Filing personal taxes in community property states as Married Filing Separately (MFS) can be complicated.
Certain states have laws about community property defining how they expect MFS couples to share, or allocate income. These states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Separate… but Equal
In separate property states, the computations for the Married Filing Separate are fairly simple. In fact, you only report your own income and deductions on your separate return. If you have joint assets with your spouse, special consideration must be given on how those assets are to be split but, generally, they are simply split right down the middle. However, in community property states, all earnings of either married spouse generally are considered “joint”, even if deposited into separate accounts. It is important to know that assets purchased with joint funds may also be considered community assets. Therefore, in community states, it is much more difficult to identify separate property.
Here’s an example:
Joseph and Mary are married and live in Texas. Joseph’s wages are $100,000 per year. Mary’s wages are $30,000 per year. You would think that, if they elect to file a Married Filing Separate tax return, they would each report their respective incomes on their own returns. However, since Texas is a community property state, they are required to combine both incomes (for a total of $130,000), and each report half of the total on their respective separate returns. So, in this case, using the married separate filing status, Philip and Mary would each report $65,000 in wages on their separate tax returns.
What To Do Before Your File as Married Separate
Before you prepare a tax return using the married separate filing status, you must first determine whether your income is community income or separate income, as determined under the laws of the state where you live. This classification is important because if you file a separate return, only half the community income is reported on your return when the IRS really requires all of your separate income must be included on the return.
Like in all situations, there are several disadvantages to filing separately. Depending on your situation, they could easily outweigh any potential benefits. One of those disadvantages is that you cannot take various tax credits like the Hope or Lifetime Learning education credits, earned income tax credit, and, in most cases, the credit for child and dependent care expenses.
Here are some other key points you should know about the Married Filing Separately status:
- The amount you can exclude from income under an employer’s dependent care assistance program is limited to $2,500 (instead of $5,000 if you file a joint return).
- You cannot take the deduction for student loan interest, or the tuition and fees deduction.
- You cannot exclude from your income any interest income from qualified U.S. savings bonds that you used for higher education expenses.
- If you live with your spouse at any time during the tax year, you’ll have to include in income more (up to 85%) of any Social Security benefits you receive.
- If you live with your spouse at any time during the tax year, you cannot roll over amounts from a traditional IRA into a Roth IRA.
- The following credits and deductions are reduced at income levels that are half of those for a joint return: child tax credit, retirement savings contributions credit, itemized deductions, and the deduction for personal exemptions.
- Your capital loss deduction limit is $1,500 (instead of $3,000 if you filed a joint return).
- You may not be able to deduct all or part of your contributions to a traditional IRA if you or your spouse was covered by an employee retirement plan at work during the year.
- If you own and actively manage rental real estate, it will be more difficult for you to deduct any losses you incur.
- If your spouse itemizes deductions, you cannot claim the standard deduction. If you can claim the standard deduction, your basic standard deduction is half the amount allowed on a joint return.
Identifying your community income, separate income, and deductions according to the laws can actually be a very complicated task. This is why DIY tax preparers who try to use the Married Separate filing status sometimes find themselves on the wrong side of the tax laws and regulations. Therefore, before you try to file your return using the Married Separate status, you need to read and thoroughly understand IRS Publication 504 and Publication 555.
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