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This was originally published on PAOO on July 5, 2010
I promised the above title in my last installment, so I will stick with it. I apologize if it seems that I am being disrespectful to someone who is barred from being married. In my defense, when it comes to taxes, my viewpoint is totally pragmatic. It is what it is. Whenever I hear somebody say that “That doesn’t make sense”, my response is “That is not a requirement.”
In my last installment, I commented on CCA 201021050 which indicates that registered domestic partners in California should be splitting their community income in filing federal tax returns. This will often give them a better deal than if they were married filing a joint return. I have seen commentary that the ruling should apply to California same-sex married couples who are barred from federal joint filing by DOMA. I indicated that there are significant tax planning opportunities for unmarried couples in all states. As in my previous post, I find it easiest to talk about this in terms of a hypothetical couple called Robin and Terry. Gets around those awkward pronoun problems. Robin and Terry are a highly committed couple who view themselves as an economic unit. For some reason or other, they are not married. So what can they do that a married couple can’t?
1. The standard deduction – Even if property is held jointly, either one can pay the real estate and mortgage interest and deduct it. (You cannot deduct somebody else’s taxes, but you can deduct all of the taxes on a property you own part of, if you pay all of it.) Robin and Terry each maintain a separate checking account. (This is a step I have found some couples find difficult to implement.). Robin pays for the groceries, home repairs, country club dues, etc. Terry makes the mortgage payments, pays the real estate taxes and makes their charitable contributions. (Terry cannot pay Robin’s state income tax, but if they have a significant diversified portfolio, Robin should own the US obligations and exempt obligations of their state of residence.) Through these steps, Robin and Terry will between them be able to deduct all their itemized deductions and one standard deduction.
2. The deferred salary – If Robin owns a C corporation (call it Robco), Robco can employ Terry. Robco should pay Terry once a year. If Robco is an accrual basis corporation it can accrue the salary due to Terry and pay it to Terry, a cash basis taxpayer in the subsequent year.
3. The free basis step-up – If Robin owns a rental property, Terry can buy it by giving Robin a long-term installment note. Robin will recognize no income until the principal is paid. Terry will have a stepped up basis for purposes of depreciation or even sale. (Thus it would even be worth doing with a vacation property, if it is likely to be sold.)
4. The basis swap – If Robin owns a high basis property and Terry owns a low basis property and they wish to sell the latter, they can do a like-kind exchange prior to the sale, thereby reducing the gain.
5. The wash sale – If Robin wants to maintain a securities position but harvest capital losses, Terry can purchase the identical security on the same day that Robin sells.
6. Forget the trade-in – If Robin has a luxury automobile that is used for business, that they would like to hang onto, Robin can sell it to Terry at loss, which unlike depreciation is not subject to luxury limitations.
If a couple chooses to use any of these techniques, the most likely way they would fail on audit is through poor execution. Everything must be done in the same way as it would be done in a truly arms-length transaction. If there is a note for a property sale a mortgage should be recorded. Payments should be made regularly as defined by the terms of the contract. Separate accounts should be maintained and receipts and disbursements should be scrupulously deposited or disbursed from the correct account (e.g. After the free basis step up, rents should go into Terry’s account and property expenses, including the interest due Robin, should be paid out of that account).
A further caveat is that I have not worked out how CCA 201021050 might affect the workings of theses techniques for California registered domestic partners.