The constantly changing tax code presents challenges to nearly everyone, but Californians face particularly vexing issues thanks to both the state's unique tax system and a combination of economic and demographic trends.
Consider the fate of the Golden State's 65,000 domestic partners. Most Americans can file a federal return and expect that their answers on the key lines showing earnings and filing status to be consistent on both federal and state forms. Not domestic partners.
They must file joint returns in California and file separate returns — following a complex formula to split joint income — with the federal government.
"It's a nightmare," said Joe Calderaro, technical research specialist with the California Society of Enrolled Agents.
Capital gains? You claim a preferential rate on federal returns, but not on state returns. Worse, this disparity in tax rates can trigger an additional federal horror called the alternative minimum tax.
Then there are demographic trends — like children and parents moving in with other adult relatives to save on expenses in today's still-tight economy — which force careful review of the sometimes Byzantine rules that determine who can be claimed as a dependent.
Here's a thicket of sticky tax situations facing California residents and how you can best deal with them this filing season.
Blame better communication — or coddling — but you're almost twice as likely to have an adult child living with you today as you were in 1970, according to the Census Bureau. More than 18% of men between the ages of 25 and 34 and nearly 10% of women in that age group are living with Mom and Dad. Grandma may be part of the household too.
Although this trend toward cohabitation has been sweeping the country, nowhere is it more prevalent than in the Golden State, where the unemployment rate and living expenses are unusually high. For instance, 9% of Californians over the age of 65 are now living in the home of another family member versus 6% nationwide. That accounts for roughly 400,000 California seniors.
At tax time, merged households raise the question: Are these semi-permanent guests deductible dependents? There are numerous tests to figure the answer. However, for adults who are capable of self-care and no longer in school, the toughest test to pass is based on income, IRS spokesman Eric Smith said. If adults living with you earn more than the exemption amount of $3,700 in 2011, they normally cannot be claimed as dependents, even if you're paying more than half of their support.
It's important to note that Social Security and welfare income doesn't count. So if a grandparent gets $25,000 in Social Security and nothing else, he or she could be claimed as a dependent. But if that same grandparent collected $3,800 in investment income, he or she could not be claimed as a dependent. When income is flexible, pay attention to the threshold. A few extra dollars pulled out of a retirement account could cost a dependency deduction, which could save a family paying a 30% tax rate a cool $1,110.
Are you an Amazon.com addict? If so, you might need to take a close look at something called "use tax." Use tax essentially replaces the sales tax that you didn't pay on a purchase made from an out-of-state retailer. It has been in effect since the 1930s, but few people had to worry about it until the Internet age, when online sales became ubiquitous.
There are two ways to calculate your liability. You can either cobble together all the purchases you made out of state and online, review whether sales tax was imposed and, if it wasn't, calculate the use tax based on the sales tax rate in your county. Or you can take the easy way out and use the tax table that determines your liability based on your income. If you earn less than $20,000, your use tax would be $7. But if you earned between $150,000 and $200,000, this method assumes you'd owe $123. Earn more than that and the safe-harbor method assumes that you owe 0.07% of your adjusted gross income.
Tens of thousands of individuals have registered with the state of California as domestic partners or entered into same-sex marriages before the passage of Proposition 8. The state demands that they file joint tax returns with the Franchise Tax Board. However, the federal government doesn't recognize these partnerships, so these same taxpayers will need to file as "single" on federal returns.
Simple enough? Not so fast. Because California is a community property state, any income that would be considered community property is supposed to be split on federal returns.
So if Sue and Jane are domestic partners and earn $50,000 and $75,000 respectively, they would file a joint California return reflecting their $125,000 in gross income. But their two federal returns would each claim $62,500 in wages — $25,000 to reflect half of Sue's $50,000 and $37,500 for half of Jane's $75,000.
Whether they would need to split investment, gift and other income — not to mention itemized deductions — depends on the type of income and deduction, Calderaro said. You can't assume that tax software programs will do it right, he added. The federal government puts out Publication 555 to help determine how domestic partners should treat community property, but Calderaro's advice is simpler: "Use a qualified tax preparer."
Real estate losses
In California, there were more foreclosures and short sales — in which a home is sold for less than the amount owed on the mortgage — than in any other state in 2011, said Daren Blomquist, vice president at RealtyTrac in Irvine. Distressed sales accounted for roughly 40% of all real estate transactions in the Golden State last year, affecting more than 200,000 taxpayers.
These sales are likely to result in a disconcerting notice from lenders, showing the amount of discharged debt as income. Thanks to the Mortgage Relief Act of 2007, this phantom income is not taxable. But anyone receiving a 1099 form for discharged debt will need to fill out an additional tax form called the 982. If the forgiven mortgage debt exceeds $500,000, some of it could be subject to California tax.
If you were among the lucky few Californians able to sell your house at a profit — or you enjoyed significant investment gains — there are more complications. Both federal and state laws allow taxpayers to exclude $250,000 per person or $500,000 per couple in net proceeds from the sale of a principal residence. But any additional profit would be subject to capital gains taxes on federal returns, and ordinary state income taxes on California returns. That's the simple part.
What's complicated is something called the alternative minimum tax, which can be triggered when you pay (and deduct) significant state income taxes on a federal return. If you have substantial capital gains, several small children, extremely high property taxes or miscellaneous business expenses, you'll have to calculate your federal tax twice: once under the ordinary system and again under the alternative minimum tax system. You pay whichever calculation comes up with the higher tax obligation. Tax software programs will do the calculation for you, but you could run into trouble if you try to do your return by hand.