Community property laws can have a major impact on how married couples file their taxes. If you live in a community property state, your income and assets might be subject to unique tax rules that differ from other states. This guide will break down everything you need to know, including which states follow community property laws, how domicile affects taxation, and the tax treatment of different types of property. We’ll also explore special considerations such as when community property ends, tax relief options, and unique tax situations that arise due to these laws.
What Are Community Property Laws?
Community property laws dictate that most income and assets acquired during a marriage are jointly owned by both spouses. This means that for tax purposes, each spouse is typically responsible for reporting half of the total community income on their tax return—regardless of who earned it.
Currently, nine states have community property laws:
- Arizona
- California
- Idaho
- Louisiana
- Nevada
- New Mexico
- Texas
- Washington
- Wisconsin
Additionally, Alaska, South Dakota, and Tennessee allow couples to opt into community property agreements voluntarily.
The Role of Domicile in Community Property
Domicile refers to the state where a person has their permanent home and intends to return. If a couple is domiciled in a community property state, their income and assets are subject to community property laws, affecting how they file their taxes. This is an important distinction because moving between states can alter how income is reported.
Community vs. Separate Property
Community Property
Most income and assets acquired during the marriage are considered community property. This means that if one spouse earns a salary of $100,000 while the other stays at home, each spouse must report $50,000 on their individual tax return (if filing separately).
Separate Property
Separate property includes assets owned before marriage or acquired through gifts or inheritance. Unlike community property, separate property is not subject to division and is reported only by the spouse who owns it.
When Does Community Property Status End?
Community property laws typically cease to apply when a couple legally separates or divorces. However, the exact timing depends on state laws and any formal agreements made during the separation. Understanding this is crucial to ensure accurate tax filing.
Special Tax Rules for Spouses Living Apart
Spouses who live apart for the entire year may be able to file as if they were not subject to community property laws. To qualify for this exception, specific conditions must be met:
- The couple must live apart for the full year.
- They must not file a joint return.
- They must not transfer income between each other.
This rule can simplify tax filing and may reduce tax liability.
Prenuptial and Postnuptial Agreements
Couples can opt out of community property laws by signing a prenuptial or postnuptial agreement. This allows them to treat their income and assets as if they were domiciled in a non-community property state, simplifying tax filing and ensuring greater control over financial matters.
Tax Relief from Community Property Laws
1. Traditional Relief
If one spouse is unaware of the other’s income or tax liabilities, they may qualify for relief from community property tax rules, protecting them from tax debts incurred by the other spouse.
2. Equitable Relief
This applies when holding one spouse liable for the other’s tax obligations would be unfair. The IRS considers factors such as the requesting spouse’s knowledge of tax issues and financial hardship.
3. When the IRS Can Disregard Community Property Laws
The IRS may disregard community property laws in cases where a valid prenuptial or postnuptial agreement exists or when a couple is domiciled in a non-community property state.
How Community Property Affects Specific Tax Issues
Additional Medicare Tax
Higher-income taxpayers must pay an additional 0.9% Medicare tax. In community property states, married taxpayers filing separately must compute this tax based on their individual earnings.
Non-Resident Alien Spouse
When a U.S. citizen or resident alien is married to a non-resident alien and domiciled in a community property state, their compensation is considered U.S. income for tax purposes.
Gifts of Community Property
Gifts made from community property are typically considered to be from both spouses equally. This means each spouse may have to report their share of the gift on their tax return.
Business Entities Owned by Spouses
If a married couple in a community property state owns a business, they can choose to treat it as either a disregarded entity (like a sole proprietorship) or a partnership for tax purposes.
Inherited Community Property
When one spouse dies, the surviving spouse receives a full step-up in basis for inherited community property. This means the property’s tax basis is adjusted to its fair market value at the time of death, reducing potential capital gains taxes when the surviving spouse sells the asset.
Example:
A couple in a community property state buys a home for $200,000. When one spouse dies, the home’s value is $350,000. The surviving spouse’s basis is adjusted to $350,000. If they sell the home for $400,000, the taxable gain is only $50,000, not $200,000.
Multiple Support Agreements
These agreements allow multiple taxpayers to share financial responsibility for a dependent. In community property states, such agreements can complicate tax filings.
Military Combat Zone Compensation
For military spouses in community property states, combat zone pay exclusions apply before apportioning income between spouses under community property laws.
Other Exemptions
Community property laws do not affect calculations for certain tax credits, self-employment taxes, or IRA deductions.
Final Thoughts
Community property laws significantly impact tax filings and liabilities for married couples in certain states. Understanding these laws is crucial for accurate tax reporting and planning.
If you reside in a community property state and have questions about how these laws affect your tax filing, consult a tax professional for guidance tailored to your situation.
