276,001 – $330,000 |
$386.10 |
|
|
$330,001– $749,999 |
$475.20 |
|
|
$750,000 and Above |
$504.90 |
|
|
Married Filing Separately (MFS) (Lived together) |
$88,000 or less |
$148.50 |
|
$88,001 – $412,000 |
$475.20 |
|
|
$412,001 and Above |
$504.90 |
|
|
Married Filing Separately (MFS) (Lived apart the entire year) |
$88,000 or less |
$148.50 |
|
$88,001 – $111,000 |
$207.90 |
|
|
$111,001 – $138,000 |
$297.00 |
|
|
$138,001 – $165,000 |
$386.10 |
|
|
$165,001 – $499,999 |
$475.20 |
|
|
$500,000 and Above |
$504.90 |
|
Example: For a married couple living together in 2019 with a joint MAGI of $200,000, we can compare the results with them listed as married filing separately and married filing jointly to see what the difference in Medicare premiums will be in 2021.
Married Filing Separately – Assume they evenly divide their joint MAGI, so each
has a MAGI of $100,000. Using the MFS (lived together) table above, their
individual premiums would $475.20 per month or $5,702.40 per year.
Their combined 2021 premiums would be………………………………………$11,404.80
Married Filing Jointly – If they had filed MFJ, their MAGI would have been
$200,000. Using the married filing jointly tables, their individual premiums would
be $207.90 per month or $2,494.80 per year.
Their combined 2021 premiums would be……………………………………….$ 4,989.60
Thus, because they filed as MFS in 2019,
their 2021 Medicare premiums increased by……..……………………………………………………$6,415.20
Allocating Home Mortgage Interest – There are limits on the amount of primary-home and second-home mortgage interest that can be deducted. However, when determining interest limits, married but separate taxpayers are treated as though they were one taxpayer. Thus, they are limited to an amount split between them that would have been allowed them on a joint return.
If they own two homes, each may deduct the interest on only one, unless they both consent in writing that the deduction for both homes is to be taken by one spouse.
Alternative Minimum Tax (AMT)
The AMT came into being some time ago as a way to curtail tax shelters, deductions and credits for high-income taxpayers by imposing a tax computed in a more restrictive and complicated manner. The authors of the AMT also included special provisions for MFS taxpayers that include:
- AMT Tax Exemption – The AMT exemption exempts an amount of AMT income from the AMT tax. The 2021 AMT exemption amount is $114,600 for a couple filing jointly, but the amount is cut in half ($57,300) for spouses when filing MFS.
- AMT Tax Exemption Phaseout – The AMT exemption amount is phased out for higher-income taxpayers. The AMT phaseout for MFS taxpayers has a lower threshold that is half the amount that applies to spouses who file jointly. As a result, for 2021, although the phaseout threshold begins at $1,047,200 for spouses filing jointly, it begins at $523,600 for MFS spouses.
- AMT Tax Rates – The 2021 AMT tax rates are 26% for alternative minimum taxable incomes of $199,900 or less and increase to 28% for higher amounts. For MFS taxpayers, the $199,900 amount is cut in half, resulting in the 28% rate occurring faster for those filing MFS.
2021 Tax Rate Tables – The IRS annually publishes tax rate schedules for each filing status. The 2021 rate schedules are reproduced below, and the higher tax rates kick in at lower income levels for MFS.
|
TABLE #1 – Married Individuals Filing Joint Returns and Surviving Spouses |
||||||
|
If Taxable Income (TI) Is: |
Tax Is: |
|||||
|
Not Over |
$19,900 |
10% of tI |
||||
|
Over |
$19,900 |
but not over |
$81,050 |
$1,990 |
Plus 12% of excess over |
$19,900 |
|
Over |
$81,050 |
but not over |
$172,750 |
$9,328 |
Plus 22% of excess over |
$81,050 |
|
Over |
$172,750 |
but not over |
$329,850 |
$29,502 |
Plus 24% of excess over |
$172,750 |
|
Over |
$329,850 |
but not over |
$418,850 |
$67,206 |
Plus 32% of excess over |
$329,850 |
|
Over |
$418,850 |
but not over |
$628,300 |
$95,686 |
Plus 35% of excess over |
$418,850 |
|
Over |
$628,300 |
|
$168,993.50 |
Plus 37% of excess over |
$628,300 |
|
|
TABLE #4 – Married Individual Filing Separately |
||||||
|
If Taxable Income (TI) Is: |
Tax Is: |
|||||
|
Not Over |
$9,950 |
10% of tI |
||||
|
Over |
$9,950 |
but not over |
$40,525 |
$995 |
Plus 12% of excess over |
$9,950 |
|
Over |
$40,525 |
but not over |
$86,375 |
$4,664 |
Plus 22% of excess over |
$40,525 |
|
Over |
$86,375 |
but not over |
$164,925 |
$14,751 |
Plus 24% of excess over |
$86,375 |
|
Over |
$164,925 |
but not over |
$209,425 |
$33,603 |
Plus 32% of excess over |
$164,925 |
|
Over |
$209,425 |
but not over |
$314,150 |
$47,843 |
Plus 35% of excess over |
$209,425 |
|
Over |
$314,150 |
|
$84,496.75 |
Plus 37% of excess over |
$314,150 |
|
Child and Dependent Care Credit – A married taxpayer filing MFS cannot claim the credit or exclude dependent care benefits unless the taxpayer and his or her spouse are legally separated under a decree of divorce or separate maintenance. However, the custodial parent can exclude the dependent care benefits per the limits. Married taxpayers qualifying as head of household may claim the credit or exclude the dependent care benefits.
Child and Dependent Credit – Married taxpayers filing MFS can claim the child and dependent credit. But the credit now begins to phase out in 2021 when the MFS filer’s modified AGI reaches $200,000, whereas for those filing MFJ, the phaseout threshold is $400,000.
Earned Income Tax Credit (EITC) – To claim the EITC, an individual must have income from working, referred to in tax law as earned income. Where a married taxpayer is able to file as head of household as discussed at the beginning of this article and lives in a state that has community property laws, earned income for the credit does not include any amount earned by the taxpayer’s spouse that is treated as belonging to the taxpayer under community property laws. That amount is not earned income for the credit, even though a taxpayer must include it in gross income on his or her tax return.
Adoption Credit – Taxpayers meeting certain circumstances can take a dollar-for-dollar tax credit for the adoption expenses they incurred in 2021, up to $14,440. However, a married individual filing a separate return (MFS) is only able to take the credit if all of the following apply:
• The credit is not phased out for higher income. The phaseout range for 2021 is $216,660 to $256,660 (this range is the same for all filing statuses).
• The spouses lived apart during the last 6 months of the year.
• The eligible child lived in the MFS individual’s home for more than half of the year.
• The MFS filer provided over half the cost of keeping up their home.
Estimated Tax Payments Allocation – When married taxpayers file as MFS, they will have sometimes made a prepayment toward their income taxes by filing estimated taxes either individually or jointly, and those payments must be allocated between their MFS returns. The IRS has established the following procedure for allocating estimated tax payments.
Separate Returns, Separate Estimates – If the taxpayer and spouse made separate estimated tax payments for the year and file separate returns, they can take credit only for their own payments.
Separate Returns, Joint Estimates – If the taxpayers made joint estimated tax payments, they must decide how to divide the payments between the returns. One can claim all of the estimated tax paid and the other none, or they can divide it in any other way they agree on.
If they cannot agree, they must divide the payments in proportion to each spouse’s individual tax as shown on their separate returns for the year.
Example – James and Evelyn Brown made joint estimated tax payments totaling $3,000. They decide to file separate returns and cannot agree on how to divide the $3,000. Since they cannot agree upon how to divide the payments, they must divide the payments in proportion to their separate tax labilities. James’ tax is $4,000 and Evelyn’s is $1,000. Since they cannot agree upon how to divide
James’ share = 4,000/5,000 x 3,000 = $2,400
Evelyn’s share = 1,000/5,000 x 3,000 =$ 600
Premium Tax Credit (PTC) – The PTC is a health insurance subsidy the government pays to lower income individuals who obtain their family health insurance through a government marketplace. Generally, a married taxpayer filing separately (MFS) cannot claim the premium tax credit (PTC) and thus must repay all advance premium tax credit (APTC) received through the marketplace. There are two exceptions:
- Individuals who qualify as victims of domestic abuse or spousal abandonment, and
- Taxpayers whose household income is less than 400% of the federal poverty level will have their payback limited based on household income relative to the federal poverty level. For 2020, Congress suspended the payback altogether, but it is to resume for 2021.
As you can see, there are quite a number of issues to think about when filing MFS. If you are considering such a move, it may be appropriate to consult with this office in advance. If you have already filed MFS, there may be some significant tax refunds available by amending your separate returns to a joint return. Please contact this office for assistance.
Isler Northwest LLC is a firm of business advisors and CPAs in Portland, Oregon. Our service goal at Isler Northwest is to earn our clients’ trust as their primary business and financial advisor.
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