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As a financial advisor, you’re likely familiar with the term “community property.” You might know that it has something to do with marriage and the way assets are divided between spouses during divorce. But you might not know that community property laws can be extremely important for tax filing, especially if spouses decide to file separate tax returns and they reside in a community property state. In certain states, community property laws can also affect the taxes of a couple in a domestic partnership even though they cannot file as married.
How might this impact your financial planning clients? This is exactly the question I’ll answer in this post. Whether you know a little or a lot about community property, this blog will give you the comprehensive overview you need to get fully up to speed.
Community property law has its origins in Spanish Law. Most community property states were part of the former Mexican territory. Although there are two forms of community property law, English and Spanish, the Spanish form of community property law still predominates in the United States. The Spanish system is based on the period of time the property is owned and the method of acquisition.
Equality is a key tenet of community property law. Community property states view a marriage as a 50/50 partnership where spouses share equally in ownership of property. Community property laws become relevant when a married couple files their taxes and they elect to file separate returns. In a community property state, one half of community income is allocated to each spouse. Each spouse must report 50% of community income plus their share of separate income on their tax return and is required to attach Form 8958 to their tax return to show how community and separate income are divided.
The Married Filing Separate Status
If you are married, you can choose to file a joint tax return with your spouse, or you can file your own separate return. A tax professional will calculate your income and your tax using both methods and will recommend the filing status that results in the lowest tax. The preparation of your returns will differ depending on whether you reside in a community property state or a common law state. Under community property law, community income items will be split evenly between you and your spouse. In a common law state, you each report your own separate items of income and expense.
Generally, a married couple is better off filing a joint return. But there are exceptions.
You may want to file separately to preserve your tax refund. If your spouse owes back taxes, child support, or student loans and you receive a joint tax refund, the IRS will apply the total joint refund toward those obligations.
Married filing separately can sometimes be advantageous if both you and your spouse earn high incomes, which will push you into a high tax bracket. You may be able to save taxes by filing separately, so you will fall into a lower tax bracket. Keep in mind that the tax brackets are the same for married filing separately and single filers up to an income level of $311,025. At that level the tax bracket for married filing separately jumps to 37%. For single filers, the 37% bracket isn’t triggered until income reaches $518,400.
There are various factors to consider when deciding whether to use the married filing separate status.
- Credits and deductions may be reduced or eliminated with this filing status. For example, you lose the childcare credit and the student loan interest deduction.
- You will be unable to exclude interest income from qualified US savings bonds used for higher education expenses.
- There is no credit for the elderly or disabled if you lived with your spouse at any point during the year.
- If you live with your spouse during the year, you will generally need to include in income a higher percentage of social security benefits or railroad retirement benefits received.
- If your spouse itemizes, you cannot take the standard deduction. Both spouses can take the standard deduction at one-half the amount allowed on a joint return. This rule does not apply for registered domestic partners, only for married couples.
- The income limit for Roth IRA contributions is greatly reduced. No Roth contributions are permitted if your modified adjusted gross income is $10,000 or more.
- You cannot claim the special allowance to deduct rental losses up to 25,000 against nonpassive income if you lived with your spouse. If you lived apart all year, each of you can deduct $12,500.
When Does Community Property Law Apply? Domicile and Community Property States
Community property laws apply to married couples who are domiciled in a community property state. The nine community property states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Additionally, in Alaska, you can “opt in” to community property laws. Tennessee and South Dakota also have passed elective Community Property laws. In California, Nevada and Washington, couples in registered domestic partnerships are subject to community property laws. Registered domestic partners must file as single or head of household, but they will be required to split income items as if they were married.
If you are domiciled in a community property state, you must follow the state’s community property laws. Domicile is a fancy way of saying “where you live.” You can spend a portion of a year traveling between different states without establishing domicile in multiple states. Your intention is more important than the amount of time you spend in a given location for the purpose of determining domicile.
Here are the important determining factors for domicile:
- Where you pay state income tax
- Where you are registered to vote
- Where you own property
- Your citizenship
- Your length of residence
- Your community involvement
Let’s look at an example. Sandra and Bill own properties in Tampa, FL and Bozeman, MT. In 2020, they spent 7 months of the year at their Bozeman property. They would fly out for a month or two at a time before returning to Florida. During 2019 and 2018, Sandra and Bill spent 10 months out of the year in Tampa. Sandra and Bill are registered to vote in Florida and have Florida driver’s licenses. Sandra has been actively involved in volunteer projects in Tampa. Bill’s business is based in Tampa and he is a member of the Chamber of Commerce. Sandra and Bill are domiciled in Tampa.
Yours, Mine, or Ours? Classifying Property
The first step in applying community property law is determining whether an asset is community property or separate property. Community property includes:
- Property you acquired during married while living in a community property state
- Property that you decided to convert from separate to community property
- Property that cannot be identified as separate property of one spouse
Separate property is considered to belong solely to one spouse, and it is not divided 50/50. Separate property includes:
- Assets you owned prior to marriage
- Money you earned while living in a non-community property state
- Property you legally converted from community to separate property under an agreement recognized by the state
- Inheritances or personal gifts you received prior to or during your marriage
- Property you acquired with separate funds or in exchange for separate property
- If property was partially acquired with separate funds, only that part of the property that was purchased with separate money is considered separate property
When it comes to separate property, you need to be aware of the potential for transmutation. This occurs when property changes character, generally from separate to community. If separate property is mixed or commingled with community property in such a way that it cannot be separately identified, it can become community property through transmutation. You can prevent this situation by keeping accurate and detailed records of separate property. It’s smart to keep a separate bank account to keep track of separate funds, such as money earned prior to marriage.
Who Earned It? Classifying Income
The classification of property is important because the source of income is the determining factor for classifying income as community or separate.
Community income includes income from:
- Community property
- Salaries, wages, and other compensation for services received by either spouse during marriage while domiciled in a community property state
- Real estate that is considered community property under the state laws where the real estate is located
In most cases, income from separate property will be separate income that is considered to belong to the spouse who owns the property. However, community property laws vary between states. In Idaho, Louisiana, Texas, and Wisconsin, income from most separate property is still considered community income.
Different income types are subject to varying treatments under community property tax laws. The rules for some common income items are as follows:
- Wages, earnings and profits and compensation for services are community income and must be split 50/50. This includes schedule C income from an LLC or sole proprietorship.
- Dividends, interest and rents can be community or separate income depending on whether they arise from community or separate property.
- Gains and losses will have the same classification as the underlying property.
- Withdrawals from IRAs and Coverdell Savings Accounts are always separate income. This is because IRAs and ESAs are legally considered separate property. The spouse whose name is on the account is the recipient of the income and is responsible for the taxes as well as any penalties.
- Social Security payments and Railroad Retirement benefits are legally separate property and belong to the taxpayer to whom the payments are issued.
- For pension income, treatment may vary by state. Usually distributions are allocated between community property and separate property based on the respective period of participation in the plan while married and domiciled in a community property state during the total period of participation in the plan.
- If you have partnership income from services you performed for the partnership, the income is community income. If income from a partnership does not relate to services performed and the partnership interest is considered separate property, the income will be treated in accordance with the state rules for income from separate property.
- Generally, tax exempt income from community sources will be exempt income for both spouses.
In addition to the more common income types, there are also some special Income considerations that must be taken into account:
- There is a special rule that applies for taxpayers born before January 2, 1936 who receive a lump-sum distribution from a qualified retirement plan and choose the 10-year option for determining the tax on the distribution. In the case where this option is selected, the taxpayer is required to disregard community property laws.
- Civil Service Retirement: Annuities payable under the Civil Service Retirement Act (CSRS) or the Federal Employee Retirement System (FERS) are treated as community property for income tax purposes. You may not be able to escape community property tax laws by moving to a common law state. The income may still be considered community income if you were married and domiciled in a community property state at the time the services were performed. If the annuity is a combination of community and separate income, it must be allocated between the two income types. The allocation is based on your domicile and marital status in community property and common law states during the relevant service period.
- When a taxpayer receives military retirement pay, state community property laws apply. Usually the pay will be considered separate or community income based on your marital status and domicile during active military service.
- The foreign earned income exclusion allows you to exclude a portion or all of your foreign earned income if certain criteria are met. If you meet the conditions to exclude foreign earned income and it is community income, your spouse will be allowed the exclusion even if your spouse does not meet the conditions.
Who Paid for It? Classifying Deductions
The same general rules that apply to community income also apply to deductions. Whether a deduction is considered community income or separate income usually depends on the classification of the underlying property.
- Business and investment expenses: Expenses related to production of community income are split 50/50 between the spouses. Expenses related to separate income are deductible by the spouse who earned the separate income.
- IRA deduction: Since IRAs are legally separate property and are not subject to community property laws for Federal taxes, deductions are not allocated between spouses. Your deduction is calculated separately based on your contribution to your IRA account.
- Personal expenses (such as medical expenses for itemized deductions): If expenses are paid with separate funds, they are deductible by the spouse who pays them. If community funds are used to pay expenses, the deduction is split evenly between the spouses.
Who Gets the Credit?
When a married couple chooses to file separate tax returns, sometimes no one gets the credit. Under this filing status, there are limits on the tax credits you can take, regardless of whether you are domiciled in a community property state. The married filing separate status disqualifies you from claiming the earned income tax credit, the credit for child and dependent care expenses, the adoption credit, and any educational credits.
The child tax credit can be claimed on a married filing separate return. However, only one parent can claim each child. If there are multiple children, you can choose how to divide the children for tax purposes. If the parents live together and cannot decide on an allocation, the IRS will award the dependent to the parent with the highest adjusted gross income. A taxpayer with a dependent who is not a qualifying child might be able to claim the credit for other dependents.
Although spouses filing separate returns cannot claim the earned income credit (EIC), if you live apart all year, and have a qualifying dependent, either you or your spouse may qualify as head of household under a special set of rules. In that case, the spouse filing as head of household may be entitled to the EIC. Under these rules, earned income for purposes of determining EIC eligibility does not include any income earned by your spouse in a community property state. When determining AGI for the EIC income limitations; however, half of community income is included in the calculation. Registered domestic partnerships are subject to the same rules in certain states.
Who Pays the Taxes?
There are some special considerations regarding taxes in community property states. One item to be aware of is self-employment tax. Self-employment tax is allocated to the spouse who is responsible for paying it. If you operate a sole proprietorship, you are the one who is engaged in the trade or business; and you are responsible for the self-employment tax on the full amount of your business income. You will report the self-employment tax and the related deduction solely on your own return. Your spouse will report half of your self-employment income and pay half of the income tax on it; however, your spouse will not be responsible for any of the self-employment tax.
You may also be subject to self-employment tax if you perform services for a partnership. Just as with a sole proprietorship, only the spouse who is a partner is subject to the self-employment tax. If both spouses are partners, the self-employment tax is divided based on their proportionate shares of the income or loss.
You will generally have taxes withheld if you receive wage income as an employee. Because wages are community income, any amount withheld is split 50/50 on your separate tax returns. Taxes may also be withheld on pensions or IRA distributions. Withholding on IRAs belongs to the spouse who owns the IRA. Withholding on pensions will be split according to the characterization of the pension income as community or separate.
If you will not have adequate withholding to cover your tax liability, you may choose to pay estimated taxes to avoid underpayment penalties and interest. There are two possible scenarios for payment of estimated taxes.
- You and your spouse can pay estimated tax separately, in which case each of you determines whether you need to pay estimated tax based on your separate return. The amount is figured for each of you using half of your community income and deductions and all of your separate income and deductions. If one of you makes the payment separately, you can only report the amount you actually paid.
- If you and your spouse make a joint payment for estimated tax, you can choose how to divide that payment. One of you can report all of the estimated tax on your return if that is what you choose. In the event that you cannot agree on how to divide estimated tax, the estimated tax each of you can report on your return is allocated to you based on the proportion of tax shown on your return divided by the total tax shown on both returns.
Tax refunds are a major factor in the decision to file separate tax returns. For example, if Mary will have her refund garnished to pay student loan debt, her wife, Nancy, may want to file a separate return to receive her share of the refund. The whole joint refund would be subject to Mary’s obligation if a joint return was filed. Depending on the specific state law, this strategy may or may not work in a community property state. In some states, community property is subject to premarital and separate debts either spouse. In these states, the full joint overpayment can be garnished to fulfill Mary’s obligation. In other states only the part of the refund allocated to the spouse who is responsible for paying the obligation will be used to offset the liability. In these states, Nancy can receive her portion of the refund.
Keeping Secrets: When a Spouse is Dishonest About Income
A marriage should be an open and honest relationship; however, that is not always the case. For example, Joseph is tired of paying so much in taxes and wants to lower his tax liability. Without telling his wife, Brittany, he omits an item of community income on his separate return. If Brittany did not know about the income and she had no reason to know about the income, she would have omitted it from her return as well. In this case, Brittany may qualify for spousal relief.
Spousal relief can excuse you from liability for the taxes on an item of community income that your spouse omitted when filing a tax return. To qualify, ALL of the following conditions must be met:
- A joint return was not filed for the year in question
- You did not include the item of community income in your gross income
- The item of omitted income is one of the following:
- Wages, salaries and compensation for services that your spouse or former spouse received as an employee
- Trade or business income from a sole proprietorship operated by your spouse
- Your spouse’s portion of partnership income
- Income from the spouse’s separate property
- Any other income that belongs to your spouse under community property law
- You can prove that you didn’t know about the income and didn’t have a reason to know about the income
- Considering all the variables, it wouldn’t be fair to include the item in your gross income
Relationship Problems: Special Rules for Spouses Living Apart
In community property states, there are certain rules that apply to married couples who file separate returns if they did not live together at any time during the tax year. To qualify, you must meet these requirements:
- You lived apart for the entire year
- Neither you nor your spouse filed a joint return for a tax year beginning or ending in the calendar year
- You or your spouse had earned income for the calendar year that is community income
- You and your spouse have not transferred any earned income between yourselves during the year. Amounts paid for child support and immaterial amounts do not count as transfers.
There is one rare but notable exception to the above criteria. If you are a US citizen or resident alien who has a non-resident alien spouse, you can use the rules for spouses living apart if you don't treat your spouse as a US resident for tax purposes. The four criteria do not have to be met in this case. However, if you choose to treat your non-resident alien spouse as a US resident for tax purposes, community property laws will apply in a community property state. If you elect to treat your spouse as a resident for taxes, you must file a joint return in the year of the election, but you can file separate returns in subsequent years.
If the four criteria are met or the exception applies, income is treated as follows:
- Earned income, trade or business income, partnership income or loss and social security benefits are treated as income of the spouse who earns or receives the income.
- Separate property income is treated as the income of the spouse who owns the property.
- All other community income such as dividends, interest, rents, royalties or other gains are still subject to state community property laws. Treatment can vary by state. Income may be separate or community income depending on the classification of property under state law.
‘Til Death or Divorce Do Us Part
Under community property law, marriage is a partnership. Much like a business partnership, the marital partnership may be terminated by death or voluntary separation. In either case, the community assets are allocated between the spouses when the community ends.
In a community property state, when your spouse dies, the total fair market value of the community property becomes the basis of the entire property. This rule will apply if, at a minimum, half the value of the community property interest is required to be included in your spouse’s gross estate. It doesn’t matter whether the estate is required to file a return. This contrasts with the treatment in common law states where only your deceased spouse’s half of the property receives a step-up in basis to fair market value. Note that this rule is not applicable to registered domestic partnerships.
A divorce or separation can be a rough legal and financial process. Luckily, no gain or loss is recognized on allocation of property due to divorce of married couples. For registered domestic partners, however, if there is an unequal division of community property as part of a legal separation, there may be a gain or loss recognized.
Each spouse is taxed on 50% of the community income for the portion of the year before the community ends. After the community ends, all additional income earned is treated as separate income and taxed only to the spouse who receives it.
There are different ways to end a community, depending on the state:
- An absolute decree of divorce or annulment terminates the marital community in ALL community property states.
- A decree of legal separation or of separate maintenance may or may not end the marital community. The court has the ability to end the marital community and allocate the property among the spouses.
- A separation agreement can be used to divide community property. It can designate current property and future earnings and property as separate property. It is possible for such an agreement to end the community.
- In certain states the community can be ended through separation of the spouses without the need for a formal agreement.
- Registered domestic partners will need to consult state law to determine when the community terminates.
As you can see, community property law introduces a lot of complexity into tax preparation. You will want to consult a tax professional before filing a separate tax return, especially if you are domiciled in a community property state. A tax professional (there are many at XY Tax Solutions) can determine the correct division of income between spouses and save you a ton of time and headaches when filing your taxes.
About the Author
Ever heard of someone who finds taxes exciting? Meet Katrina Ivancic, a Senior Tax Manager at XY Tax Solutions (XYTS). Katrina, who has been a CPA since 2012, first got her start in corporate accounting before moving on to taxes, which she finds more rewarding and challenging than corporate financial reporting. Why? Because she loves helping clients save money and save them the stress of doing their taxes themselves. Katrina loves all things taxes, but if she had to pick, her favorite tax topics would be rental properties and employee stock.