Giant tax headaches for gay couples

By MarketWatch

The tax rules for same-sex marriages, civil unions and domestic partnerships are fraught with complications -- and expense.

The 2000 U.S. census counted more than a million people in the U.S. who were part of same-sex couples (those who were willing to say so in census forms), according to data analyzed by GayDemographics.org. About 21% lived in states that today have laws for gay couples on the books, and some of those states allow same-sex partners to file joint tax returns.

California's recently expanded domestic-partnership law gives the largest population of same-sex couples in the country access to a sort of matrimonial tax recognition, according to GayDemographics.org.

In 2004, Massachusetts became the only state with legal same-sex marriage. A same-sex couple files a joint tax return in that state, just as any heterosexual couple would. But complications arise when it's time to prepare an Internal Revenue Service tax return, says Shari Levitan, an attorney and partner in Holland & Knight's Boston office. The federal government doesn't recognize same-sex couples, so each taxpayer must file as single.

To file jointly at the state level, that couple would have to prepare four tax returns, says Debra Neiman, a certified financial planner in Arlington, Mass., and a co-author of "Money Without Matrimony."

The couple would prepare a joint state return and a "dummy" joint federal return for the Massachusetts Department of Revenue -- because the state return is based on the joint federal return -- and then two individual returns, prepared as single filers, to actually send to the IRS.

If a tax preparer was hired, the couple would pay for four tax returns. But sometimes costs go even higher, with tax preparation for same-sex couples running double the price of two single returns. Neiman deplores the extra cost, but there is so much extra time involved that there's no way to avoid it, she said.

Why the extra time?

Levitan and Neiman explain that completing these returns is not like pushing a button. You have to devote time to separating income from joint assets, such as bank accounts, businesses and securities sales. You must split up expenses, such as medical insurance, mortgages, property taxes and business expenses. And then there are the children. How do you go about equitably splitting a child? You need the wisdom of Solomon not to alienate and anger one of the partners. Often, the child is related by blood to a partner who is not producing income.

This creates problems with dependency exemptions, earned-income credits, child-care credits, student-loan deductions and more. The Massachusetts Department of Revenue site details some special provisions that apply to same-sex couples. (Visit the Web site.)

California more complex than most

In California, where the first same-sex tax returns will be filed in 2008, Lynn Freer, the president of Spidell Publishing in Anaheim, is pushing for legislation to get the California Franchise Tax Board to allow registered domestic partners (RDPs) to file the same joint tax returns that married couples file.

Under current law, when a registered couple file jointly in California, they have to make several adjustments to their joint return based on two federal single returns. Freer says some of the rules are still unclear. For instance:

• Federal rental losses are limited to $25,000 per joint tax return or per single tax return. Will California use the combined $50,000 ($25,000 times 2) loss on the RDP return? Or just the federal joint limit of $25,000?
• What if one person has a capital loss of $100,000 but the other has a capital gain of $100,000? Will they be allowed to net the losses, or will they pay tax on the gain but not benefit from the loss?
• If one owns a home for two years and then the couple sell it, will California grant them each a $250,000 exclusion from the gain? Or just the one owner that the IRS would allow?

And so it goes. In all other states that allow joint tax returns, same-sex couples follow the same rules as heterosexual couples within the state.

The combination of elements from the two single returns will generally result in higher joint taxable income on the California Form 540 than the couple would have paid using a dummy federal joint return. For anyone, even a tax professional, preparing the California version of the RDP joint return requires a specialized checklist of line items to change, combine or eliminate. No other state has made joint filing this complicated.

Across state lines

If you got married in Massachusetts and moved to California, will California recognize your marriage for tax purposes? No. California hasn't legalized same-sex marriage.

However, if you have a registered domestic partnership in another state, California will honor that relationship and allow you to file jointly. Couples married in Massachusetts would have to register as domestic partners in California to have the same privilege.

States with domestic partnerships and civil unions have reciprocity with each other. But if you move, it's worth checking the state laws to find out whether you may file a joint return.

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