Spouses living in any of the nine community property states must classify their incomes as either community income or separate income when they're preparing separate federal income tax returns. They must generally follow their state's laws to determine whether a particular source of income is separate or community property, because the IRS generally defers to each community property state's rules.
The Community Property States
Community property law dictates that anything acquired during the course of a marriage is owned equally by both spouses, with the exception of assets or income that are received as inheritances or that are otherwise gifted to just one spouse. The states that recognize community property law as of 2021 are:
- New Mexico
Three additional states allow couples the option of electing community property law: Alaska, Tennessee, and South Dakota.
Federal law doesn't distinguish between same-sex and opposite-sex married couples, but it does draw a line between registered domestic partnerships or civil unions and marriages. Federal law doesn't recognize domestic partnerships or civil unions.
Each state's community property laws aren't necessarily the same. States often put their own unique spin on certain provisions.
Community Income and Property
By law, community income is considered to be equally shared by a married couple, regardless of who earns it. Community income also includes income generated by such community property.
Community property is that which is acquired while married and while the couple resides in a community property state (or one that allows election of that arrangement). The property can't be otherwise identified as separate property.
Separate Income and Property
Separate income is that which is considered by law to belong to just one spouse or the other. This might be because it's produced or earned by property that was owned separately prior to marriage, property bought with separate funds, or property that both spouses have agreed to convert from community property to separate property through a legally valid spousal agreement. This process is referred to as "transmutation."
Each spouse would report one-half of the total community income, plus their own separate income, if any, when they're preparing a separate federal tax return.
Separate income is income generated by separate property. There are special rules for compensation income and retirement income.
This rule can vary somewhat by state, however. Income generated by separate property is still considered community income in Idaho, Louisiana, Wisconsin, and Texas, so the only income that would be classified as separate income in these jurisdictions would be distributions from an IRA, Social Security benefits, or alimony.
By contrast, income from separate property is considered to be separate income in Arizona, Nevada, New Mexico, and Washington.
Reporting Earned Income
Compensation in the form of wages, salaries, commissions, and self-employment is always treated as income belonging to the marital community in community property states. Each spouse would report one-half of the total compensation income and one-half of the withholding from that compensation income when filing separate federal tax returns.
Reporting Investment Income
Interest, dividends, rent, capital gains, and other income from investments can be classified as either community or separate income. It depends on the character of the property that's generating the income.
Income earned by separate property is separate income, whereas it would be community income if the property were community property. It would be allocated as community property in the same proportion as the underlying community property when there is a mix of separate and community property.
Retirement and Pension Income
Income from IRAs and IRA-based plans, such as SEP-IRAs and SIMPLE-IRAs, is always separate income and is allocated to the spouse who owns the account. Similarly, Social Security benefits are always separate income and are allocated to the spouse who receives the benefits.
Income from 401(k) plans, 403(b) plans, and other types of pensions can be a mix of separate and community income. Distributions from a retirement plan other than an IRA are characterized depending on the respective periods of participation in the pension while a couple is married and living in a community property state. The ratio is based on the time you were participating in the retirement plan or pension.
You might be eligible to use an optional 10-year tax-calculation method that disregards community property factors if you receive a lump-sum payment from a pension plan. Speak with a tax professional to find out whether you qualify.
Alimony and Community Property
Alimony is taxable to the extent that the payments exceed 50% of imputed community income if one spouse is paying alimony or separate maintenance to another. This is only the case until their divorce is finalized, however.
The Tax Cuts and Jobs Act eliminated the requirement to report alimony received as income and the ability to deduct it from the payer's taxable income for any divorce or separation agreement entered into after December 31, 2018.
Each spouse is considered to already own half the community income, so transfers of those amounts would be non-taxable. Amounts in excess of the community income allocations are income to the receiving spouse, and deductible to the paying spouse, provided that the alimony order was entered into prior to January 1, 2019.