The advent of marriage for same-sex couples in Connecticut and New York has altered the legal landscape in many respects. This dramatic change in the rights of same-sex couples has not, however, affected one important area of law: federal taxes.
The federal Defense of Marriage Act prevents the Internal Revenue Service from interpreting the tax law to include same-sex couples in any reference to “spouses” or “marriage.” Therefore, federal tax law continues to treat married same-sex couples as if they were unmarried individuals.
As a result, married same-sex couples face a number of knotty federal tax issues, including:
1. NO MARITAL DEDUCTION
Federal estate and gift tax law generally permits spouses to transfer property between themselves without incurring any gift tax (on transfers made during one’s lifetime) or estate tax (on transfers occurring at one’s death). Such tax-free transfers are unavailable to married same-sex couples. If a person transfers property to his or her same-sex spouse, that transfer will be subject to gift or estate tax unless the transfer is covered by the transferor’s gift or estate tax exemption.
2. NO DISCLAIMER
An increasingly popular estate planning strategy is to permit a surviving spouse to disclaim any property passing from the deceased spouse and to have the disclaimed property held in a trust for the benefit of the survivor and other family members. The purpose of the disclaimer is to allow the decedent’s estate tax exemption to be applied to the property held in the trust. Federal tax law permits the survivor to disclaim property and still benefit from the disclaimed property held in trust, but only if the survivor is the spouse of the decedent. Since a married same-sex couple cannot be treated as “spouses” under federal tax law, this disclaimer strategy is unavailable.
3. NO PORTABILITY OF FEDERAL ESTATE TAX EXEMPTION
Under the current federal estate tax law, each decedent has an estate tax exemption of $5,000,000. If the estate of the first spouse to die does not utilize all of that decedent’s exemption, the unused amount of the exemption will be available in the estate of the surviving spouse. This is commonly referred to as the “portability” of the estate tax exemption. Portability, however, will not be available in the estates of same- sex couples. This will necessitate more sophisticated planning to ensure that the exemption of the first spouse to die is utilized.
4. NO TAX-FREE TRANSFERS IN DIVORCE
When property is transferred between spouses as part of a divorce settlement, federal tax law shields each spouse from any tax consequence resulting from the transfers (such as a capital gains tax on the built-in appreciation of transferred property). This tax relief, however, does not apply to divorcing same-sex couples and thus may lead to tax liabilities when the couple’s property is divided.
5. NO SHIFTING OF INCOME TAX ON ALIMONY PAYMENTS
Federal tax law permits divorcing spouses to shift the income tax burden of alimony payments by allowing the paying spouse to deduct the payments and the receiving spouse to include the payments in taxable income. This tax shifting is not permissible for divorcing same-sex couples, and the federal tax law is unclear about how to treat alimony payments between same-sex couples.
6. NO QUALIFIED PLAN ROLLOVER
When the participant in a 401(k) plan or other qualified retirement plan dies, his or her surviving spouse can roll over the plan balance to an IRA in the name of the survivor. A surviving same-sex spouse, however, cannot have the benefit of rollover to his or her own IRA.
7. NO JOINT SPOUSAL $500,000 EXCLUSION OF GAIN ON SALE OF RESIDENCE
The federal tax law allows each individual, subject to certain requirements, to exclude up to $250,000 of capital gain resulting from the sale of his or her residence. For married couples, their aggregate exclusion of $500,000 may be claimed even if one spouse is not an owner of the residence. Thus, if one spouse purchases and is the title owner of the residence in which both spouses reside, then upon the sale of the residence the spouses will be able to exclude $500,000 of the capital gain from their income for tax purposes. For same-sex couples, the joint spousal exclusion of $500,000 is unavailable and instead each spouse must separately use his or her separate $250,000 exclusion. Thus, if the residence was purchased solely by one same-sex spouse, only that spouse’s $250,000 exclusion will be available to shield capital gain from tax upon the sale of the residence. The other spouse’s exclusion can be used only if he or she has contributed to the purchase price, and will be applicable only to the portion of the capital gain attributable to his or her share of the residence.
Although these tax issues may seem daunting, there are planning strategies that may offer solutions in many cases. For more information, please contact Robert L. Teicher (rteicher@brodywilk.com).