Minnesotans face higher taxes with gap between state, federal codes

Minnesotans who lost their homes this year could lose even more when they sit down to pay their 2013 state taxes.

Dozens of federal tax breaks no longer exist in Minnesota. New parents face a state tax bill for the money they got from their employers to help with adoption expenses. Homeowners who went through a foreclosure or short sale or who refinanced their mortgages in 2013 will be taxed by the state — but not the federal government — on that discharged debt.

Congress pushed through a raft of tax breaks and extensions early this year, but the Minnesota Legislature did not follow suit. That has opened gaps where state tax law does not line up with the federal tax code. Those small differences on tax returns may cost some Minnesotans dearly — people like Brenda Scandin, who lost her home to a short sale this year.

"How can they tax people who have lost their homes?" asked Scandin, whose $600,000 lakefront home in Mound sold for $200,000 this spring.

Scandin learned about the tax changes in an e-mail from the Minnesota Department of Revenue, alerting her to changes in the tax code. She now owes state taxes on the $300,000 or so in mortgage debt the bank forgave. She expects that tax bill to amount to tens of thousands of dollars.

"I was horrified," said Scandin, who says she and her husband emptied their retirement accounts in a frantic race to keep up mortgage payments on their home after she lost her job as a corporate comptroller during the recession.

Scandin has since retrained and works as a real estate agent, helping other families find their homes even as she was slowly losing her own. "I just can't grasp the concept of being taxed on money you never received," she said.

Those mortgage forgiveness tax breaks were set to expire this year, but Congress passed a one-year extension, through the end of this year, along with dozens of similar breaks and extensions packaged in the American Taxpayers Relief Act of 2012.

Every time Congress tweaks the tax code, states must decide whether to bring their own tax codes into conformity or leave taxpayers to navigate the difference between their state and federal filings.

The Minnesota House passed a conformity bill this year, but the Senate did not. Ultimately, a handful of minor proposals were signed into law by Gov. Mark Dayton.

Dayton now says there may be something the state can do to help people like Scandin and other Minnesotans who slipped through the cracks.

"Anybody who's had the misfortune of having to sell a $600,000 home for $200,000 certainly shouldn't have to pay taxes on a paper loss that's somehow counted as income," he said. "I'm very willing to look at what we can do the next legislative session to retroactively exclude that income from state taxation."

"One man's loophole is another man's livelihood," Dayton said, quoting the late U.S. Sen. Russell Long. "For the person who's been getting one or another of these exclusions that have been ongoing, it's a tax increase. I haven't found anybody who likes tax increases. … It's hard to say yes to one and no to another."

If there's enough money in the budget once the Legislature finishes paying off the last of the money it borrowed from Minnesota schools, Dayton said he would urge legislators in 2014 to push for retroactive tax breaks for at least some of the Minnesotans pinched by tax conformity on their 2013 tax forms.

House Taxes Committee Chair Ann Lenczewski, DFL-Bloomington, favors across-the-board tax conformity, both to keep the tax process simple and to avoid unpleasant shocks like the one Scandin faces.

"Generally, Minnesota tries to conform, but sometimes that costs a lot of money," said Lenczewski, who pushed a bill this session that would have brought the state in full compliance with the feds.

But tax breaks don't come cheap. The state revenue department estimates that complying with every federal tax break of the past few years would cost the state $186 million in 2014 and $114 million in 2015.

Minnesota families formerly got a tax break on money they received from their employers — up to $12,970 — to help offset adoption costs. Congress made those tax breaks permanent. Minnesota did not, so those families could owe the state hundreds of dollars on their 2013 taxes. The same goes for employees who get tuition assistance from their workplace and who now must pay additional state taxes for continuing their education.

"The [taxes] that hit average families, those are things we always look at," said state Rep. Jenifer Loon, R-Eden Prairie, who said she would support the return of tax breaks for adoptive families. Republicans also want the state to do away with the so-called marriage penalty tax on married couples.

Why didn't conformity pass this year? By the time Congress passed its tax bill, it was January, days before the governor was about to release the state budget and his own tax proposals. At the Legislature, most of the attention was on the $2.1 billion package of tax increases under debate in St. Paul, not the changes that had just passed in Washington.

When the House took up debate on conformity, Republicans balked at the cost, sparking a bitter floor fight.

The small cluster of conformity provisions that did pass include one that preserved the right of Minnesota teachers to write off $250 worth of school supplies they buy for their classrooms, along with a few measures that will spare businesses from having to keep separate sets of books for their federal and state taxes.

At General Mills, which offers employees both education and adoption assistance, workers are bracing for tax time. One employee, who recently adopted twins, received an $18,000 benefit from the company and now faces a hefty state tax bill.

"The tax on that $18,000 benefit was pretty substantial. To have it be applied retroactively only added to the sting," said company spokeswoman Maerenn Jepsen. "General Mills has offered adoption benefits and educational assistance for years, so this has impacted our Minnesota-based employees. Most states choose to adopt and conform with federal changes when they occur."

Restoring the tax exemption for adoption assistance from employers would have cost the state an estimated $400,000 in 2014. Allowing workers tax-free employer tuition assistance would cost $4.4 million.

Exempting homeowners who go through foreclosures or mortgage debt forgiveness from additional taxes would cost $7.2 million, but Dayton said: "I think that would be manageable for the state and would make a big difference for [Scandin] and others in that situation. The challenge then becomes: If you do this one, then why not another one and then why not another one?"

Eliminating the marriage penalty — a quirk of the tax code that can bump married couples with comparable incomes into a higher tax bracket — would cost the state a whopping $111.9 million in 2014.

Meanwhile, the state Revenue Department has been sending out letters to Minnesota residents and businesses who may be caught by conformity issues.

"We hope that it's fairly straightforward for taxpayers to crosswalk from the federal return to the state return," said Deputy Revenue Commissioner Matt Massman. "But obviously, if [the two returns were identical], it would be easier, but we think we've done quite a bit to make it easier for taxpayers."