Census data shows that approximately 12% of all couples living together are unmarried, up from barely 1% 50 years ago. Unmarried couples can be of any age, from young people contemplating a formal union to seniors who have grown children from previous marriages, and may be same-sex or opposite-sex couples. When it comes to tax obligations, unmarried couples may enjoy advantages over their married peers. Nevertheless, the tax code does provide some benefits for married couples and drawbacks for the unwed. Skillful planning by financial advisors can help unmarried couples avoid missteps that can lead to painful mishaps.
To Wed or Not To Wed
For income taxes, the marriage penalty still exists, especially for couples where both partners enjoy high incomes. Suppose, for example, Tom and Sheila are both successful executives, each with taxable income of $300,000 in 2016. Living together but not married, Tom and Sheila file as single taxpayers. They’re both in the 33% tax bracket ($190,150 to $413,350 for single filers in 2016).
If Tom and Sheila get married in December 2016 and file a joint return for the year, their taxable income would rise to $600,000. This would move them into the top 39.6% bracket (over $466,950 for joint filers in 2016). Choosing “married filing separately” would result in a similar increase in tax brackets.
This marriage penalty may also affect taxpayers with moderate incomes, especially if both partners are collecting Social Security benefits. Those benefits are tax-free for many seniors with low incomes, but those with high incomes will owe tax on 85% of their benefits. In the middle, the calculation can be complex.
To gauge whether Social Security benefits are partially taxable, taxpayers calculate their combined income, which is the total of adjusted gross income, any tax-exempt interest income, and one-half of Social Security benefits. If a single taxpayer has combined income under $25,000, Social Security benefits will not be taxed; however, taxation begins at $32,000 of combined income on a joint return. Taxability scales up as income increases.
Thus, for example, Larry could have $24,000 of combined income and owe no tax on his Social Security benefits, as he’s below the $24,000 threshold. If Larry is living with Frank, who also has $24,000 in combined income, they could file single tax returns and enjoy untaxed Social Security benefits. If Larry and Frank were to marry and show $48,000 in combined income, however, they would be well over the $32,000 threshold for combined income on a joint return and would owe a substantial amount of tax on their benefits. This might be another reason for Larry and Frank not to get married.
On the other hand, suppose that Olivia, who has $75,000 in annual taxable income after deductions, lives with Mandy, who stays at home with their young child. The couple is not married, so they file as single taxpayers, with Olivia well into the 25% tax bracket ($37,651–$91,150 for singles in 2016). Mandy, with no earned income, owes scant income tax. If Mandy and Olivia were to marry, they could file a joint return; assuming their joint taxable income remains at $75,000, they would stay within the 15% bracket and owe less in tax. For such couples, the marriage penalty is actually a marriage bonus.
Of course, tax savings are not likely to be the most important factor in deciding when to marry, or whether to marry at all. Nevertheless, the issue may be a consideration if major amounts are involved, at least when it comes to setting the date.
Joint Tax Returns for Unmarried Couples
The IRS lists several tests for filing jointly, such as married and living together or married and separated. One such test might apply to unmarried couples; taxpayers can file a joint tax return if “you are living together in a common law marriage recognized in the state where you now live or in the state where the common law marriage began.”
A minority of states recognize common law marriages, but such marriages may be recognized in other states if the couple relocates. The states recognizing common law marriages all have their own rules, but living together for a given amount of years will generally not be enough to qualify. Often, the couple may have to represent themselves as being married. An unmarried couple seeking to file a joint tax return should seek local counsel on the possibility of qualifying as common law spouses.
To extend the example above, Olivia might be able to claim Mandy as a dependent and take an exemption, which will provide a $4,000 tax deduction in 2016, subject to the phaseout of personal exemptions for high-income taxpayers. For Olivia to claim Mandy as her dependent, she must provide over half of Mandy’s total support (housing, food, utilities, clothing, education, healthcare, travel, recreation). In addition, Mandy must earn less than $4,000 in 2016 and be a U.S. resident who lives with Olivia the entire year. In addition, Mandy cannot file a joint return, even if she is still married to a previous spouse.
Another possibility is to have Olivia file as head of household if Olivia and Mandy have a child who lives with them more than half the year (other than temporary absences such as attending school). Olivia might be able to claim exemptions for Mandy and their child and perhaps save more tax by using the child credit and dependent care credit.
Single Success Stories
Even if a cohabitating couple has no desire to get married, there may still be ways to reduce the household’s income tax bill. One strategy is to arrange financial matters so that the higher-income partner has the tax-deductible expenses; the higher the tax bracket, the more tax saved from deductible outlays.
Suppose that Karen has $250,000 in taxable income in 2016 (33% bracket). She lives with Ivan, whose taxable income is $75,000 (25% bracket). This unmarried couple decides to contribute a total of $10,000 to their favorite charities. If Karen writes the checks for the donation, she will reduce her taxable income by $10,000 and save $3,300 in tax. If Ivan writes the checks, he will save only $2,500. Therefore, it makes sense for Karen to make the couple’s charitable donations from her personal checking account.
The same principle applies to other tax-deductible expenses. Suppose Karen and Ivan buy a home, taking out a mortgage. Karen should be sure that her name is on the property deed and mortgage documents, and she should also tell the lender to put her Social Security number on the report of mortgage interest filed with the IRS. Karen should also write the monthly mortgage payment checks so that she can take the deduction for interest paid.
A Matter of Ownership
One Tax Court case (Wheeler v. Comm’r, T.C. Summary Opinion 2011-83, July 6, 2011) illustrates the issues that can arise unless all proper steps are taken to secure a tax deduction for mortgage interest. Here, Wheeler moved in with her boyfriend Beeman in 2003, residing in a house owned by Beeman. When Beeman went back to school and eventually became a stay-at-home dad for their child, Wheeler took over responsibility for paying the bills. Wheeler would remit an amount for the home mortgage payments to Beeman, who would send the money to the lender. In June 2007, Wheeler’s name was added to the mortgage and placed on the deed to the home; she began making mortgage payments directly at that time. For 2007, Wheeler claimed over $16,000 of mortgage interest payments as deductions. The lender, however, reported less than $6,000 of interest payments from Wheeler to the IRS. This was the amount Wheeler personally paid in 2007 after her name was added to the mortgage and the deed.
The IRS allowed the amount reported as interest deductions but disallowed the balance of over $10,000. Wheeler took the matter to Tax Court, which held that she was not “either a legal or equitable owner” of the home before being named as such. Thus, only the payments made after Wheeler officially became an owner could be tax-deductible mortgage interest outlays.
Beyond mortgage interest deductions, which income tax planning strategy should unmarried couples apply to real estate property tax payments? Should Karen write those checks as well, instead of Ivan, to get the tax deduction in her higher bracket? That depends on whether she will be subject to the alternative minimum tax (AMT). Taxpayers who are subject to the AMT cannot deduct state or local tax payments. Thus, if Karen is subject to the AMT but Ivan is not, then Ivan should pay the property tax bills. If Ivan is a co-owner of the home and not subject to the AMT, he can deduct the property tax payments.
Moreover, Ivan has lower taxable income than Karen. If he also has lower adjusted gross income (AGI), then he should be the one to pay for items that qualify as miscellaneous itemized deductions, such as tax preparation fees, legal bills, and investment expenses. Miscellaneous items are deductible only to the extent that they exceed 2% of AGI, and Ivan has a lower hurdle than Karen.
The 0% Solution
Unmarried couples where one partner has little or no taxable income may also be able to save on long-term capital gains taxes. The partner with ample earned income can transfer appreciated assets to the partner with scant income, who can sell those assets. As long as the seller has taxable income of no more than $37,450 (in 2016), realized gains on assets held longer than one year will have a 0% tax rate. Such transfers may have gift and estate tax consequences, however, which should be evaluated.
Another tactic for unmarried couples is to put investments in the name of the low-income partner. That could result in a 0% tax rate on dividends as well. Losses from investment property might be deductible if the property is held by the low-income partner, while such losses might not be immediately deductible by the high-income partner.
Tax breaks on capital gains are also available on the sale of a principal residence. Married couples can exclude up to $500,000 of such gains, while single taxpayers get a $250,000 tax exclusion. An unmarried couple can take a $250,000 capital gain exclusion on each partner’s single tax return, essentially leveling the playing field with married couples. This only applies, however, if both partners have owned and lived in the home for at least two of the five years prior to the sale. If practical, an unmarried couple should wait until both partners pass the ownership and residence tests before entering into an extremely profitable home sale.
Grasping the Gift Tax
Married couples can make unlimited gifts to each other with no tax consequences, but this is not true for unmarried couples. For non-spouses, the annual gift tax exclusion is $14,000 a year as of 2016; that is, a taxpayer can give up to $14,000 worth of assets to any number of recipients with no tax consequences.
Suppose high-income Julia and homemaker Helen live together but are not married. Julia wants to sell $100,000 worth of stock at a $25,000 long-term gain. She could give the shares to Helen, who would owe 0% tax on the sale, rather than the 15% or 20% Julia would owe. Julia’s $14,000 gift tax exclusion will not cover the transfer, however, so Julia would have to file a gift tax return, Form 709, to report the excess $86,000 gift.
For many unmarried couples, this will not be an issue. In 2016, each taxpayer has a $5.45 million cumulative gift tax exemption. Thus, Julia can keep making gifts to Helen, tax-free, until the total of reported gifts reaches $5.45 million. The tax savings may be worth the time and expense of filing a gift tax return, assuming Julia is willing to transfer the $100,000 to Helen.
Gifts between unmarried partners may have another effect: taxable gifts reduce the estate tax exemption of the person making the gift. If the estate tax exemption is $6 million when Julia dies, and she has made no other taxable gifts to anyone, her estate tax exemption would be reduced to $5,914,000, more than ample for many people. Nevertheless, Julia may anticipate leaving a larger estate, or she may live in a state with an estate tax and a smaller exemption. In those situations, sophisticated estate planning strategies might be advisable, including the use of trusts.
CHECKLIST FOR ACTIONS BY UNMARRIED TAXPAYERS
- [ ] If marriage is a possibility, calculate the probable income tax burden or savings.
- [ ] If marriage is not desired and both parties will file singly, check to see if one can claim the other as a dependent.
- [ ] If a child lives with the couple, explore the possibility of filing as head of household.
- [ ] Determine whether the higher income partner should pay tax-deductible expenses.
- [ ] Arrange homeownership to support mortgage interest and property tax deductions for the partner who will benefit the most.
- [ ] Investigate titling options for investments so that ownership may facilitate low-bracket income and maximum tax deductions.
- [ ] Compare unified health insurance coverage with separate plans.
- [ ] Decide whether either partner’s net worth is likely to require sophisticated gift and estate tax strategies.
- [ ] Create an estate plan that ensures the desired inheritance after one partner dies.
- [ ] Understand how to handle an inherited retirement account after the account owner’s death for extended tax deferral.
Another point to consider: anyone can pay education tuition and medical expenses for someone else with no gift tax consequences. There are no limits to these exclusions, and there is no need to file a gift tax return. To qualify, Julia must make the payments directly to any school that Helen attends or to any medical provider treating Helen.
No Equality in Estate Tax
Just as the tax code favors married couples when it comes to gift tax, the same is true for estate tax. If Julia and Helen were married, and Julia were to die first, she could leave any amount to Helen free of estate tax, assuming Helen is a U.S. citizen. A recent addition to estate planning known as portability allows a surviving spouse to use any estate tax exemption not used by the first spouse to die.
Unmarried cohabitants, though, do not receive these benefits. A bequest from Julia to non-spouse Helen is treated the same as a bequest to a child, a cousin, or the neighbor across the street. Assets up to $5.45 million are exempt from estate tax for deaths in 2016, and any excess amount is taxed at 40%.
As mentioned above, the $5.45 million exemption will spare many unmarried survivors from owing estate tax. Still, those with have larger estates, especially business owners and individuals with extensive real estate holdings, may benefit from sophisticated planning.
Moreover, tax planning might not be a prime concern for unmarried couples. Instead, the key might be making sure Julia’s assets pass to Helen, as per her intentions, if she is the first to die. Unmarried cohabitants should both have wills drafted by experienced attorneys, as state intestacy laws generally do not favor unmarried surviving partners. For assets that pass outside of a will, such as retirement accounts, beneficiary forms should specify the unmarried partner as the desired recipient.
To protect unmarried heirs from challenges from other parties, such as relatives, extra steps might be necessary. Life insurance can guarantee a payout to the surviving partner. As another tactic, assets could be transferred or bequeathed to a trust, with the unmarried partner named as trust beneficiary. Alternatively, assets might be titled as joint tenants with right of survivorship, so that one co-owner will automatically inherit after the other dies.
Yet another wrinkle in estate planning involves retirement plans such as IRAs and 401(k)s. After the account holder dies, a surviving spouse beneficiary can rollover the account to her own IRA, which can provide extended tax deferral. A surviving non-spouse beneficiary cannot do this. Ongoing tax deferral might be limited to five years, or even less than a year, before the account must be depleted. Fortunately, surviving non-spouses do have some better options. The decedent’s account may be rolled directly to an inherited IRA, titled in the participant’s name for the benefit of the non-spouse beneficiary. Then the non-spouse beneficiary may stretch out the tax deferral over a longer time period.
Health Insurance Pitfalls
Some surprising tax code pitfalls may trap unmarried couples. For example, employment-based health insurance premiums paid for an employee’s spouse and legal dependents are excluded from taxable income, but not for unmarried partners.
Suppose Andy and Brett are an unmarried couple. Brett is a freelancer, while Andy works for a company with a health plan that includes coverage for unmarried partners, so Brett can be covered by Andy’s plan. The premium paid by Andy’s company to cover Brett will be considered taxable income. In this example, Andy may have to pay for Brett’s health insurance premiums with after-tax dollars, as well as pay income taxes on the company’s cost of the benefit for Brett.
One solution would be for Andy and Brett to get married. If that is not desirable, it might be preferable for Brett to purchase his own health insurance, perhaps through their state’s Affordable Care Act exchange. Advisors can help by calculating the after-tax cost of including Brett on Andy’s health insurance and comparing it with Brett’s costs for obtaining his own plan. Self-employed health insurance premiums may also be tax-deductible. They should note, however, that federal Consolidated Omnibus Budget Reconciliation Act (COBRA) health insurance rules, which offer some continuation of health insurance at full cost, do not apply to an unmarried partner if a covered employee loses or leaves a job.
Hurdles for Unmarried Couples
Couples who live together without being married can face significant tax hurdles. Careful planning that enlists the aid of a knowledgable financial advisor, as well as an attorney if necessary, can mitigate the effects of these hurdles and ensure financial security for these couples, regardless of what challenges they face.