Consequences of Filing Married Separately

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:
  
  
  o 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.
  
  o 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:
  
  
  o Distributions – Are reported by the individual who owns the IRA.
  
  o 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.

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 phase out 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.