Income in Community Property States

Chapter 4 Digging Deeper

Contents:

INCOME IN COMMUNITY PROPERTY STATES

1. General. State law in Louisiana, Texas, New Mexico, Arizona, California, Washington, Idaho, Nevada, and Wisconsin is based upon a community property system. Alaska residents can elect community property treatment. All other states have a common law property system. The basic difference between common law and community property systems centers around the property rights of married persons. Questions about community property income most frequently arise when husband and wife file separate returns.

Under a community property system, all property is deemed either to be separately owned by the spouse or to belong to the marital community. Property may be held separately by a spouse if it was acquired before marriage or received by gift or inheritance following marriage. Otherwise, any property is deemed to be community property. For Federal tax purposes, each spouse is taxed on one-half of the income from property belonging to the community.

The laws of Texas, Louisiana, Wisconsin, and Idaho distinguish between separate property and the income it produces. In these states, the income from separate property belongs to the community. Accordingly, for Federal income tax purposes, each spouse is taxed on one-half of the income. In the remaining community property states, separate property produces separate income that the owner-spouse must report on his or her Federal income tax return.

What appears to be income, however, may really represent a recovery of capital. A recovery of capital and gain realized on separate property retain their identity as separate property. Items such as nontaxable stock dividends, royalties from mineral interests, and gains and losses from the sale of property take on the same classification as the assets to which they relate.

Example:Bob and Jane are husband and wife and reside in California. Among other transactions during the year, the following occurred.

Nontaxable stock dividend received by Jane on stock that was given to her after her marriage by her mother
Gain of $10,000 on the sale of unimproved land purchased by Bob before his marriage.
Oil royalties of $15,000 from a lease Jane acquired after marriage with her separate funds.

Since the stock dividend was distributed on stock held by Jane as separate property, it also is her separate property. The same result occurs for the oil royalties Jane receives. All of the proceeds from the sale of the unimproved land (including the gain of $10,000) are Bob's separate property.

In all community property states, income from personal services (e.g., salaries, wages, income from a professional partnership) is generally treated as if one-half is earned by each spouse.

Example:Fred and Wilma are married but file separate returns. Fred received $25,000 salary and $300 taxable interest on a savings account he established in his name. The deposits to the savings account were made from Fred's salary that he earned since the marriage. Wilma collected $2,000 taxable dividends on stock she inherited from her father. Wilma's gross income is computed as follows, under three assumptions as to the state of residency of the couple.

California / Texas / Common
Law States
Dividends / $2,000 / $1,000 / $2,000
Salary / 12,500 / 12,500 / -0-
Interest / 150 / 150 / -0-
$14,650 / $13,650 / $2,000

Community Property Spouses Living Apart. The general rules for taxing the income from services performed by residents of community property states can create complications and even inequities for spouses who are living apart.

Example:Cole and Debra were married but living apart for the first nine months of 2007 and were divorced as of October 1, 2007. In December 2007, Cole married Emily, who was married but living apart from Frank before their divorce in June 2007. Cole and Frank had no income from personal services in 2007.

Cole brought into his marriage to Emily a tax liability on one-half of Debra's earnings for the first nine months of the year. However, Emily left with Frank a tax liability on one-half of her earnings for the first six months of 2007.

When this occurs, the accrued tax liability could be factored into a property division being negotiated at a time when the parties do not need further complications. In other cases, an abandoned spouse could be saddled with a tax on income earned by a spouse whose whereabouts are unknown.

Congress has developed a simple solution to the many tax problems of community property spouses living apart. A spouse (or former spouse) is taxed only on his or her actual earnings from personal services if the following conditions are met.

The individuals live apart for the entire year.
They do not file a joint return with each other.
No portion of the earned income is transferred between the individuals.

Example:Jim and Lori reside in a community property state, and both are gainfully employed. On July 1, 2007, they separated, and on June 30, 2008, they were divorced. Assuming their only source of income is wages, one-half of such income for the year is earned by June 30, and they did not file a joint return for 2007, each should report the following gross income.

Jim's Separate
Return / Lori's Separate
Return
2007 / One-half of Jim's wages / One-half of Jim's wages
One-half of Lori's wages / One-half of Lori's wages
2008 / All of Jim's wages / All of Lori's wages

The results would be the same if Jim or Lori married another person in 2008, except that the newlyweds would probably file a joint return.

The IRS may absolve from liability an innocent spouse who does not live apart for the entire year and files a separate return but omits his or her share of the community income received by the other spouse. To qualify for the innocent spouse relief, the taxpayer must not know or must have no reason to know of the omitted community income. Even if all of these requirements cannot be satisfied, the IRS has additional statutory authority to absolve the innocent spouse from tax liability. If, under the facts and circumstances, it is inequitable to hold the spouse liable for any unpaid tax, the IRS can absolve the spouse from tax liability.

Planning with Community Property. The classification of income as community or separate property becomes importantwhen either of two events occurs.

Husband and wife, married taxpayers, file separate income tax returns for theyear.
Husband and wife obtain a divorce and therefore file separate returnsfor the year.

For planning purposes, it behooves married persons to keep track of the sourceof income (community or separate). To be in a position to do this effectively whenincome-producing assets are involved, it may be necessary to distinguish betweenseparate and community property.

INCOME FROM PROPERTY

2. Dividends. The following payments are frequently referred to as dividends but are not considered dividends for tax purposes.

Dividends received on deposits with savings and loan associations, credit unions, and banks are actually interest (a contractual rate paid for the use of money).
Patronage dividends paid by cooperatives (e.g., a farm cooperative) are rebates made to users and are considered reductions in the cost of items purchased from the association. The rebates are usually made after year-end (after the cooperative has determined whether it has met its expenses) and are apportioned among the members on the basis of their purchases.
Mutual insurance companies pay dividends on unmatured life insurance policies that are considered nontaxable rebates of premiums.
Shareholders in mutual investment funds are allowed to report as capital gains their proportionate share of the funds’ gains that are realized and distributed. The capital gain and ordinary income portions are reported on the Form 1099 that funds supply to shareholders each year.
When a corporation issues a simple stock dividend (e.g., common stock issued to common shareholders), the shareholder has merely received additional shares that represent the same total investment. Thus, the shareholder does not recognize income.

INTEREST ON CERTAIN STATE AND LOCAL GOVERNMENT OBLIGATIONS

3. The lower cost for the state and local governments is more than offset by the revenue loss of the Federal government. Many consider the exclusion of tax-exempt interest to be a substantial loophole for the very wealthy. For these reasons, bills have been introduced in Congress calling for Federal government subsidies to state and local governments that voluntarily choose to issue taxable bonds. Under the proposals, the tax-exempt status of existing bonds would not be eliminated.

INCOME FROM DISCHARGE OF INDEBTEDNESS

4. Shareholder Cancellation

Example:Red Corporation owes Connor $10,000. Connor is a shareholder of Red. If Connor cancels the debt in exchange for $9,000 of Red’s stock, Red will have gross income of $1,000. If Connor’s basis for the Red corporation debt is $10,000, Connor will have a bad debt of $1,000 (see Chapter 6 for a discussion of the bad debt deduction).

GAINS AND LOSSES FROM PROPERTY TRANSACTIONS

5. Capital Gains and Losses.To ascertain the appropriate tax treatment of capital gains and losses, a complex netting process is applied. First, capital gains and losses must be classified as short term or long term, based on the holding periods noted above. Capital gains and losses are then netted within each category. In particular, short-term capital losses (STCL) are offset against short-term capital gains (STCG), resulting in either a net short-term capital loss (NSTCL) or a net short-term capital gain (NSTCG). Similarly, long-term capital losses (LTCL) are offset against long-term capital gains (LTCG), resulting in either a net long-term capital gain (NLTCG) or a net long-term capital loss (NLTCL). After netting within category, the categories are netted against each other, with losses always being netted first against gains in the category carrying the highest tax rate.

Example:Colin has a 35% marginal tax rate and has the following capital transactions for the year.

Penguin Corporation stock (held for 7 months) / $ 1,000
Owl Corporation stock (held for 9 months) / (3,000)
Flamingo Corporation bonds (held for 14 months) / 2,000
Land (held for 3 years) / 4,000

The Penguin Corporation gain of $1,000 is offset by the Owl Corporation loss of $3,000. The resulting NSTCL of $2,000 then offsets the NLTCG of $6,000 from the sale of the bonds and the land. The $4,000 net capital gain is taxed at a 15% rate.