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The Long Arm of Community Property Laws

In nine states, community property laws govern the interests of spouses in income and property they acquire or earn during marriage and affect the federal tax treatment of those individuals during and after marriage.

August 2009
by Michael Stevens/The Tax Adviser

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. 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 percent of any income from his or her separate property. 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.

On the other hand, married taxpayers who file joint returns are jointly and severally liable for the tax computed on their aggregate income. 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.

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.

This article has been excerpted from The Tax Adviser. View the full article here (PDF).