Tax on Income in Community Property States
When married couples file separate income tax returns, a special problem arises. Tax is not computed just on income earned by each spouse. Instead, wages and other income earned by a husband and wife must be allocated according to state law, as will income earned from property held by a married couple, either jointly or separately.
The law in nine states is based on a community property system. The property rights of married couples are different in these states, than the property rights of married couples living in the common law states. Under the community property system, property is deemed to be either separate propertyseparate propertyProperty obtained by gift, inheritance, or prior to marriage. or community property. Separate property includes property acquired by a spouse before marriage or received after marriage as a gift or inheritance. All other property owned by a married couple is deemed to be community property. For federal income tax purposes, each spouse is automatically taxed on half of the income from community property.
The tax treatment of income from separate property depends on the taxpayer‘s state of residence. In four community property states, half of the income from community property and half of the income of most separate property will be taxed to each spouse.
In the other five community property states, income on separate property is “separate income” and is reported in full on the tax return of the spouse who owns the property. Income such as nontaxable dividends or royalties from mineral interests assumes the classification of the asset from which the income is earned. Capital gains also retain their classification based on the classification of the property from which the gain arises. The nine states that use the community property system are listed in Table 6.1, “Community Property States”.
Table 6.1. Community Property States
| Separate Property | Separate Community Property |
|---|---|
| Arizona | Idaho |
| California | Louisiana |
| Nevada | Texas |
| New Mexico | Wisconsin |
| Washington |
Example
Tony and Wilma are married and live in Idaho. Tony owns, as his separate property, stock in Google. During the year, Tony receives dividends of $3,000. Assuming Tony and Wilma file separate returns, each of them must report $1,500 of the dividends. On the other hand, if they live in Nevada, Tony would report the entire $3,000 of the dividends on his tax return and Wilma would not include any of the dividend income on her tax return. How to report income while living in a community property state only becomes an issue when a married couple files separate income tax returns.
In all of the community property states, income from salary and wages is generally treated as having been earned one-half by each spouse.
Example
Matt and Linda are married but file separate tax returns. Matt receives a salary of $60,000 and has interest income of $1,000 from his savings account established with salary Matt earned since his marriage. Linda collects $10,000 in dividends on stock she inherited. The amount of income, which Linda must report on her separate income tax return depends on the state in which Matt and Linda reside. Three different assumptions are presented below:
| State of Residence | |||
|---|---|---|---|
| Arizona | Wisconsin | New York | |
| Salary | $30,000 | $30,000 | none |
| Dividends | 10,000 | 5,000 | $10,000 |
| Interest | 500 | 500 | none |
| Total | $40,500 | $35,500 | $10,000 |
To simplify problems that could arise when married spouses residing in a community property state do not live together, the tax law contains an exception to the above community property rules. Under this special provision, a spouse will be taxed only on his or her actual earnings from personal services. For this provision to apply, the following conditions must be satisfied:
The individuals must live apart for the entire year,
They must not file a joint return, and
No portion of the earned income may be transferred between the spouses.
Example
Nancy and Mike live in Nevada. They are married but live apart for the entire year. Nancy‘s salary was $40,000 and Mike‘s salary was of $30,000. Normally, Nancy and Mike would each report $35,000 but if the required conditions are met, they would each report their own salary. If Nancy and Mike had any unearned income, such as dividends or interest, the income would be reported under the general community property rules. The special provision applies only to earned income of the spouses.
Another provision addresses the problem of spouses who fail to qualify for the above special exception because they do not live apart for the entire year. In certain cases, a spouse who fails to include in income his or her share of community income, as required by the community property laws, may be relieved of any liability related to this income. To be granted relief, the taxpayer must not know of or have reason to know of the omitted community property income.
Questions
Joel and Kate are married and live in Katy, Texas. Kate earns a salary of $45,000 and Joel has $25,000 of rental income from his separate property. If Kate and Joel file separate tax returns, what amount of income must Joel report?
$0
$22,500
$25,000
$47,500
None of the above
Which of the following conditions need not be satisfied in order for a married taxpayer, residing in a community property state, to be taxed only on his or her separate salary?
The husband and wife must live apart for the entire year
A minor child must be living with the spouse
The husband and wife must not file a joint income tax return
The husband and wife must not transfer earned income between themselves
All of the above must be satisfied
