Editors' Note: Guest blogger Gideon Alper publishes the Gay Couples Law Blog. The blog discusses new developments in same-sex family law and estate planning. He lives in Atlanta, Georgia, and you can email him at firstname.lastname@example.org or follow him on twitter.
In general, when someone loses money, they can use that amount to offset their income. That means they only have to pay taxes on the amount that their income exceeds their losses.
Now, imagine if you could create losses out of thin air. You then use the artificial losses to offset any income you receive.
Sound too good to be true? For most people, it is. But for same sex couples, it's another case where it can pay to be gay.
How it works:
People use one of two accounting methods: cash and accrual. Peter Pappas, a CPA and tax attorney that publishes the Tax Lawyer's Blog, has a nice summary of the differences between the two methods. The basic difference lies in when to recognize income and losses.
- Cash method: you have income when someone pays you and have losses when you pay someone else.
- Accrual method: you have income when someone owes you money and have losses when you owe someone else money.
Under the accrual method, you can have income even if you haven't actually received any money yet. Similarly, you can incur a loss even if you haven't actually paid anyone.
Individuals and businesses choose which accounting method they use. Most people use the cash method, and most businesses use the accrual method. Businesses using the accrual method often do transactions with individuals using the cash method.
So let's take a hypothetical married couple, Amy and Bob. Amy owns a business. Her business makes an obligation to make a deductible payment of $10,000 to Bob. No money actually changes hands--Amy's business now owes Bob $10,000.
Because Amy's business uses the accrual method of accounting, her business immediately recognizes a loss of $10,000. That's because her business recognizes losses when money is owed, not given.
But Bob, using the cash method, hasn't actually gotten any money. So Bob doesn't recognize any income. Since Amy and Bob pool all their money together anyway, Bob isn't ever going to make Amy's business actually pay him.
All of the sudden, Amy's business has a $10,000 loss to offset any income it has received. The loss isn't real--it's just on paper.
Unfortunately for Amy and Bob, the IRS won't let married heterosexual couples create losses out of thin air. Instead, because Amy and Bob are spouses, Amy's business can't recognize a loss until Bob recognizes the income.
But what if you're gay:
According to the IRS, gay couples, even if legally married, are unrelated. That means the IRS treats gay couples making this kind of transaction just like it treats a random business owing money to a random person.
With enough planning, gay couples could take advantage of this technique and create phantom losses whenever they want.