The long arm of community property laws.

• Author: Stevens, Michael G.

EXECUTIVE SUMMARY

* Nine states have some form of community property laws. These laws govern the interests of spouses in property and income acquired or earned during their marriage.

* In general, in a community property state, the husband and wife are considered to own equal and undivided half interests in each item of community property, and income earned by one spouse generally will be treated as if it had been earned half by each. However, there is considerable variation in the community property laws in the different states.

* Taxpayers living in community property states who separate or divorce are in some circumstances treated much differently for federal tax purposes than taxpayers living in common law states, particularly with respect to pensions and retirement accounts.

* Relief from the effects of community property laws is available in certain situations under the innocent spouse provisions in Sec. 6015.

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The impact of community property laws on a client's tax situation can be unexpected and diverse. The fact that a tax adviser practices in one of the 41 common law (non-community property law) states does not mean the adviser can pretend that community property laws are not possibly relevant to some of his or her clients. Community property laws may affect married clients if they ever lived in a community property state.

Overview

Nine states follow community property rules, which affect the interests of spouses in property and income acquired during a marriage. (1) Under community property laws, a marriage is viewed essentially as a partnership. Accordingly, the husband and wife are considered to own equal and undivided half interests in each item of community property. Income earned by one spouse generally will be treated as if it had been earned half by each.

For married spouses who file separate tax returns, each one generally has to report half of such income along with 100% of any income from his or her separate property. (2) This also applies to income produced by any property that is considered community property, such as investments purchased with community income. However, there are special situations in which this result may not ensue because it would be inequitable. (See the "Relief from Community Property Laws" section below.)

On the other hand, married taxpayers who file joint returns are jointly and severally liable for the tax computed on their aggregate income. (3) Community property laws do not directly affect these married taxpayers for federal income tax purposes.

The IRS points out that its rules regarding community property laws do not apply to an election available under Alaska law to treat property as community property. This is consistent with the Supreme Court's position on optional community property laws. (4)

Whether community property laws apply or not, and the type of community property laws that apply, can also affect the determination of other tax items such as the amount of the basis of property inherited by a surviving spouse. Community property laws will generally result in a lower capital gains tax when a taxpayer sells such property. Moreover, all the community property states allow spouses to vary the effects of the community property laws by written agreements. The IRS will recognize these agreements in accordance with state law. (5)

Part of the considerable complexity inherent in this area is a result of the fact that the community property laws vary among the nine community property states. For example, Arizona deems income earned by a spouse after a married couple has separated to be community income, but California treats it as separate income. Therefore, practitioners should check the laws of the particular jurisdiction applicable to their client.

Since federal tax law respects the characterization of property under the relevant state law of the state of domicile, (6) a client's tax situation may differ from one community property state to another. (7) In fact, the impact of state and local property laws on federal tax results can be substantial because these laws govern the fundamental aspects of property ownership such as transferability and basis.

Legal issues pertaining to certain concepts, such as where a spouse or couple live (domicile) and what a marriage is (based on the state of domicile), (8) also complicate matters. For example, the tax rules for reporting community income do not apply to registered domestic partners in California. (9) It remains to be seen what uncertainty may be thrown into this area as gay marriage laws evolve. It is incumbent upon the practitioner to monitor changes in state community property laws that may affect a client's tax situation.

Domicile

Of course, there may be disputes as to whether community property laws apply in the first place. This depends on the state in which the spouses are domiciled. "Domicile" refers to a permanent legal home that is intended to be used for an indefinite period and to which the inhabitants intend to return. (10) One's intentions as reflected by various actions help determine true domicile even if more than one home is present. Where do the spouses pay state income tax, vote, and own property; how long have they resided there; and what kind of ties to the community have they established? (11) Legally, a taxpayer may have more than one place of residence but only one domicile. Some states recognize that spouses may even have different domiciles. For example, Wisconsin does not subject either spouse to its community property rules unless both spouses are domiciled there. (12)

Classifying Property

Community property is generally property that an individual, his or her spouse, or both acquire during the marriage while both spouses are domiciled in a community property state; property that both spouses agreed to convert from separate to community property; or property that cannot be identified as separate property. Community income generally includes income from community property or salaries, wages, and other pay received for services performed by either spouse (or both) during marriage or from real estate that is treated as community property under the laws of the state where the property is located. (13)

Separate property is:

* Property that an individual or his or her spouse owned separately before marriage;

* Money earned while domiciled in a non-community property state;

* Property that an individual or his or her spouse received separately as a gift or inheritance during the marriage;

* Property that an individual or his or her spouse bought with separate funds or acquired in an exchange for separate property during the marriage;

* Property that an individual and his or her spouse converted from community property to separate property through an agreement valid under state law; or

* The part of property bought with separate funds, if part was bought with community funds and part with separate funds. (14)

Income from separate property is generally the separate income of the spouse who owns the property. However, in Idaho, Louisiana, Texas, and Wisconsin, income from most separate property is deemed to be community income.

Note that IRAs and Coverdell education savings accounts are deemed under federal law to be separate property. Thus, taxable distributions from them are separate property even if the funds in the account would otherwise be community property. They are taxable to the spouse whose name is on the account. (15) There can be other situations in which federal rights preempt state community property rights, such as with federally sponsored life insurance and U.S. savings bonds. (16) Also note that for purposes of the earned income credit, earned income is to be computed without regard to any community property laws. (17)

If spouses file separate returns, the allocation of deductions usually depends on whether the expenses relate to community or separate income. Expenses incurred to earn or produce community business or investment income are generally divided equally between the spouses. If separate business or investment income is involved, the spouse who earns the income deducts the expenses. (18)

Community Property Laws Reach into Common Law States

Never before has our society been more mobile. Population shifts are dynamic, and people will move to wherever professional opportunities, quality of life, and affordability overlap. Retirees tend to move to the "sunbelt" states. Thus, many clients may have lived in a community property state, leading to the possibility that community property rules may still affect property and related income, depending on the laws of the state they now live in.

If a married couple moves to a community property state from a common law state, how does the community property state classify property the couple already owns? Some states, such as California, may treat the property as community property for certain purposes--for example, for division upon a divorce--if it would have been community property had it been acquired in the community property state. (19) Such property may be referred to as quasi-community property. Other community property states will simply honor the rules of the state where the couple acquired the property...