This is the third and final part of my series on same-sex couples, community property law and multi-state income.
This part will detail how to handle the state returns. Refer to Part 1 for a basic overview of community property law and to Part 2 for an in-depth analysis of applying community property laws to the actual federal returns that Angie and Alice (the fictional couple being used in this example) filed.
(For people who read Part 2 when it was first published on 5/15 — Part 2 had a few errors and things that needed clarification. You might want to go back and re-read to see the changes. Thanks to an attentive reader named Ray who pointed out the error of my ways regarding dividends, which caused me to make a few other tweaks to parts of the scenario.)
The Mock Federal Return
Same-sex couples must prepare a “mock” federal tax return for use in filing their state returns. The mock return will generally use a filing status of married filing jointly, but a couple couple also use married filing separately. I tell people to use whichever filing status they would have used if they were filing the return with the IRS.
If we refer back to Part 2, if Angie and Alice filed as married filing separately, their taxable income would be exactly the same as in table 1. And their income is such that their tax liability under an MFS filing status is the same as under the single filing status of that table. End result: Angie $8,424 tax liability + Alice $10,774 tax liability + Alice $4,000 early withdrawal penalty = $23,198 total tax liability.
How about married filing jointly? In that case, there’s no community property law to worry about and everything is simply combined onto one tax return. Total taxable income = $108,500. Total tax, including the $4,000 early withdrawal penalty, would be $23,185.
Advantage, by a hair, is married filing jointly on the mock return.
Remember, our scenario has Angie and Alice moving from California to Iowa during the year. The first thing they would need to do on the state returns is file their California return. I have prepared California non-resident returns before but am by no means an expert on California taxes. Therefore I’ve decided to leave out a detailed discussion of the California return.
My interest is more in the Iowa return.
In Iowa, most couples with dual income will benefit by filing as married filing separately. I talked about this filing status in more detail here.
Part-year residents of Iowa must first calculate their Iowa taxes as if they were a full-year resident. This means reporting all income from all sources on the Iowa return and calculating their Iowa tax on all income from all sources. Then, they get to take a credit based on the percentage of income earned in the other state vs. earned in Iowa.
So, if a couple files as married filing separately on the Iowa return, does community property law apply in reporting their all-source income on the Iowa return?
The answer is, no. The California income is reported in Iowa 100% by the spouse who earned it. This is true even if Angie and Alice created a mock return with a filing status of married filing separately and applied community property law to their California income on that mock return. Iowa is not a community property state and community property law would never apply to any item on the Iowa tax return. (I should mention that, just to be safe, I did confirm this with the Iowa Department of Revenue before I wrote this blog post!)
Thus concludes this series on multi-state taxation issues of same-sex couples who move from a community property state to a common-law state.
I learned a few things along the way (see the text and the comments section of Part 2 for the things I learned/had to clarify). This is a complex topic but hopefully I helped shed a little light on it.