Six years ago, my wife and I celebrated our first Valentine’s Day together. We were at a fancy steak restaurant enjoying a romantic conversation when out of nowhere she handed me a red velvet box. I fondly recall that day when my wife gave me my first pendant from the Jane Seymour Open Hearts Collection. **SWOON** I was completely smitten, but I digress.
It is estimated that roughly 6,000,000 couples get engaged every Valentine’s Day. Think about that. That is a lot of chocolates, diamonds and chocolate diamonds (if you shop at Zales). It’s a pretty romantic day. For those of you hopeless romantics who are considering getting engaged this Valentine’s Day, but want to look before you leap, I thought it would be fun to examine the tax and legal ramifications of marriage. After all, only fools rush in, right?
In addition to enjoying the benefits of having a soul mate, someone who cares about you no matter what and who’ll put up with your morning breath (to a point), marriage comes with a number of (often overlooked) tax benefits that come with marriage.
- Unlimited Spousal Gifting: Generally speaking, you can transfer an unlimited amount of assets from spouse to spouse without incurring Federal Estate and Gift Taxes. For those of you who are unfamiliar with what Estate & Gift Taxes are, they are a tax on assets you transfer to others either 1) during your lifetime or 2) at your death. The current tax rate for these taxes is 40% but it only applies once you’ve used up your unified exemption. The current exemption amount is $5.45 million per spouse and is indexed for inflation.
The unlimited spousal deduction can be very helpful in protecting assets from taxes when you have one very wealthy individual who marries another individual who is not so financially blessed (i.e. J. Howard Marshall and Anna Nicole Smith). In such a case, Mr. Marshall can pass along a large amount of assets to his much younger spouse, tax-free, in order to defer any estate taxes due upon his impending death. Furthermore, Anna Nicole Smith will have a largely unused exemption which can be used to protect more of Mr. Marshall’s assets upon her passing.
- Stepped Up Basis For Community Property: Under most circumstances after you sell an asset that appreciated in value you pay a capital gains tax. If that asset is owned by an individual at the time of their death, the IRS allows for what is called a “step up in basis” whereby any capital gains in the asset are eliminated up to the fair market value of the asset on the decedent’s date of death. Let’s say a married couple purchase a beachfront rental property as community property in Manhattan Beach in 1975 for $100,000 and the property is now worth $1,000,000. If the property is sold while the couple is still living, there would be a capital gain on $900,000, the difference between the sales price and the original purchase price (assuming no capital improvements). If the property is sold after one spouse passes away, the new basis in the property would be the fair market value on date the spouse died, in this case, $1,000,000. This means that the surviving spouse could sell the property for $1,000,000 without incurring any capital gains. Let’s assume instead that the property was owned as joint tenants by two first cousins. If one cousin died and the surviving cousin sold the property immediately afterwards, there would only be a step up on 50% of the property and the other 50% would keep the original basis for capital gains purposes. Without getting too technical, married couples who own assets as community property can eliminate significantly more capital gains tax on death than non-married individuals who own assets jointly.
- Federal Income Tax Savings: Couples whose incomes vary widely often receive tax savings as a result of filing jointly as a married couple. Usually when one spouse with a relatively high income marries and files jointly with a spouse with a significantly lower income, the additional income is usually not enough to push the couple’s combined income into a higher tax bracket. However, because the income tax brackets are wider for married couples, a larger percentage of the couple’s income is now taxed in lower brackets, thus lowering their income tax bill.
However, just as every rose has its thorns, so too does marriage also have some negative tax and legal ramifications.
- Federal Income Tax Penalties: In contrast to the example above regarding couples with widely varying income, married couples with roughly equal paying jobs are often penalized with high income tax bills. This is due in large part to the fact that although tax brackets are wider for married couples, they are not twice as wide as the equivalent brackets for single individuals. Where both spouses make substantially similar amounts of income, much of their joint income is pushed up into higher tax brackets, resulting in a higher overall tax bill.
- Joint and Several Liability for Community Property: For those of you who live in community property states like California, Texas or Arizona, all of the property you acquire during the course of your marriage (absent a prenuptial agreement or other select exceptions) is considered community property. People often assume that community property means that everything is owned 50/50 by each respective spouse, but that is not actually true. Much like Tom Cruise and Katie Holmes became a singular entity called “TomKat” or Ben Affleck and J-Lo became “Bennifer” so do all other spouses in community property states similarly merge upon marriage. As such, in the eyes of the state, Tom and Katie’s communal assets were owned 100% by TomKat. One exceptionally onerous aspect of community property is that it is wholly subject to the liabilities of each spouse. If Katie’s creditors secured a judgement against her, the entirety of TomKat’s communal assets would be available to fulfill the judgement regardless of whether or not Tom was involved. Understanding how to structure communal assets to provide additional asset protection is extremely important, especially for professionals or business owners since they generally are at heightened risk of liability.
As with all things, marriage is about tradeoffs and compromise. This applies even to the tax and legal ramifications of Holy Matrimony. The moral of the story here is, if you plan properly beforehand, you can maximize your chances of living happily ever after.