Married taxpayers may maximize savings by filing separately.

For most married taxpayers, Federal income tax liability can be minimized by filing jointly. In some cases, however, married taxpayers can reduce their overall tax burden by filing separately. This article will discuss when and how married taxpayers can achieve such tax savings.

Why File Separately?

The obvious motivation for filing separately is the opportunity for Federal income tax savings. Other factors, however, may motivate taxpayers to file separately: desire to lower state income taxes, planning for divorce or separation, desire to keep financial obligations segregated, desire to be shielded from the joint and several liability of joint filing, or the need to file separately if the taxpayer's spouse is a nonresident and an election to file jointly under Sec. 6013(g) is not made.

"Married" Defined

For tax purposes, marital status is generally determined as of either the last day of the tax year or, if the taxpayer died during the tax year, as of the date of death.(1) A taxpayer is not married if, as of the applicable date, he is divorced or legally separated under a decree of separate maintenance.2 Taxpayers who are "married" under these rules generally have two filing options: married filing jointly under Sec. 6013, or married filing separately. The decision to file separate returns must be made by the due date of the return for any tax year. Taxpayers initially filing a joint return for a tax year cannot later amend to file separately.3 However, married taxpayers who have originally filed separately can later amend to file jointly.4

* Abandoned spouse rule

A taxpayer is not married for tax purposes if he meets the requirements of the "abandoned spouse rule" (ASR): (1) the individual files a separate return; (2) his household is the principal place of abode for more than one-half of the year of a dependent child; (3) he provides more than 50% of the cost of maintaining the household during the tax year; and (4) his spouse is not a member of the household for the last six months of the tax year.(5)

The six-month requirement may not be satisfied if the spouse's absence from the taxpayer's residence is only temporary. The regulations indicate that a spouse's failure to occupy the taxpayer's household during the last six months of the year for reasons due to illness, education, employment, vacation or military service will not satisfy the requirement.(6) However, the courts appear to ignore the permanency of the absence, and only require that the spouses maintain and occupy separate residences for the requisite six-month period.(7) A spouse's absence under more permanent circumstances, such as incarceration or placement in a nursing home, should satisfy the ASR's abandonment requirement.

The ASR is a relief provision that allows a taxpayer to file as head of household in situations in which filing separately might represent the only other viable alternative.(8) Unless the taxpayer's spouse also qualified for the ASR, that individual would have to file as married filing separately. The combination of head of household status for one spouse and married filing separately status for the other spouse provides many married taxpayers with a lower tax liability than that achievable from a joint return. Because this tax savings can be significant, taxpayers should consider using the ASR whenever applicable.

Opportunities for Tax Savings

The greatest opportunity for separate return tax savings lies in the ability to increase the overall deductibility of adjusted gross income (AGI)-based deductions. Several itemized deductions are computed with regard to AGI, and a greater overall deduction can be achieved by concentrating these deductions on one separate return having a lower AGI than on a joint return. The AGI-based deductions include medical expenses (7.5%-of-AGI limitation), casualty and theft losses (10%-of-AGI and $100 limitations), and miscellaneous itemized deductions 12%-of-AGI limitation). See Example 1 above. Upper-income taxpayers filing separately can achieve additional tax savings by minimizing the effects of the itemized deduction and exemption phaseouts (to be discussed later).

Example 1: Filing Separately to Increase Itemized Deductions

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If married taxpayers file separately and one spouse itemizes, the other spouse's standard deduction is zero (i.e., both spouses must either claim the standard deduction or itemize).(9) The filing of separate returns also affects the application of a number of other Code provisions (discussed below). In some cases, these provisions will not alter the married taxpayers' overall tax liability, while in other cases, the filing of separate returns will result in an increased liability.

* Tax neutrality

Several provisions dealing with the treatment of married taxpayers are, in general, neutral with respect to marital filing status. While these provisions do not "penalize" (i.e., result in a reduced tax benefit for) married taxpayers who file separately, they do impose limitations on the available tax savings that can otherwise be achieved.

* Tax brackets 

The taxable income subject to each of the various lower tax rates for separate returns is one-half of the amount applicable to joint returns. The key to ensuring neutrality of these tax brackets is for each spouse to fully use the lower bracket amounts on a separate return. This requires the spouses to have relatively comparable taxable incomes. In most cases, however, married taxpayers will have disparate incomes, and the benefit of the lower tax brackets will not be fully used by each. In those cases, the increase in tax resulting from the tax brackets has to be offset by tax savings attributable to other, more favorable aspects of filing separately.(10)

Kiddie tax. Children under age 14 with unearned income greater than $1,200 will generally have a portion of their income taxed at their parents' highest marginal tax rate.(11) If the parents do not file jointly, the parental portion of the child's tax is calculated using the rate of the parent with the higher taxable income.(12) To the extent separate returns increase the kiddie tax, the tax rates are not neutral as to marital filing status. Thus, the kiddie tax must be considered in the overall strategy to save taxes by filing separately.(13)

* Alternative minimum tax (AMT)

The individual AMT is now a progressive tax with two rates. For a joint return, a 26% rate applies to the first $175,000 of alternative minimum taxable income (AMTI), and a 28% rate applies to any remaining AMTI. For a married taxpayer filing separately, only the first $87,500 of AMTI is taxed at the lower rate.14 In computing AMTI under a separate return, a $22,500 exemption is allowed ($45,000 for a joint return), reduced by 25% of AMTI in excess of $75,000 $150,000 for a joint return). Further, AMTI on a separate return is increased by the lesser of (1) 25% of the excess of AMTI over $165,000 or (2) $22,500.(15)

* Capital gains and losses

Long-term capital gains of individuals are taxed at a maximum rate of 28%, regardless of filing status.(16) This ceiling can reduce the negative effect of the separate return tax brackets when such gains are attributable to the higher-income spouse. Capital losses are not always neutral as to marital filing status, however. Up to $3,000 in capital losses are deductible against noncapital gain income for taxpayers filing jointly, and up to $1,500 for a married taxpayer filing separately.17 When each spouse has a net capital loss of $1,500 or more for any year, separate returns do not reduce the deductibility of capital losses. The capital loss rules will adversely affect separate return tax savings when one spouse has capital gain net income that, because of separate filing, cannot be offset by the other spouse's net capital loss. Additionally, separate returns will reduce the deductibility of capital losses when one spouse has a net capital loss of more than $1,500 and the other spouse has a net capital loss of less than $1,500.

* Sec. 179 expense

Under Sec. 179, a taxpayer can elect to expense up to $17,500 of the cost of tangible business property placed in service during the year. For purposes of the $17,500 limitation, married taxpayers filing separately are treated as one taxpayer.(18) In addition, unless an alternative allocation is elected by the taxpayers, the cost of Sec. 179 property placed in service during the year is allocated one-half to each.(19) If one spouse places in service a sufficient amount of Sec. 179 property during the year and the proper allocation election is made, the full $17,500 deduction can be claimed entirely on that taxpayer's separate return.(20)

* Sec. 121 exclusion

Taxpayers age 55 or older may elect under Sec. 121 to exclude from gross income up to $125,000 of gain realized on the sale of a principal residence. For a married taxpayer filing separately, the maximum exclusion is $62,500.(21) Additionally, both spouses must agree to the Sec. 121 election, even if the gain is attributable to only one spouse and separate returns are filed.(22) If a residence is jointly owned and, on disposition, each spouse has a realized gain of at least $62,500, Sec. 121 is neutral as to marital filing status. If, however, the residence is not jointly owned and gain on disposition exceeds $62,500, separate returns will result in a reduced Sec. 121 exclusion.(23)

* Itemized deduction phaseout 

A taxpayer's itemized deductions24 are reduced by 3% of the amount by which AGI exceeds a certain threshold. For 1994, the threshold is $55,900 for a married taxpayer filing separately, and $111,800 for all other taxpayers.25 While the itemized deduction phaseout is, in general, neutral as to marital filing status, separate returns can reduce the amount of the phaseout. By concentrating AGI-based itemized deductions on the return of the lower-income spouse, married taxpayers can increase their pre-phaseout itemized deductions. For married taxpayers with a combined AGI in excess of $111,800, this strategy has the additional benefit of minimizing the amount of the phaseout. Additionally, the deductions for medical expenses, casualty and theft losses, investment interest expense and gambling losses are exempt from the phaseout. To the extent these exempt deductions are allocable to the higher-income spouse, significant tax savings can be achieved by filing separately. See Example 2 above.

Example 2: Filing Separately to Minimize the Phaseout of Itemized Deductions

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* Exemption phaseout

In 1994, the deduction for exemptions on a joint return is reduced by 2% for every $2,500 (or part thereof) by which AGI exceeds $167,700.26 For a married taxpayer filing separately, the exemption is reduced by 2% for every $1,250 (or part thereof) by which AGI exceeds $83,850.27The exemption phaseout, like the itemized deduction phaseout, can also be reduced by filing separately. This is the case when the lower-income spouse is the taxpayer claiming most of the dependency exemptions. That spouse must be prepared to document that separate funds were spent to provide more than one-half of each dependent's support. See Example 3 on page 568.

Example 3: Filing Separately to Minimize the Phaseout of Dependency Exemptions

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* Educational assistance programs

Under Sec. 127, a taxpayer can exclude from gross income up to $5,250 annually for educational assistance provided by an employer. This ceiling applies per employee; thus, the exclusion is neutral as to marital filing status.(28)

* Dependent care assistance programs

The maximum exclusion for an employer-provided dependent care assistance program is generally $5,000, but the maximum exclusion for a married taxpayer filing separately is $2,500.(29) In most cases, only one spouse will have employer-provided dependent care assistance. When the benefits exceed $2,500 in those cases, filing separately will decrease the otherwise excludible amount. The child care credit may not be claimed with respect to the nonexcludible portion of dependent care assistance.(30)

* Moving expenses

For tax years beginning in 1994, the moving expense deduction is available only with respect to direct moving costs(31) (thus eliminating a prior law bias against separate returns with respect to the deductibility of indirect moving expenses). In addition, moving expenses are deductible in computing AGI(32); thus, the deduction is neutral as to marital filing status.

* Sec. 1244 stock losses

Married taxpayers filing jointly may treat up to $100,000 of losses realized on Sec. 1244 stock as ordinary. The maximum ordinary loss treatment on a separate return is $50,000.(33) The provision is therefore neutral as to marital filing status only to the extent that the Sec. 1244 stock is jointly owned or the loss does not exceed $50,000. If there is a loss in excess of $50,000 on separately owned Sec. 1244 stock, separate filing is less advantageous.

Potential Pitfalls of Filing Separately

Several Code provisions "penalize" married taxpayers filing separately. In some cases, these provisions can eliminate some or all of the tax savings otherwise obtainable. In other cases, the provisions may not even apply to the taxpayers in question. The potentially punitive provisions range from the disallowance of certain credits (e.g., child care credit), to less favorable treatment of certain income (e.g., social security benefits) and loss (e.g., rental loss) items.

* Tax credits

Generally, the child care credit,(34) the credit for the elderly or disabled(35) and the earned income credit(36) are only available to married taxpayers if they file jointly.(37) With the exception of the child care credit, however, these credits apply to low-income taxpayers who would not normally derive separate return tax savings. Additionally, the effect of the joint return requirement for the child care credit can be minimized to the extent that expenses otherwise qualifying for the credit represent deductible medical expenditures (e.g., inhouse nursing costs associated with a handicapped spouse or dependent child).

* Social security benefits

One of the more prohibitive rules regarding separate return filing is the gross income inclusion rule for social security benefits. While the base amount for married taxpayers filing jointly is $32,000 ($44,000 in the case of the 85% inclusion rules) before social security benefits are includible in gross income, the base amount for a married taxpayer filing separately is zero (as is the base amount for the 85% inclusion rules).(38) Married taxpayers receiving social security benefits therefore risk having a greater amount of benefits subject to tax by filing separately rather than jointly. See Example 4 above.

Example 4: Filing Jointly to Minimize Inclusion of Social Security Benefits

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The inclusion rules are neutral as to marital filing status to the extent the maximum amount of benefits (i.e., 85%) would be subject to tax under either filing option. See Example 5 on page 570.

Example 5: Tax Neutrality and Social Security Benefit Inclusion

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* Passive rental losses

Married taxpayers with investments in passive activities must address a potentially prohibitive limitation regarding the treatment of rental losses on separate returns. In general, no part of the $25,000 loss allowance otherwise applicable for rental real estate activities is available to married taxpayers who file separately.(39) This rule could preclude any tax savings from separate filing. If, however, the recently enacted real property business exception to the passive loss rules can be satisfied with respect to the rental losses, the separate return limitation would not affect the deductibility of such losses.(40)

To qualify for the real property business exception, the rental loss must be attributable to a taxpayer who performs more than 750 hours and 50% of personal services during the year in real property trades or businesses in which he materially participates. These rules must be met by each taxpayer, without consideration of a spouse's participation or filing status.(41) If the taxpayers' rental losses can either be treated as active losses under the real property business exception or be offset against passive income from other activities, the passive loss rules do not prohibit tax savings from the filing of separate returns.

* IRA deduction

The spousal individual retirement account (IRA) deduction for a nonworking spouse is not available unless a joint return is filed.(42) Additionally, if either spouse is a participant in an employer's retirement plan, the IRA deduction is phased out for separate return filers when AGI exceeds zero ($40,000 for joint returns).(43) For two-income households, these limitations do not preclude separate return tax savings, as most married taxpayers of moderate income would not receive an IRA deduction under the joint return phaseout rules. The nondeductible IRA is unaffected by the filing status of married taxpayers.(44)

* Education savings bonds 

Under Sec. 135, taxpayers may exclude from gross income interest realized on the redemption of certain U.S. savings bonds. The exclusion does not apply in the case of married individuals filing separately.(45) The exclusion under a joint return is subject to a phaseout when modified AGI exceeds a specific threshold. The separate return prohibition is therefore relevant only when the exclusion would not otherwise be completely phased out on a joint return.

* Loss of dependency exemption

For a joint return, the relationship test for claiming an individual as a dependent may be met by either spouse.(46) If separate returns are filed, however, the test must be satisfied by the spouse claiming the dependent.(47) Thus, separate returns may result in the loss of an exemption when an individual is supported by one spouse but is the relative of the other.

Sourcing of Income and Deductions

The key to obtaining tax savings from separate return filing is the ability to allocate certain items of income and deduction to the individual spouses to maximize specific deductions. To successfully attribute income or deductions to a particular spouse, the income or deductions have to be

sourced to that spouse. In general, state law will control the sourcing of income and deduction items to the individual spouses.(48)

* Common law states

In common law states, income is attributable to the spouse owning the related income-producing property, and deductions are attributable to the spouse who incurred the costs (i.e., when paid from identifiable funds).(49) While the segregation of income between spouses is more easily achieved under common law than under community property law, the source of funds from which deductible expenditures were made must be substantiated. To successfully support an allocation of deductible expenditures to the spouses, the expenditures should be traceable to specific spousal accounts and adequately documented.

* Community property states

The sourcing rules are more complex and less uniform in the community property states; still, taxpayers residing in such states are not without opportunities for tax savings via separate returns. In general, income and deductions will be sourced one-half to each spouse.(50) Income derived from a spouse's separate property can be either separate property income or community property income, depending on the state of residence. Deductions for expenses incurred to produce community income are community deductions and are taken one-half by each spouse. If an expenditure not related to the production of income (e.g., medical expenses) can be traced to a spouse's separate funds, that spouse should be attributed any related deduction.(51)

To overcome the presumption that expenditures are made from community funds, the taxpayers must give adequate attention to keeping each spouse's separate property segregated (e.g., maintaining separate bank accounts). The extra costs associated with these tracing and recordkeeping requirements, in addition to the costs of preparing and filing an additional return, must be compared with the potential tax savings. The documentation of this information may also be useful for other purposes, such as in determining the property includible in a decedent's estate.

Conclusion

Separate returns will not provide all married taxpayers with a reduction in their Federal tax liability. However, upper-income married taxpayers stand to save a significant amount of taxes by filing separately. This is particularly true with respect to minimizing the itemized deduction phaseout and deducting casualty losses. The exemption phaseout provides upper-income married taxpayers with additional separate return tax savings opportunities, and can be minimized by having the lower-income spouse provide over 50% of each dependent's support and maintaining the proper documentation.

Upper-income married taxpayers are not the only couples who can save taxes by filing separately. To the extent there are AGI-based itemized deductions, other married taxpayers may also realize tax savings by filing separately.

Even when some separate return tax savings can be achieved, the additional recordkeeping requirements may prove to be burdensome. However, the documentation required of separate return filers will serve other goals (e.g., estate or divorce planning), in addition to supporting tax return positions. Further, the same documentation will generally suffice to support separate returns at the state level, to the extent such returns will additionally reduce taxes.

The opportunity for providing significant tax savings to clients through additional planning and documentation should appeal to all tax practitioners. The documentation required of separate returns is generally not of a type taxpayers would ordinarily maintain. The fact that separate returns impose additional documentation requirements highlights the advance planning practitioners must perform. The consequence of this planning can be a value-added client service in the form of significant separate return tax savings. (1) Sec. 7703(a)(1). (2) Sec. 7703(a)(2). (3) Regs. Sec. 1.6013-1(a)(1). (4) SCC. 6013(b) and Regs. Sec. 1.6013-2(a)(1). (5) See. 7703(b). (6) Regs. Sec. 1. 143 - 1 (b)(5) (under Sec. 7703). (7) See, e.g., Laurel M. Hopkins, TC Memo 1992-326. (8) See Sec. 2(c). If the taxpayer has truly been abandoned by his or her spouse, a joint return may not be possible or desirable. (9) Sec. 63(c)(6)(a). (10) Under the ASR, a married taxpayer will file as a head of household. The total taxable income subject to the lower tax rates under the combination of head of household status for one spouse and married filing separately for the other is greater than that available under joint return status, For instance, the amount of taxable income subject to the 15% tax rate for that filing combination in 1994 is $49,500. Compared with a joint return, the ASR provides a potential tax savings of $1,725 at the 15% bracket alone. (11) Sec. 1(g). (12) Sec. 1(g)(5)(b). (13) If a taxpayer is filing as head of household under the ASR, the parental portion of any applicable kiddie tax will generally apply at that spouse's highest marginal rate. Secs. 1(g)(5)(a), 152(e)(1)(a) and 7703[b). (14) Sec. 55(b)(1)(a). (15) Sec. 55(d). A spouse filing as head of household under the ASR receives the full benefit of the lower tax brackets and an exemption of $33,750 (with an AMTI phaseout at $112,500). Secs. 55(b)(1)(a)(iii), (d)(1) and 7703(b). (16) Sec. 1(h). (17) SCC. 1211(b)(1). (18) Sec. 179(b)(4)(a). (19) Sec. 179(b)(4)(b) and Regs. Sec. 1.179-2(b)(6). For the allocation election, see Regs. Sec. 1. 1 79-5. (20) Regs. Sec. 1.179-2(b)(6)(i). A spouse filing as head of household under the ASR receives a full $17,500 limitation under Sec. 179. Regs. Sec. 1.179-2(b)(61(i) (last sentence) and Sec. 7703(b). (21) Sec. 121(b)(1). (22) Sec. 121(c). (23) The ownership rule of Sec. 121(a)(21 prohibits overcoming this problem with a presale gift of an ownership interest in the residence to the other spouse, unless such gift occurs at least three years prior to the date of sale. See Sec. 121(d)(1). (24) A married taxpayer filing separately may deduct mortgage interest with respect to one residence only. However, if both spouses consent in writing, one spouse may deduct mortgage interest with respect to two residences (with the other spouse receiving no mortgage interest deduction). Sec. 163[h)14)(ii). (25) Sec. 68(b)(1). The 1994 AGI threshold for a married taxpayer filing as head of household under the ASR is $111,800. (26) SCC. 151(d)(3)(b). (27) Sec. 151(d)(3)(c). For a married taxpayer filing as head of household under the ASR, the 1994 phaseout occurs at a rate of 2% for every $2,500 (or part thereof) of AGI in excess of $139,750. Secs. 151(d)(3) and 7703(b). (28) Sec. 127(a)(2). (29) Sec. 129(a)(2)(a). A married taxpayer filing as head of household under the ASR receives the full $5,000 exclusion allowance. Secs. 129(a)(2)(c) and 21(e)(4). See Sec. 7703(b). (30) See note 34 and accompanying text. (31) Sec. 217[b). (32) Sec. 62(a)(15). (33) Sec. 1244(b). (34) Sec. 21(e)(2). (35) Sec. 22(e)(1). (36) Sec. 32(d). (37) A married taxpayer filing as head of household under the ASR can also qualify for these credits. The credit for the elderly and disabled can be claimed by married taxpayers who live apart for the entire year and file separately [Sec. 22(e)(1)). (38) Sec. 86(c). Married taxpayers living apart for the entire year and filing separately, or as head of household, each receive a base amount of

$25,000 ($34,000 in the case of the 85% inclusion rules). See See. 7703(b). (39) Sec. 469(i)(5)(b). Married taxpayers living apart for the entire year and filing separate returns each receive a rental loss allowance of $12,500. The allowance is reduced by 25% of the amount by which AGI exceeds $50,000 ($100,000 for joint returns). Sec. 469(i)(5). When both spouses have rental losses of $12,500 or more, the rental loss deduction rules are neutral as to marital filing status. If, however, only one spouse has rental losses and they exceed $12,500, separate returns for taxpayers living apart may not be advisable. (40) Sec. 469(c)(2) and (c)(7). See Sage, Gorgy and Sage, "The Effect of the Revenue Reconciliation Act of 1993 on Real Estate Owners," 25 The Tax Adviser 491 (Aug. 1994). (41) SCC. 469(c)(7). (42) Sec. 219(c). For a discussion of the rules pertaining to IRAs, see Boes and Ransom, "Untangling the IRA Rules," 25 The Tax Adviser 498 (Aug. 1994). (43) Sec. 219(g). Married taxpayers living apart for the entire year and filing separately are not subject to these rules. Sec. 219(g)(4). Instead, each spouse's IRA deduction is subject to an AGI phaseout threshold of $25,000 when the taxpayer is a participant in an employer's retirement plan. Such taxpayers are not subject to the phaseout due to a spouse's participation in an employer plan. Thus, taxpayers living apart for the entire year have an opportunity to increase their IRA deduction over that on a joint return. (44) Sec. 408(o). (45) Sec. 135(d)(2). The exclusion for a spouse filing as head of household under the ASR is subject to the same phaseout rules as other nonjoint return filers. Secs. 135(d)(21 and 7703(b). (46) Regs. Sec. 1.152-2(d). (47) See, e.g., Russell S. McCann, 12 TC 239 (1949). (48) IRS Publication 555, Federal Tax Information on Community Property. (49) Audrey L. Zeeman, 395 F2d 861 (2d Cir. 1968)(21 AFTR2D 1380, 68-1 USTC [paragraph] 9406). (50) See, e.g., IRS Publication 555, note 48. (51) Mellie E. Stewart, 35 BTA 406 (1937), aff'd, 95 F2d 821 (5th Cir. 1938)(21 AFTR 20, 38-1 USTC [paragraph] 9246); Ernest W. Clemens, 8 TC 121 (1947); and Marilyn G. Dooley, TC Memo 1992-39. See also IRS Publication 555, note 48, at 3.