Community Property Rules for Federal Income Tax Returns
Spouses must compute income and deductions using community property rules
Nine states have community property laws that govern how married couples hold ownership of their incomes and property: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. These laws have a significant impact on their tax situations.
Residents of Alaska, Tennessee, and South Dakota can "opt in" to community property law, handling their assets and their debts in this way if they want to.
So, what does it mean to your tax situation if you live in one of these states (or have elected to follow these laws in one of the opt-in states)? In short, it means you have to follow a whole unique set of tax provisions when you're reporting your income and calculating your federal tax liability.
Community Income and Community Property
Each spouse legally owns an undivided one-half interest in the total income and property of the marital community when they live in a community property state. If a married couple living in a community property state chooses to file separately, they must evenly divide their total income and property for their separate returns.
A couple may also own their own separate income if it comes from separate property they hold, such as assets they owned prior to marriage or income generated by such properties.
Federal tax laws generally respect state laws in determining whether a source of income is community income and whether property is community or separate property.
In general, you can expect these rules to apply:
- Community property is considered that which is acquired while the couple is married, and it cannot be otherwise identified as separate property.
- Community income is the income generated by such community property, as well as the full earnings of each spouse during the marriage. If your spouse earns $1,000 this week, $500 of that is attributable to you. Under community property law, you both equally earned it.
In community property states, a spouse may still have separate property under certain conditions:
- Separate property is property that was owned separately before marriage, property bought with separate funds or exchanged for separate property, and property that both spouses have agreed to convert from community property to separate property through an agreement that's considered legally valid by the state. This is known as "transmutation," and transmutation laws vary from state to state—they might not apply to every circumstance.
- Inheritances and gifts clearly bequeathed to just one spouse are also typically considered to be that spouse's separate property.
- Separate income is income that's generated by separate property, such as if you own a premarital home that you now rent out. However, in Idaho, Louisiana, Texas, and Wisconsin, income from most separate property is still considered community property.
Reporting Community Income and Claiming Community Deductions
Most married couples file jointly, and therefore, all of their income and deductions would be reported on a single return. If they file separate married returns, each spouse reports one-half of total community income and one-half of total community deductions on their tax return.
What's Strategic About Community Property?
Spouses might be able to achieve lower federal tax liability by filing separately rather than jointly.
For example, let's consider a hypothetical couple who earns a combined total of $50,000 in a year—one spouse earns $40,000, and the other spouse earns $10,000. The threshold for itemized medical expense deductions is scheduled to increase from 7.5% to 10% of adjusted gross income (AGI) at the start of the 2021 tax year. A spouse with an AGI of $25,000 who files a separate return for that year could deduct any portion of medical expenses exceeding $2,500. (10% of $25,000 is $2,500.) However, if that same spouse were to file jointly on marital income of $50,000, or $25,000 attributable to each spouse in a community property state, that threshold would increase to $5,000.
Spouses might also find it advantageous to execute separate property agreements to take investments, real estate, and other property out of the marital community in states where this is possible. Talk to a tax professional to find out whether this is a feasible option for you.
Do You Have to Use Community Property Rules?
Married couples with at least one spouse residing in a community property state should follow the community property rules for allocating income and deductions. However, you might be able to disregard community property rules or use a modified set of community property rules under certain circumstances. For instance:
- Community property rules might be disregarded if one spouse does not communicate the nature and/or amount of income, but this would be subject to proof.
- Community property rules can often be modified for spouses living apart from each other for the entire year.
Same-Sex Marriages and Domestic Partnerships
When it comes to same-sex couples, the federal tax treatment will depend on whether they are technically "married" or not. The Internal Revenue Service (IRS) doesn't recognize registered domestic partnerships as marriages for federal tax purposes. That means that any couples joined by civil unions, domestic partnerships, or any other similar situation aren't subject to community property laws.
Registered domestic partners and persons in civil unions can file as single for federal tax purposes, or, if they qualify, they can file as head of household. They cannot file as married at the federal level, on separate or joint returns.
Filing Status Issues
Under federal law, you must meet three conditions to qualify as head of household:
- You must be unmarried on the last day of the tax year. If you're legally separated from your spouse, this counts as "unmarried" under IRS rules. You can also qualify if you're not yet legally separated or divorced, but you and your spouse did not live together at any time during the last six months of the year.
- You must pay more than half the cost of maintaining your household.
- You must have a qualifying dependent who lived with you for more than half the year.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to them. For current tax or legal advice, please consult with an accountant or an attorney.