Before you get your hopes up . . .
Here's the rub: You and your spouse cannot just split up your income and deductions any way you want in order to maximize the MFS tax savings. Instead, state law determines how you must divide up your income and deductions.
The single most important factor is whether you live in one of the nine community property states (Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington and Wisconsin). If you do, you may be unable to gain much benefit from filing separately because you will probably have to split most or all of your income and deductions 50/50.
If you live in one of the 41 non-community-property states or the District of Columbia, the general rule is that you and your spouse can each report the income you earn and the deductible expenses you pay on separate returns. (See IRS Publication 17 on the IRS website.) For instance, the tax savings in the preceding example can be collected as long as the husband paid all the medical bills out of his own account and split the other deductible expenses 50/50 with his wife (by paying them out of a joint account funded equally by both spouses, for example).
Beware of the dark side of filing separately
Beware: Using MFS status can disqualify you from a number of potentially valuable tax breaks. For instance, the following tax goodies are off-limits.
- The child and dependent care tax credit.
- The deduction for college tuition expenses.
- The American Opportunity and Lifetime Learning tax credits for higher education expenses.
- The college loan interest write-off.
- The deduction for up to $3,000 of net capital losses (the deduction is limited to only $1,500 on a separate return).
- The right to make a Roth IRA contribution if your separate AGI exceeds $10,000.
This is not a complete list. You should always "run the numbers" with your tax preparation software when evaluating whether MFS status might work for you.
If you live in a community property state
In the nine community property states, state law requires community income to be split 50/50 between the spouses. Therefore, you and your spouse must split community income down the middle if you use MFS status. Community income generally includes all income from wages and providing services (it doesn't matter which spouse actually earns the income). Community income also generally includes all income from community property assets -- those assets that are considered owned 50/50 under state law.
Deductible expenses paid out of community property funds must also be split 50/50 if you use MFS status. Deductible outlays paid out of separate property funds generally must be allocated to the spouse who paid them. (Separate property usually means assets acquired with funds from gifts and inheritances that you've kept separate from community property assets.)
If you use MFS status, each spouse can claim his or her own personal exemption ($3,700 for 2011) on his or her separate return. You can allocate exemption deductions for your dependent kids ($3,700 each for 2011) any way you want.
Because the typical outcome for community property state residents is that most or all income and deductions must be split 50/50, there is usually no tax-saving advantage from filing separate returns. Using MFS status is beneficial only when you're allowed to split income and deductions unequally, as illustrated in the example.
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