Community Property-Breaking up is Hard to do

Ms. Tamara Buck
November 26, 2012 — 1,570 views  
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COMMUNITY PROPERTY - or breaking up is hard to do!

By Tamara Buck, CPA – October 11, 2012

There are nine community property states in the United States: Arizona, California, Idaho,
Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

When a married couple lives in one of these states, their income and property is subject to the
community property rules.

Generally speaking, when a couple lives in one of these states, a "community" forms which is
similar in concept to a partnership.

Both parties own community property equally, and have an equal right to any income generated
from the community property and from the services of either partner in the marriage. The
income that results from community property is called community income.

However, most states allow the marriage partners to retain rights to property owned before the
community partnership began. This is referred to as separate property.

What is community property?

-Property acquired while the couple lived in a community property state.

-Property that the spouses agree to convert to community property.

(maybe this was separate property before, but they agree that it now belongs to both partners
equally)

-Anything that cannot be identified as separate property. (The couple would need to be able to
show that separate funds were used to buy the separate property. Not everyone keeps that good
of records!)

What is community income?

-Income from community property. This could include interest earned on a joint bank account or
the earnings from a pension.

-Salaries, wages & other payments for services. While the community partnership is in existence,
any income earned belongs to both partners equally.

-Income from real estate that is treated as community property. If a property generates rental
income, this could be community income.

What is separate property?

-Property owned before the marriage community began.

-Property acquired by separate gift or inheritance during the marriage.

-Property bought with separate funds during the marriage.

(Does anyone see how this might be hard to prove? The spouse would have to keep their bank
accounts separate from day one of the marriage.)

-Property that the spouses agree to convert to separate property. This has to be allowed under
state law & all of the community property states have slightly different laws.

-Personal injury awards - this property can generate separate income, but only if the funds from
the award are isolated from the community property.

What is separate income?

-Income generated from separate property.

WARNING! In Idaho, Texas, Louisiana and Wisconsin, even income generated from separate
property can be considered community income, since it arose after the marriage partnership
began.

Here is an example:

Dan and Linda get married, while living in Washington State. Dan owned a house before they
were married and Linda had a 401(k) account. Each of those items is separate property.

After Dan & Linda married, they worked and earned a salary. Their salaries are considered
community income. They opened a joint bank account, which earned interest. Both the funds in
the joint account and the interest earned are considered community property. The interest is
community income.

They later purchased a home together, which is also community property.

Dan decides to rent out his house that he owned before they were married. The rental income is
considered separate property.

Why does this matter?

As long as Dan and Linda file a joint income tax return, it doesn't matter. All of the community
income is reported on one tax return. All of their income and deductions are combined.

But if they decide to file separate federal income tax returns, everything gets complicated. Dan
& Linda must each report their share (1/2) of the community income and their separate income.

Dan would report half of his salary, plus half of Linda's salary and half of the interest on the
bank account. He could deduct half of the mortgage interest and taxes paid on the house they
bought together.. He would report all of the rental income and expenses from his rental house.

Linda would report half of her salary, plus half of Dan's salary and half of the interest on the
bank account. Her 401(k) funds are not taxed yet, even if they increase in value. (Are you
getting concerned yet about how the funds would be taxed when she gets distributions from the
401(k)? Me too!) She could also deduct half of the mortgage interest and taxes on the house
they own together.

Why would they do this?

The married filing separately federal status is generally not favorable. Many tax breaks are not
allowed or are reduced for married couples filing separately. But sometimes it's the best choice.

Maybe Dan and Linda have separated and would rather not be responsible for the tax debts of the
other. When a joint return is filed, both spouses are liable for any taxes due.

Maybe the spouses are still together, but decide to file separate returns for personal or legal
reasons.

Missing information.

There is relief for a spouse who does not have all of the facts. In some cases, particularly in a
divorce, one spouse may not tell the other about all of his or her income. If one spouse can
establish that they did not know about an item of community income, and the couple files
separately, the non-reporting, non-earning spouse will not be held liable for the missing income.

But of course, the spouse who did know (they are the ones that earned it, after all!) would have
to report the income on their own, separately filed tax return.

Separated couples.

If a couple is going through a divorce, and everything is not settled up by tax time, filing a
separate tax return may be a wise course of action.

Are you in this position? Take the time to read IRS Publication 555-Community Property. Find
an attorney that understands the community property laws of your state.

Ms. Tamara Buck

Tamara Buck CPA

Married & divorcing couples in community property states have questions regarding the division of income when filing separate tax returns. This article discusses the difference between community property and income with separate property and income.