Tax Issues When You Live in a Community Property State
How Your State's Community Property Laws Can Affect Your Tax Returns
Married couples who live in community property states jointly own their marital property, assets, and income. It's your spouse's income as much as it is yours if you earn $80,000 a year. Likewise, your spouse is legally obligated to repay a $100,000 debt even if you contracted for it in your sole name. Your spouse jointly owns the property if you buy a $350,000 home, even if you title it in your name alone.
Needless to say, these rules can really complicate things at tax time if you don't file a joint married return.
Which States Are Community Property States?
There are only nine community property states as of 2021:
- New Mexico
Alaska is something of a hybrid. You can elect to treat your assets and debts as community property in this state by signing a joint agreement to do so.
There can be slight variances in the laws from state to state, and the IRS defers to state law in this situation. Married couples must follow their specific state's rules for community property at tax time.
Separate vs. Married Returns
Filing separate married returns forces each spouse to analyze their income and expenses to figure out how much belongs to the marital community and how much, if any, belongs to each spouse separately. Just as income is considered to be earned by both spouses equally, community deductions are owned by each spouse equally.
But there's a downside to filing a joint married return as well. The IRS can and will hold both spouses "jointly and severally liable" for any errors or omissions on the return. This means that you're just as guilty as your spouse is if they intentionally "goof" when reporting certain information. And the IRS can collect the full tax due on the return from either of you.
Community and Separate Income
The general rule when preparing a separate tax return is that spouses report half their community income on each return, as well as all their separate income. This would generally be income derived from premarital investments. They would each claim half of their community deductions plus all their separate deductions
Let's say you purchased a home years before you were married. This would be your separate property, assuming that you never took any actions to "commingle" it, such as by making mortgage or property tax payments on it with money earned after the date of the marriage. That money would have been community money, so you've effectively erased the separate property status of the home by adding community money to the pot.
But these rules can vary slightly from state to state. The rental income would become community property in Texas, Wisconsin, Idaho, and Louisiana if you decided to rent the property out, even if you didn't commingle the asset. It might be your separate, premarital property, but income it earned while you were married must be divided between you and your spouse if you file separate married tax returns.
Community Property Deductions
The passage of the Tax Cuts and Jobs Act (TCJA) more or less doubled the standard deductions in 2018. Many taxpayers find that they're more than all their itemized deductions added together, especially because the TCJA also places restrictions on some itemized deductions.
Who gets which deductions related to community assets in a community property state can be tricky if you do decide to itemize. Maybe your home is jointly owned. You want to claim the mortgage insurance deduction but you're filing separate married returns. Can you just scissor the deduction down the middle, each of you claiming half of it?
Yes, if both your Social Security numbers appear on the Form 1098 you received from your lender. You must be contractually liable for any deduction you want to claim on your separate return.
Both you and your spouse must itemize your deductions if you file separate married returns. Federal tax law prohibits one spouse from itemizing while the other claims the standard deduction, even if you don't live in a community property state.
Claiming Your Dependents
You and your spouse can't both claim the same dependents if you have children unless you file a joint married tax return. Each dependent can only be claimed by one taxpayer per year.
You can "split" your dependents at tax time if you have more than one child. You could claim your son while your spouse claims your daughter. This is perfectly legal. But who claims the third if you have three children?
Filing separate married returns can also disqualify you from claiming certain tax breaks, including the Earned Income Tax Credit, the Child and Dependent Care Tax Credit, the student loan interest deduction, the American Opportunity Tax Credit, the Lifetime Learning Tax Credit, and the Adoption Tax Credit. Special rules apply to the Child and Dependent Care credit for spouses living separately, however.
You Might Want to Get Professional Help
The IRS offers guidance for spouses in community property states in Publication 555, and a special worksheet in Form 8958. But even the IRS cautions that you might want to at least consult with a tax professional as you prepare your separate tax returns.
This is particularly true if you own income-producing property or if you're thinking that you might want to itemize. A professional will probably want to run your tax returns both ways, assessing your tax liability or refund if you file jointly versus your tax situation if you file separate returns.