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Special Tax Rules for Community Property

A number of states are “community property” states, meaning that they recognize the concept of community property law. Community property law is dependent on state law and will therefore vary somewhat from state to state, but generally 50% of community property and community income is considered owned by each spouse. State laws usually identify whether income or assets are considered community or separate property; separate property is owned exclusively by one of the spouses.

Community Property

Community property and income may include:

  • Property acquired by the couple during the marriage while domiciled in a community property state, unless purchased with separate property assets.
  • Property that the spouses have agreed to convert from separate to community property.
  • Property that cannot be identified as separate (by default it is considered community).
  • In certain states, income from community property assets (but not separate property assets), is community income. In other community property states (e.g., Texas, Idaho, Louisiana and Wisconsin), even income from separate property is community income.
  • Salaries, wages, or pay for the services of either or both spouses while married and living in a community property state; money earned while living in a non-community property state can be separate income to the spouse who earned it. In some community property states, money earned after a marital separation is separate income.
  • Income from real estate that is community property under the laws where the real property is located.

Separate property and income may include:

  • Property owned by a spouse prior to the marriage.
  • Property received as a gift or inherited by one of the spouses, even while married.
  • Property purchased with separate property assets, even during the marriage.
  • Any property that the couple agrees to convert from community to separate property under a valid state law agreement.
  • Money earned while domiciled in a non-community property state.
  • Income from separate property, which is income to the owner/spouse.
  • Federal Tax Treatment of Community and Separate Income

Whether a couple has community property and/or income depends on the laws of the state where they are “domiciled.” Domicile is not necessarily the same as residence. Domicile is the couple’s permanent, legal home, intended for use for an indefinite or unlimited time. It is a question of the intent of the couple, but the IRS looks to a variety of factors to verify domicile, including where the spouses pay tax, vote, own property, and have social and business ties to the community.

For federal tax purposes, couples who have community assets and income (as determined under state law) may have to calculate their federal income tax differently. However, it is only if they are married and file separate tax returns that the disparate treatment arises. Just as community property is considered owned 50/50 by spouses, community income is also considered attributable 50/50 to each spouse.

When filing separately, each spouse must report one-half of the community income as their own income, regardless of who actually earned the money. Usually, all community income from the sources set forth above is added together, divided by two, and each spouse must list that amount as income on a separate tax return. In addition, each spouse must report in full whatever separate income was earned in the tax year from the sources described above. It sounds simple, but in practice figuring the amount or portion of income that may be community or separate can become complicated.

Income Tax Deductions and Exemptions

When filing separately, spouses claim an exemption for themselves. When there are dependents, (entitling the couple to further exemptions), the exemptions must be divided between the spouses by number, not the value amount of the deductions from income. Thus, if the couple has three children, all eligible to be taken as exemptions, the spouses must divide up this number (two for one spouse, one for the other spouse, etc.), not allocate the total exemption amount for all the dependents.

If one spouse itemizes deductions on the return, the other spouse must also itemize deductions. Deductions may be allocated as follows:

  • Expenses incurred to earn or produce community business or investment income are generally divided equally among the spouses; each spouse is entitled to deduct one-half.
  • Expenses incurred to earn or produce separate business or investment income are deductible by the spouse owning the business or investment, provided the expenses were paid with separate funds.
  • Expenses that are not attributable to any specific income, such as medical expenses, are usually deductible by the spouse who pays them. If they are paid with community funds, the amount of the deduction is divided equally between the spouses.

Equitable Relief

This division of community income can lead to inequitable results. For example, if one spouse deserts the other, the deserted spouse may have to file a separate tax return listing income earned and received by the other spouse, without having the resources to pay the resulting taxes. U.S. tax laws provide equitable relief for this under certain circumstances specified in the Internal Revenue Code and its regulations.

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