Tax Issues That Concern Unmarried Couples

There are many differences in the way the tax code applies to an unmarried couple as compared to a married couple. For tax purposes, you're considered to be two unrelated single people. Because the tax code provides certain benefits to married couples, you may face disadvantages in how you're treated for income tax purposes as well as for federal gift and estate tax purposes. On the other hand, there are some advantages to filing your federal income tax returns as two single taxpayers rather than as a married couple.

Marriage Penalty
The fact is, it's often more advantageous to be single than to be married (at least from a tax perspective). This concept is often termed a "marriage penalty." The marriage penalty refers to the inequitable result that can occur when a couple that files as married filing jointly (MFJ) winds up with a tax liability that is greater then it would have been if they were unmarried and filing as single individuals. This occurs when the tax code provides a standard deduction for MFJ filers in an amount that is less than twice the amount for single filers, tax brackets that are wider but not twice as wide as those for single filers, and other inequities. Whether spouses experience the marriage penalty depends on many factors including the distribution of earnings between them (some spouses may actually experience a marriage "bonus"). Spouses who earn relatively equal amounts are more apt to experience the penalty than spouses who earn disproportionate amounts.

The Economic Growth and Tax Reconciliation Act of 2001 (2001 Tax Act), the Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act), and the Working Families Tax Relief Act of 2004 reduce, but do not completely eliminate, the marriage penalty by: (1) increasing the MFJ standard deduction to twice the single standard deduction, and (2) widening the MFJ 15 percent tax bracket to twice as wide as the single 15 percent tax bracket. These changes are effective through 2010.

Other income tax issues
Domestic partner health benefits counted as income
When you're an unmarried couple, the value of health insurance your employer provides to your partner under a domestic partner benefit plan is taxable to you as income (unless the partner otherwise qualifies as your dependent). In contrast, health insurance coverage provided by your employer to your spouse generally is not taxable. For more information on this topic, refer to Insurance Issues That Concern Unmarried Couples or Special Considerations for Gay and Lesbian Couples.

Claiming dependents
You can claim your unmarried partner and his or her children as dependents only under certain conditions. In contrast, married couples may be able to claim each other's children as dependents.

Personal exemption
In 2007, every taxpayer, regardless of filing status, can exempt $3,400 from income tax. As a single person, your exemption starts phasing out at $156,400 of adjusted gross income (AGI). For a married couple filing jointly, phaseout begins at $234,600.

Deductions
As single filers, you can't combine deductions. You also can't claim deductions for expenses that were paid by your partner. In contrast, married couples filing jointly can combine itemized deductions. They can also use business or investment losses belonging to either partner to offset either partner's gains (subject to the usual limitations on the use of losses, like the passive loss and at risk rules).

Limits on itemized deductions
In 2007, itemized deductions, excluding medical expenses, investment interest, and casualty losses, are reduced by 3 percent of AGI in excess of $156,400 regardless of whether you are a single filer or a married couple filing jointly.

Phaseout of individual retirement account (IRA) deduction
In 2007, your deduction for traditional IRA contributions as a single filer begins phasing out at $52,000 in modified AGI and is completely phased out at $62,000. For a married couple, it begins phasing out at $83,000 in modified AGI and is completely phased out at $103,000.

Phaseout of Roth IRA deduction
For 2007, your maximum annual contribution to a Roth IRA as a single filer begins phasing out at $99,000 in modified AGI and is completely phased out at $114,000. For a married couple, it begins phasing out at $156,000 in modified AGI and is completely phased out at $166,000.

Converting traditional IRAs to Roth IRAs
Taxpayers with modified AGI of more than $100,000 canít convert a traditional IRA to a Roth IRA. The limit is the same for both single taxpayers and married couples filing jointly. (Married taxpayers filing separately arenít allowed to convert.)

Example(s): Robin has modified AGI of $100,000, and a traditional IRA worth $50,000. Robinís unmarried partner, Terri, has $500 of modified AGI, and a traditional IRA worth $125,000. Since neither has modified AGI in excess of $100,000, both Robin and Terri are eligible to convert their traditional IRAs to Roth IRAs. However, if Robin and Terri were married, their total modified AGI would be $100,500. Since this is greater than $100,000, neither would be eligible to convert to a Roth IRA.

Tip:ÝThe Tax Increase Prevention and Reconciliation Act of 2005 eliminates the $100,000 ceiling for converting a traditional IRA to a Roth IRA for tax years after 2009. In addition, married individuals filing separate tax returns will be able to convert funds from a traditional IRA to a Roth IRA beginning in 2010.

Deduction for passive losses
Taxpayers generally cannot deduct losses from passive investment activities (such as investment in real estate) against income from wages, business activities in which they actively participate, and portfolio investments. However, if you fulfill certain IRS requirements for having actively participated in management of the rental real estate, then you are allowed to offset certain rental losses against your income from other business and investment activities. Here, as two single filers, you have the advantage. A married couple can offset only up to $25,000 of passive losses from rental real estate activities against income from nonpassive sources each year. This $25,000 allowance begins to be phased out when your AGI is $100,000 and is completely phased out when your AGI reaches $150,000. However, if you file singly, you may each be eligible to offset up to $25,000 of passive losses from rental real estate against income from nonpassive sources each year for a combined annual maximum of $50,000.

Limits on the size of nontaxable estate
Everyone is entitled to the estate tax applicable exclusion amount (formerly known as the unified credit) that shelters up to a certain amount from federal estate taxes. If you and your partner are unmarried at the time of your death, your estate will be taxed on any amount you leave your surviving partner in excess of your applicable exclusion amount. Married couples, however, benefit from the unlimited marital deduction. As a result of this deduction, there is no limit on the size of the estate that can be left to the surviving spouse free from federal estate taxes.

Technical Note: The estate tax applicable exclusion amount is $2 million in 2006 through 2008, and $3.5 million in 2009. In 2010, the estate tax will be repealed for one year only. In 2011, the estate tax will be reinstated and the estate tax applicable exclusion amount will be reduced to $1 million.

Taxation of jointly held property
Although it avoids probate, property you share in joint tenancy with rights of survivorship (JTWROS) does not automatically escape estate taxes. When you're an unmarried couple, the entire value of property you hold jointly is included in the gross taxable estate of the first to die, unless your estate can prove the surviving partner contributed to the cost of the property. In other words, your estate must prove the property wasn't a gift. You should keep accurate records of your payments on jointly held property to verify your share of the ownership. For more information on JTWROS, refer to Property Ownership Issues That Concern Unmarried Couples.

Transfers of property to your partner
If you and your partner are unmarried, any property you transfer to your partner for less than its fair value may be considered a gift subject to gift tax over $12,000 per donee. Ordinarily, you may think of a gift as something you give expecting nothing in return. The IRS, however, considers gifts to include uneven exchanges of property.

Example(s): If Pat, who owns a house worth $300,000, adds his unmarried partner Sandy's name to the deed without a fair exchange of value, the IRS would consider this a $150,000 gift. Assuming that Pat had already exhausted his $1 million gift tax applicable exclusion amount, Pat would be subject to federal gift tax on $138,000 ($150,000 less the $12,000 annual gift tax exclusion).

Caution:ÝThe applicable exclusion amount for gift tax purposes is fixed at $1 million even though the applicable exclusion amount for estate tax purposes increases through 2009 (see above). Any portion of your gift tax applicable exclusion amount you use for lifetime gifts effectively reduces your estate tax applicable exclusion amount that will be available at your death.

A married couple, however, can transfer any amount of assets to each other free from gift tax due to the unlimited marital deduction.

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