Married Filing Separate Returns

By Arthur F. Rothberg

Sometimes, married taxpayers file separate returns because they have to or because it may be advantageous to do so. Once that decision has been made, a number of questions arise. How do they split income earned on a joint account? Who is entitled to a medical deduction for a payment made from that account? The issues are not as simple as they may seem.

Married taxpayers have the choice of filing status when filing their income tax returns. Usually, an election to file a joint return will result in a lower overall tax bill; however, this is not always the case. At times, a better result can be obtained by filing separate returns. For instance, a situation where one spouse has large medical expenses may result in the payment of less taxes through the filing of separate returns.

Many married taxpayers are faced with the dilemma of deciding not only whether to file separate tax returns but also how to properly do so. While the desire to file separately may be driven by pure tax saving considerations, very often, married taxpayers are faced with this decision because there is discord in the marital relationship. When this situation presents itself, questions of filing status and how items of income, exemptions, and deductions should be treated arise.

Filing Status

In deciding on the best filing status to use, married taxpayers are always free to file a joint tax return. They may elect to do so even after having previously filed separate returns. Unfortunately, because the filing of a joint return constitutes making an election, married taxpayers may not file separate returns if they have already filed jointly. There is a limited exception to this rule for a personal representative of a deceased spouse. The personal representative has one year from the due date of a previously filed joint return to change to a separate return.

Filing joint income tax returns also results in each spouse having joint and several liability for any tax due. This exposes each of them to potential liability for the total amount of any future deficiency that may by imposed by the IRS. Filing separate returns avoids this
problem.

Married taxpayers who are living apart may, under certain circumstances, be considered unmarried for income tax purposes. If the qualifying circumstances are met, a husband or wife may file as head of household even though he or she is married. To qualify for this more favorable status, a taxpayer must meet all of the following tests:

* File a separate return.

* Pay more than half of the cost of maintaining a household.

* For more than one-half of the year maintain said household as the principal home of a dependent.

* Not live with the estranged spouse in this home for the last six months of the tax year.

* Be qualified to claim an exemption for the dependent.

The head of household status results in more than a reduction in tax rates. It also allows the taxpayer to take certain credits and exclusions not available to spouses that file separate returns. These items will be more fully discussed below.

Income

Generally, a taxpayer and spouse must report only their own income on separate returns. This income is easy to identify when it is earned separately and reported on appropriate W-2 and 1099 forms. The difficulty surfaces when income producing property is held jointly. In this case, it may not be correct to merely have each filer report one-half of the income generated by the property.

The rights of multiple property holders are governed by state law. Property may be held as tenants in common, joint tenants, or tenants by the entirety (a special category of joint ownership available only to husband and wife). Tenants in common each own an undivided interest in property; upon the death of a co-tenant his or her interest passes to his or her estate or heirs. Joint tenants also hold an undivided interest in property; however, upon the death of a joint tenant the entire rights to the property go to the survivor. In the case of a tenancy by the entirety, the property not only passes to the surviving spouse, but during life neither husband nor wife can alienate or encumber the property without the consent of the other. Upon the dissolution of a marriage, a tenancy by the entirety is transformed into a tenancy in common.

Taxpayers who live in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin) may have their income considered as separate income or community income for income tax purposes. The intricacies of community income are not included in this discussion.

The treatment of interest income from a joint savings account demonstrates the complexity. State law, and the governing instrument under which the account was established with the bank, may result in at least three different treatments. In the case of a revocable account, each co-tenant or owner has the right to withdraw all or any part of the amount on deposit for his or her own use. In contrast, in a true joint tenancy account each co-owner has a right to one-half of the deposited funds. Finally, in an accommodation or convenience account, only the co-owner who provided all the funds on deposit has exclusive rights to them. The other co-owner is merely the agent of the contributing owner and can only make withdrawals at the contributing owner's direction. Additionally, under this type of arrangement, there may or may not be a right of survivorship.

Clearly, in a true joint
tenancy account, each co-owner would report half of the income earned. In the case of a revocable account, where each co-tenant may have made disproportionate deposits, they would report their income in proportion to the deposits each made. Conversely, in a pure accommodation account, the sole contributing co-owner would report all the income earned. These latter types of accounts are treated more like a tenancy in common, where the co-tenant can have unequal interests and share the income proportionally.

Early case law, decided by the Board of Tax Appeals, the predecessor to the Tax Court, interpreted relevant state law in determining the proportion of income reportable by each spouse that filed separate returns. In Hafner, (31 B.T.A. 338), a case decided under New York law, the court stated, "Whether they deposited an equal sum of money is immaterial, for where money is deposited in a bank in the name of husband and wife, it will be presumed to belong to each equally," and held that each taxpayer was entitled to one-half of the income generated from a joint account. However, the court held differently in First National Bank of Duluth, Special Administrator (13 B.T.A. 1096), a case relying on Minnesota law, where it was held that income from jointly held property was the income of the husband and wife in proportion
to their ratable contributions to the principal amounts.

The effect of state law on the sharing of income is further illustrated by Emmons [T.C. Memo 1961-290 (1961)]. In this case, the petitioner, a severely disabled taxpayer, maintained a joint savings account with her mother. The account was originally established with one deposit for $2,500, 40% of which was contributed by the petitioner. The Tax Court, applying Kentucky law, held that the petitioner was only required to report two-fifths of the interest income earned during the year in question. It reasoned, "Her original contribution to the savings account was two-fifths of the total opening deposit, which was the only deposit ever made in this savings account."

Special rules apply to the reporting of interest on U.S. Savings Bonds. Interest income is reported in proportion to the contribution made by each spouse, without regard to the state they live in.

Exemptions and Deductions

On joint returns, personal exemptions are generally allowed for both spouses, and exemptions for dependents can be claimed for all of their children and other dependents. However, when filing separately, an exemption for a spouse may only be claimed if he or she had no gross income and was not the dependent of another taxpayer. Dependency exemptions may only be claimed for those dependents that meet the five normal dependency tests. Where one spouse cannot clearly demonstrate that he or she paid more than one half of the child's support, a multiple-support agreement (Form 2120) must be filed.

When married taxpayers file separate returns, they both must either itemize their deductions or use the standard deduction. Under no circumstances may one spouse itemize while the other spouse uses the standard deduction. This is not the case when filing as head of household, as each taxpayer is free to use the method that yields the lowest tax.

The IRS and case law provide specific guidance about certain itemized deduction categories. In other areas there is less direction, and the taxpayer is forced to determine the proper treatment only
after reviewing state law and other
considerations.

Generally, a taxpayer is allowed a deduction for items he or she actually paid. In the case of mortgage interest and real estate taxes, they must not only be paid, but they must also be an obligation of the person making the payment and claiming the deduction.

Medical Expenses. Payments of a dependent's medical expenses with funds from a joint tenancy checking account (not a revocable or accommodation account, see above) are presumed to have been paid equally by the husband and wife, and each can take a deduction for one-half the total expenditure. This presumption is rebuttable, and if it can be shown that the funds came from a revocable or accommodation account, the taxpayer may be entitled to a deduction pro rata to the deposits made into it.

A dependent for medical care expenses does not have to meet the same test as a dependent for purposes of claiming a personal exemption. Therefore, a parent can deduct medical expenses incurred for a child that does not live with him or her.

Mortgage Interest and Real Estate Taxes. IRC Secs. 163 and 164 allow the deduction of mortgage interest and real estate taxes, respectively. It has long been established that for a taxpayer to be entitled to deduct these items, he or she must not only pay them, but that they must also be his or her obligation.

Under common law, where property is held in a joint tenancy or a tenancy by the entirety, the spouses have a unity of interest and both are obligated to make mortgage and real estate tax payments. The problem only presents itself when one spouse holds title to the property and the other spouse attempts to deduct amounts paid. Even if the payments came from a joint tenancy checking account, only the spouse that holds title would be allowed the deduction.

It is important that a taxpayer claiming a deduction for these items show that he or she actually made the payments. Where a spouse claiming these deductions transfers funds to another for the purpose of paying them, there must be an agreement obligating the latter spouse to use the transferred funds to make the required payments. This point was made in Kazupski [T.C. Memo. 1982-182 (1982)], where the Tax Court denied a husband a deduction for mortgage interest and real estate taxes because he failed to show the actual payments were made with his funds. This can be contrasted with Finney [35 TCM 1976-329 (1976)], where it was held that an agreement between the spouses that the funds used to pay the mortgage interest and taxes were supplied by the husband was sufficient to show that the payments were made with his funds.

Returning to Emmons, the petitioner paid the mortgage interest on a home that was owned by her mother, although both of them lived in it. The court disallowed the deduction because "petitioner has not shown that she assumed the mortgage.... The debt was not hers. We hold respondent correctly disallowed the interest deduction." The court also disallowed a deductions for personal taxes the petitioner paid on her mother's property

Casualty Losses. When a casualty loss is sustained on property held in a joint tenancy or a tenancy by the entirety, each spouse may deduct, under IRC Sec. 165, one half the loss on their separate returns. Neither spouse may deduct the total loss on his or her separate return. This position was taken by the IRS in Rev. Rul. 75-348 (IRB 1975-33, 8), where a husband was allowed to deduct only half of the loss, even though he paid the full amount of the cost to restore the damaged property.

Charitable Contributions and Other Itemized Deductions. There is no available guidance, for charitable contributions and other miscellaneous deductions, other than the general rule that a spouse may deduct on his or her separate return only those items that he or she actually paid. This rule is easy to follow when payments are made from separate funds, but becomes more murky when paid from a joint checking account. Again, reference must be made to state law and the governing instrument under which the account was set up to determine what amount each spouse is entitled to.

Arguably, if we rely upon the decisions involving the reporting of income, where payments were made from a joint tenancy checking account, the spouses are each allowed to deduct one-half the amount paid. In other types of joint checking accounts (i.e., revocable or accommodation), the spouses must look to the contributions each made to it and then deduct items in the same proportion.

Credits

Married taxpayers that choose to file separate returns are not only faced with a harsher tax-rate schedule, but also face the loss of several tax credits. These include the following:

* The credit for child and dependent care,

* The earned income credit, and

* The credit for the elderly or disabled, unless they lived apart for the full year.

These credits are only allowable to married taxpayers that file a joint return or otherwise married taxpayers that qualify for head of household status.

In addition to the loss of these credits, separate filers cannot exclude any interest income from series EE U.S. Savings Bonds that are used for higher education purposes. They also may have to include a greater amount of Social Security income than would be the case with joint filers. Separate filers that have lived together with their spouse at any time during the year are considered covered by an employee retirement plan if the spouse is so covered. This may result in an ineligibility for an Individual Retirement Account (IRA)
deduction.

Another item that taxpayers who file separate returns and have lived together for any time during the tax year lose is the $25,000 loss offset that is generally available for passive rental activities. Married taxpayers who did not live together during the year may each claim $12,500 on the separate returns.

Estimated Tax Payments

Separate estimated tax payments may only be claimed by the spouse that made them. Where joint payments were made, the spouses may agree to share the payments in any amounts they want. One spouse may even claim credit for all the payments, while the other spouse claims none. In the absence of an agreement, the spouses must share the estimated tax payments in proportion to each one's individual tax as shown on the separate returns.

The IRS has issued a revenue ruling (80-7, 1980-1 C.B. 296) that contains a formula to be used in determining the allocated share of each spouse's portion of an overpayment that was credited on the prior year's joint income tax return. Basically, the formula allocates the credit by applying the ratio of a spouse's separate tax liability for the prior year to the total of both spouses separate liability for that year, to the amount of the total payments shown on the joint return. Once this separate contribution amount is determined, the amount of the overpayment credited to each spouse is simply the difference between each spouse's separate contribution and his or her liability for taxes computed using the same ratio applied against the actual joint liability. *