The problem involves several sources of income taxed at the federal level but exempt or partially exempt from New Mexico taxes. One of these involves interest on federal bonds/Treasury bills, which according to the IRS is federally taxable but exempt from all state and local income taxes. This exemption is because federal activities are immune from powers of the states due to federalism, a principal set forth in the Constitution that creates separate government powers and immunities between the federal and state governments.
At first glance, it appears N.M. takes care of this by deducting the interest from a taxpayer’s total state income. But the NM income is derived from the taxpayer’s Federal Adjusted Gross Income (FAGI), a number that contains the exempt N.M. interest. Although this sounds reasonable – include the interest in the federal, then later subtract it to get N.M. taxable income – several problems occur.
First, the FAGI is used by New Mexico to determine two N.M. exemptions, a low- and middle-income tax exemption and an exemption for persons over 64 or blind, so both of these exemptions may be lowered before the N.M. tax-exempt interest is later subtracted.
In addition, for seniors on Social Security, the inclusion of the federally taxable interest in the FAGI will often lead to additional increases in FAGI beyond the N.M. non-taxable inclusion.
A simple example of a retired, married filing jointly (MFJ), medium-income senior couple over age 64 with and without $1,000 in Treasury interest can be used to show the issues involved. Suppose their total income without the Treasury interest involved $22,500 of Social Security and $34,400 of fully taxable pension. This gives a FAGI of $41,803 since only $7,403 of the Social Security income is taxable. With $5,000 in medical expenses, a standard deduction of $15,200 and the two above N.M. exemptions, their N.M. taxable income becomes $7,113, resulting in a N.M. tax of $122.
With the exact same situation except that the taxpayers received $1,000 in Treasury interest, the FAGI will go up by $1,000 due to the Treasury interest but, in addition, the $1,000 will cause the taxable portion of the Social Security benefits to be increased by 85 percent of $1,000 to $8,253, giving a FAGI of $43,653. The change in FAGI will lower the two N.M. exemptions by $2,370, resulting in N.M. taxable income of $10,333, which is $3,220 more than the N.M. taxable income without the $1,000 in Treasury interest! N.M. taxes would increase $89 or an 8.9 percent tax rate on the $1,000 interest – almost two times the N.M. maximum tax rate of 4.9 percent when the tax rate by law should be 0 percent!
A simple way to fix this problem would be to take the federal 1040 Tax Form and modify it by subtracting out the $1,000 not taxable in N.M., leading to a N.M. modified AGI (NMmAGI) to replace the FAGI as the starting point in deriving N.M.’s taxable income and exemptions. This, with the accompanying $850 reduction in the taxable Social Security income, would give the exact same results for the N.M. modified federal as calculated above before the $1,000 Treasury interest was added – e.g., a “NMmAGI” of $41,803. This modification would result in no change in the N.M. taxable income, the desired result.
Similar problems occur for several other sources, but the same corrective approach – deriving the NMmAGI – would also resolve this issue.
The issues described are most relevant for low- to medium-income taxpayers, single as well as married, and they completely disappear for higher-income taxpayers, certainly inconsistent with fairness. It should also be noted that most other states handle such tax-exempt interest properly but several – Colorado, Minnesota, North Dakota, Utah, Vermont and West Virginia – appear to have the same issues facing New Mexico based on using the FAGI without proper corrections.