Community property conundrums abound

Editor: Alexander Semerano, CPA

For practitioners such as myself who live in Texas or one of the eight other community property states, community property means complexity when married clients want to file separately and in determining tax benefits to the surviving spouse when the other spouse dies. But what about practitioners who work in the 41 other states — why should they care about community property? In our increasingly wealthy and mobile society, practitioners need to be aware of the laws of other states to properly prepare both federal and state tax returns. This item highlights some of the ways in which community property laws could affect the tax situation of clients residing in common law states.

The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In addition to these nine states, three states have laws that allow for a community property election: Alaska, South Dakota, and Tennessee. The IRS views elective community property differently than it does statutory community property. On page 2 of Publication 555, Community Property, the IRS states that this publication does not apply to individuals in elective community property states.

Several times, individual clients who have gotten married have told me that they plan on filing their tax returns separately. My first question is, “Do you have a prenup?” A prenuptial agreement can override the community property laws and allow the couple to agree on how income earned is to be allocated and who owns property obtained during the marriage. However, the usual answer to my question about a prenuptial agreement is “no.” In most cases, any income received for services during the marriage is community property income. Therefore, to file separately in one of these community property states means having to report half the income from each spouse’s Form W-2, Wage and Tax Statement, on each tax return. That is not what my clients are thinking when they indicate that they want to file separately.

In addition to wages being treated as community property income, income from community property real estate is considered community property income. An important item to remember is that property that is owned separately before marriage is considered separate property. However, in Idaho, Louisiana, Texas, and Wisconsin, income earned on most separate property is considered community property income. Community income generally includes income from real estate that is treated as community property under the laws of the state where the property is located. So, this is one area where practitioners in other states need to know about community property laws. Did your married client in Kansas buy a condo on South Padre Island, Texas, with separate property income to use personally and rent out? The condo is considered separate property, but the rental income from that property is considered community property income to the couple because it is earned in Texas.

Separate property generating community property income also has many implications for residents of these four community property states. For example, in these states, an inherited brokerage account is considered separate property, but the earnings on that account are considered community property income. To avoid commingling separate property and community property, the income from the account needs to be swept into a joint account monthly.

Our mobile society can also cause practitioners in common law states to have to deal with community property laws. Did that new client move to Colorado from California or Texas? If so, then they just brought that community property with them. So, if the new client has one brokerage account that is considered community property and one that is considered separate property prior to the move, the income in Colorado on the community property account is community property income. However, the income on the separate property account for a client from Texas is now separate property income and no longer needs to be swept into a joint account. As long as the married couple is filing jointly, whether the income is considered separate property or community property has little impact on the tax filing, but such a distinction could have significant impact if they choose married filing separately status.

Additionally, death or divorce when community property assets are involved can have significant tax implications. If one spouse dies, the community property will have substantial implications postmortem for the filing of Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, and for income taxes. When a person dies owning community property, the entire asset is included in the estate of the deceased person because each spouse is considered to own an equal and undivided half interest in the property. However, there is also a deduction for one-half of the value of the community property interest to get to the reportable asset value on Form 706. This deduction is separate from the marital deduction because it removes value that is not part of the estate. Due to the equal and undivided interest, all community property receives a basis step-up upon the death of the first spouse. Thus, the spouse’s one-half share of the community property is stepped up to fair market value, even though it is not subject to estate tax at the first spouse’s death.

When a couple who has lived in a community property state during their marriage divorces, the implications of the community property created during their marriage can affect the divorce settlement even if the couple lives in a common law state at the time of the divorce. One example of this can be found in Balding, 98 T.C. 368 (1992), in which the divorce settlement included the taxpayer’s relinquishment of her interest in her ex-husband’s military retirement pay in exchange for cash payments. The court ruled the payments were treated as a nontaxable gift under Sec. 1041, Transfers of Property Between Spouses or Incident to Divorce, and not an assignment of income. For more considerations regarding community property during divorce and much more detailed information on the tax implications of community property, see Stevens, “The Long Arm of Community Property Laws,” 40 The Tax Adviser 536 (August 2009).

If your clients live in a community property state, you must be aware of the tax implications of community property and how community property laws may affect a married couple’s tax filing even in a common law state, through real property ownership or previous domicile in a community property state. Therefore, when considering tax planning involving married filing separately status, remember to dig deeper and determine the proper allocation of income and expenses if any of the property could be considered community property. And if you are preparing the income tax return of a widow or widower from a community property state, make sure you have the proper stepped-up basis for reporting gains and losses.

Editor Notes

Alexander Semerano, CPA, is a partner with Pease Bell CPAs in Cleveland.

For additional information about these items, contact Alexander Semerano at taxclinic@cpamerica.org.

Unless otherwise noted, contributors are members of or associated with CPA America.